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International Parity Relationships and Forecasting Foreign Exchange Rates

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International Parity Relationships and Forecasting Foreign Exchange Rates

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Interest Rate Parity (IRP) is an arbitrage condition that must hold when international financial

markets are in equilibrium.

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Theory of purchasing power parity (PPP):

The exchange rate between two currencies should equal the ratio of the countries’ price levels:

S($/£) =P$/P£

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The Fisher effect holds that an increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the

country.

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Interest Rate Parity Defined

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Covered Interest Arbitrage

When IRP doesn’t hold, the situation also gives rise to covered interest arbitrage

opportunities.

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IRP and Exchange Rate

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Reasons for Deviations from Interest Rate Parity

Transactions Costs

The interest rate available to an arbitrageur for borrowing, ib , may exceed the rate he can lend at, il.

There may be bid-ask spreads to overcome, Fb/Sa < F/S

Thus

(Fb/Sa)(1 + i£b) − (1 + i$a) </= 0

Capital Controls

Governments sometimes restrict the import and export of money through taxes or outright bans.

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Purchasing Power Parity and Exchange Rate Determination

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PPP Deviations and the Real Exchange Date

If there are deviations from PPP, changes in nominal exchange rates cause changes in the real exchange rates, affecting the international competitive positions of countries. This, in turn, would affect countries’ trade balances.

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Exact Equilibrium Exchange Rate Relationships

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Exact Equilibrium Exchange Rate Relationships

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Efficient Markets Approach

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Fundamental Approach

Generating forecasts using the fundamental approach would involve three steps:

Step 1: Estimation of the structural model like Equation 6.18 to determine the numerical

values for the parameters such as α and β’s.

Step 2: Estimation of future values of the independent variables like (m − m*), (v − v*), and

(y* − y).

Step 3: Substituting the estimated values of the independent variables into the estimated

structural model to generate the exchange rate forecasts.

The downside is that fundamental models do not work any better than the forward rate model or the random walk model.

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Technical Approach

Technical analysis first analyzes the past behavior of exchange rates for the purpose of identifying “patterns” and then projects them into the future to generate forecasts..

Clearly it is based upon the premise that history repeats itself.

Thus it is at odds with the EMH

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Performance of the Forecasters

Forecasting is difficult, especially with regard to the future.

As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate.

The founder of Forbes Magazine once said:

“You can make more money selling financial advice than following it.”