Advance Topics in

International Finance
Dr. Wajid Shakeel Ahmed
(RMS 1st & 2nd)
Fall 2022
The Balance of Payments
BOP information, measurements, components and derivation
The Balance of Payments and Exchange Rate

• Domestic residents can engage in a variety of

international transactions involving the purchase
or sale of goods, services, and assets.

• BoP accounts are an accounting record of all

monetary transactions that have taken place
during a given period between a country and the
rest of the world.
BOP

• These transactions include payments for the

country’s exports and imports of goods, services,
financial capital, and financial transfers.

• The BoP accounting system reveals whether

countries are in surplus or deficit on trade or
capital transactions with the rest of the world.
BOP

• Sources of funds for a nation, such as exports or

the receipts of loans and investments, are
recorded as positive or surplus items.

• Uses of funds, such as for imports or investment in

foreign countries, are recorded as negative or
deficit items.
(BoP = 0).
Information by BOP
• Very useful for business managers, economists,
government officials, and academics for many
reasons;

• First, the BoP helps to forecast a country’s market

potential, especially in the short-run.
• Second, the BoP can be used as an important
indicator of pressure on a country’s foreign exchange
rate (or on other domestic prices, if the country does
not have its own currency, e.g., Eurozone members)
Continue…

• Finally, the BoP is also important to government

officials because it influences a nation’s GDP,
employment, prices, exchange rate, interest
rate, and public policies.
Measuring the Balance of Payments

• The BoP accounts are a systematized procedure

for measuring, summarizing, and stating the
effects of all economic, financial, and
accommodating transactions between residents
of a country and residents of the rest of the
world during a particular time period.
Continue…
• If a nation earns more abroad than it spends,
that nation incurs a “surplus” in a sub-account of
its balance of payments.

• BoP accounts are intended to show the size of

any deficit or surplus and to indicate the manner
in which it was financed—that is, settled by the
central bank of the nation.
Dr. & Cr. Of A/c’s of BOP
• The first thing to clarify is the notion of a “resident.”
• Individuals in the e.g., United States, but also of US
firms and the US government at all levels.

• The basic rule of BoP accounting is that any

transaction giving rise to a receipt from the rest of
the world is considered a credit (+) and appears as a
positive item in the account; these are transactions
in which the country earns foreign currency or assets.
Continue…
• Any transaction giving rise to a payment to the rest
of the world is a debit (−) and appears as a negative
item; with these transactions, the country expends
foreign assets.

• In general, international sales of a nation they

generate “capital inflows” (Credits). Conversely,
international purchases, whether in the form of
goods, services, or assets, are regarded as debits.
They generate “capital outflows” for the country).
BOP Components
• The BoP is composed of three basic groups of
accounts: the current account (CA), the capital
account (KA), and the official settlements
(reserves) account (OS); each one of them is
divided into some subaccounts. Exhibit 1.1

• The term “balance of payments” often refers to

this sum (OS = 0):
• BoP = CA+KA=−100+100= 0 (1.1)
Continue…
• The central bank settles the BoP to zero by
accumulating foreign assets, or “gains” (OS < 0).
• BoP = CA+KA+OS =−100+120−20= 0
(1.2)

• There is said to be a balance of payments deficit

if the CA is less than the KA. In this case, the
central bank pays for the deficit by offering
foreign assets, or “losses” (OS > 0).
• BoP = CA+KA+OS =−100+90+10= 0
Exchange rate System
• Under a fixed exchange rate system
• central bank accommodates - buying up any net
inflow of funds into the country;
• by providing foreign currency funds to the foreign
exchange market - international outflow of funds;
• Off-set E.R effect
• balance of payments surplus or deficit - net change
per year in the central bank’s foreign exchange
reserves;
Continue…
• “managed float,” - where some changes of
exchange rates are allowed;

• a “purely floating exchange rate,” also known as

a “purely flexible exchange rate” - The central
bank does not intervene at all to protect or
devalue its currency - rate to be set by the
market - the central bank’s foreign exchange
reserves do not change;
Sterilization Policy
• for a balance of payments deficit - loses foreign
assets, and the bank’s reserves fall;
• the monetary base (MB) is declined - the money
supply (Ms) is reduced - due to money multiplier
(mM);
• And vis – a – versa;
• Fed sterilizes the deficits and surpluses of trade by
buying or selling government securities - offset the
effect on the monetary base;
• sterilization policy - neutralizing the monetary
impact of payments imbalances;
Composition of the Accounts of the
BoP
• The two principal parts of the BoP accounts are
the current account and the capital account;

• the sum of these previous two accounts is not =

0 - an intervention by the central bank through
the official settlement or official reserve account
(OS) makes the overall balance zero (BoP = 0);
Continue…
• current account shows - sum of the trade account or
merchandise trade (XGoods−MGoods);
• the services and “invisible” trade item (XServices
−MServices);
• The income receipts/payments is income derived from
the ownership of assets;
• unilateral (unrequited) transfers are one-way transfers
of assets;
• Table 1.1 gives the US international trade in goods and
services;
Capital Account
• The capital account measures the international economic
transactions of financial and non-financial assets;
• capital transfers – tangible and intangible financial assets;
• financial account - includes direct foreign investment,
portfolio investment, government;
• By the principles of double entry accounting - an entry in
the current account gives rise to an entry in the capital
account, and in aggregate, the two accounts
automatically balance;
• BoP ≡ CA+KA = 0 (1.4)
Continue…
• Official Settlements (Reserves and Related
Items) are the total reserves held by official
monetary authorities within the country;
• monetary gold, major or “hard” currencies used
in international trade and financial transactions,
SDRs, reserve position in the IMF etc.

• BoP ≡ CA+KA+OS = 0
(1.5)
International Imbalances between
Countries
• there is concern over deficits in the current
account, known as external debt;
• types of deficits that typically raise concern are;
• (1) a visible trade account deficit - (TA = X − M <
0);
• (2) An overall current account deficit - (CA < 0);
• (3) A basic deficit – CA + FA (FDI + PI only)
“Washington Consensus”
