Chapter 2

Foreign Exchange Parity Relations

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Introduction
In this chapter we look at:
Foreign exchange fundamentals; in particular
the balance of payments and exchange rate regimes. Describe the factors that cause a nations currency to appreciate or depreciate. International parity relations. Define and discuss the International Fisher relation.
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Introduction
Discuss the implications of the parity
relationships combined.

Exchange rate determination theories and their

potential implications.

Discuss the asset markets approach to pricing

exchange rate expectations.

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Supply and Demand for Foreign Exchange

In general, there are many types of

transactions that affect the demand and supply of one national currency. From an accounting viewpoint, each country keeps track of the payments on all international transactions in its balance of payments.

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Exhibit 2.1: Foreign Exchange Market Equilibrium

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Balance of Payments
The balance of payments tracks all financial
flows crossing a countrys borders during a given period (a quarter or a year). A balance of payments is not an income statement nor a balance sheet. The convention is to treat all financial inflows as a credit to the balance of payments.

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Balance of Payments
An export, for example, creates a financial
inflow for the home country, whereas an import creates an outflow. There are two main categories: Current account Financial account

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Current Account
Covers all current transactions that take place in
the normal business of residents of a country. Dominated by the trade balance, the balance of all exports and imports. Made up of: Exports and imports (trade balance) Services Income Current transfers

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Current Account
It also covers:

Services (such as services in transportation,

communication, insurance and finance). Income (interest, dividends and various investment income from cross-border investments). Current transfers (flows without quid pro quo compensation).

A current account deficit is not necessarily a bad

economic signal as long as nonresidents are willing to offset it by investment flows.

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Financial Account
Covers investments by residents abroad and
investments by nonresidents in the home country. It includes: Direct investment made by companies. Portfolio investments in equity, bonds and other

securities of any maturity. Other investments and liabilities (such as deposits or borrowing with foreign banks and vice versa).

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Financial Account
The sum of the current and financial
accounts should be zero. Question: What if the overall balance is negative? Answer: The central bank can use up part of its reserves to restore a zero balance.

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Capital and Financial Account

The Capital Account includes unrequited
(unilateral) transfers corresponding to capital flows without compensation such as foreign aid, debt forgiveness and expropriation losses. This is typically a very small account with a misleading title. It is often aggregated with the financial account (capital and financial account).

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Capital and Financial Account

Similarly, Net Errors and Omissions (or
statistical discrepancy) are usually aggregated with the capital and financial account. To be sustained, a current account deficit must be financed by a financial account surplus.

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Exhibit 2.2: U.S. Balance of Payments for 2004

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Balance of Payments Equilibrium

The sum of the current account and of the capital
and financial account is called the overall balance and should be zero in the absence of government intervention. The official reserve account tracks all reserve transactions by the monetary authorities. By accounting definition, the overall balance must mirror the official reserve account.

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Differences in Economic Performance

Financial flows are attracted by high

expected return, but also by low risk. Desired Attributes: A stable political system A rigorous but fair legal system A fair tax system Free movements of capital

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Factors That Cause a Nations Currency to Appreciate or Depreciate

In a flexible exchange rate system, the value

of a currency is driven by changes in fundamental economic factors. Amongst the factors are: Differences in national inflation rates. Changes in real interest rates. Differences in economic performance. Changes in investment climate.
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Government Policies: Monetary and Fiscal

An expansionary monetary policy will lead to a
depreciation of the home currency. A restrictive monetary policy will lead to an appreciation of the home currency. A more restrictive fiscal policy should also slow down economic activity and inflation. These two factors should lead to an appreciation of the home currency. A more expansionary fiscal policy has the reverse effect.

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Exchange Rate Regimes

Historically, there have been three different
regimes: Flexible (or Floating) Exchange Rates Fixed Exchange Rates Pegged Exchange Rates

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Flexible (Floating) Exchange Rate Regime

One in which the exchange rate between two
currencies fluctuates freely in the foreign exchange market. Advantage The exchange rate is a market-determined price that
reflects economic fundamentals at each point in time. Governments are free to adopt independent domestic monetary and fiscal policies.

Disadvantage

Quite volatile exchange rates.

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Fixed Exchange Rate Regime

One in which the exchange rate between two
currencies remains fixed at a preset level, known as official parity. Advantages: Eliminates exchange rate risk, at least in the short run. Brings discipline to government policies. Disadvantages: Deprives the country of any monetary independence. Also constrains countrys fiscal policy. Its long-term credibility

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Currency Board
Today some countries try to maintain a
fixed exchange rate regime against the dollar or euro. This is done through a currency board The supply of home currency is fully backed by an equivalent amount of that major currency.

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Pegged Exchange Rate Regime

Characterized as a compromise between a flexible
and a fixed exchange rate. The exchange rate is allowed to fluctuate within a
(small) band around a target exchange rate (peg) and the target exchange rate is periodically revised to reflect changes in economic fundamentals.

Advantages
country.

Reduces exchange rate volatility in the short run. Also encourages monetary discipline for the home Can induce destabilizing speculation.

Disadvantage

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International Parity Relations

The parity relations of international finance
are as follows: Interest rate parity relation Purchasing power parity relation. International Fisher relation. Uncovered interest rate parity relation. Foreign exchange expectation relation.

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International Parity Relations: Definitions

The term spot rate (S) refers to the exchange rate
for immediate delivery. The forward rate (F) is set on one date for delivery at a future specified date. For example, the $: forward exchange rate for delivery in six months might be F = 106.815 yen per dollar. rFC and rDC are the foreign and domestic interest rates (annualized). IFC and IDC are the foreign and domestic inflation rates (annualized).
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Interest Rate Parity Relation

Interest rate parity is the relation that the
forward discount (premium) equals the interest rate differential between two currencies. Indicates that what we gain on the interest rate differential, we lose on the discount on the forward contract.

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Interest Rate Parity Relation

Exact relation
F/S = (1 + rFC)/(1 + rDC)

Linear approximation
= F/S -1 rFC - rDC

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Parity Relations
The purchasing power parity relation,
linking spot exchange rates and inflation. The International Fisher relation, linking interest rates and expected inflation. The uncovered interest rate parity relation, linking spot exchange rates, expected exchange rates and interest rates. The foreign exchange expectation relation, linking forward exchange rates and expected spot exchange rates.
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Purchasing Power Parity (PPP) Relation

PPP states that the spot exchange rate

adjusts perfectly to inflation differentials between two countries. There are two versions of PPP: Absolute PPP
This claims that the exchange rate should be equal
to the ratio of the average price levels in the two economies.

Relative PPP
Focuses on the general across the board inflation
rates.
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Purchasing Power Parity (PPP) Relation

Relative PPP
This claims that the percentage movement of
the exchange rate should be equal to the inflation differential between the two economies

The PPP relation is presented as:

Exact
S1/S0 = (1 + IFC)/(1 + IDC) Linear approximation s = S1/S0 1 IFC - IDC
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Purchasing Power Parity (PPP) Relation

PPP says that what you gain with lower

domestic inflation, you can expect to lose on foreign currency depreciation when you invest in foreign currency assets.

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International Fisher Relation

Claims that the interest rate differential between
two countries should be equal to the expected inflation rate differential over the term of the interest rate. The International Fisher Relation can be represented as: Exact

(1 + rFC)/(1 + rDC) = (1 + E(IFC))/(1 + E(IDC)) Linear approximation rFC rDC E(IFC) - E(IDC)
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Example
Question: How are the nominal and real
interest rates calculated? Answer: Nominal interest rate is observed in the marketplace. The real interest rate is calculated from the observed interest rate and forecasted inflation.

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Uncovered Interest Rate Parity Relation

This is a theory combining purchasing power
parity and the international Fisher relation. It refers to the exchange rate exposure not covered by a forward contract. It claims the expected change in the indirect exchange rate approximately equals the foreign minus the domestic interest rate. It can be represented as: Exact

E(S1)/S0 = (1 + rFC)/(1 + rDC) Linear Approximation E(s) = E(S1)/S0 1 rFC - rDC

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Foreign Exchange Expectation Relation

This relation states that the forward

exchange rate, quoted at time 0 for delivery at time 1, is equal to the expected value of the spot exchange rate at time 1. This can be written as:
F = E(S1)

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Combining Relations - Summary

Interest rate differential: forward discount (premium)
equals the interest rate differential. Inflation differential: exchange rate movement should exactly offset any inflation differential. Expected inflation rate differential: expected inflation rate differential should be matched by the interest rate differential, assuming (Fisher) real interest rates are equal. The interest rate differential: expected to be offset by the currency depreciation. The expected exchange rate movement: forward discount (or premium) is equal to the expected exchange rate movement.
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Summary of Parity Relations

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Exhibit 2.3: International Parity Relations Linear Approximation

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Exchange Rate Determination

The following approaches are proposed:
Fundamental value based on relative PPP Balance of Payments Approach Asset Market Approach

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Fundamental Value Based on Relative PPP

Such estimation is not an easy task and exchange
rates can become grossly misaligned and remain so for several years without a correction. This correction will usually take place, but it may take several years and its timing is unclear. Additional models are needed to provide a better understanding of exchange rate movements.

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Exhibit 2.4: Fundamental Value for the Japanese Yen

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Balance of Payments Approach

An analysis of balance of payments provided the
first approach to the economic modeling of the exchange rate. The four component groups include the current account, financial account, capital account and official reserves account. An imbalance in some account could lead to a depreciation or appreciation of the home currency.

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Sources of Data for BOP

Customs data Central bank stats Bank reports of transactions

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BOP Components
Current Account Capital account Financial account Official reserve account

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Exhibit 2.5: Balance of Payments and the Dollar Exchange Rate

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Asset Market Approach

This approach claims that the exchange rate is the
relative price of two currencies, determined by investors expectations about the future, not by current trade flows. News (unexpected information) about future economic prospects should affect the current exchange rate. Several types of news influence exchange rates.

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Asset Market Approach: A Simple Example

Lets consider a one-time sudden and unexpected increase
in the domestic money supply that will lead to higher home inflation. The long-run exchange rate effect is a depreciation of the home currency so that purchasing power parity is maintained as the percentage increase in the price level matches the percentage increase in the money supply. Given sticky-goods prices, the short-run exchange rate effect is an immediate drop in the real interest rate and more depreciation of the currency than the depreciation implied by purchasing power parity.

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Exhibit 2.6:
Exchange Rate Dynamics

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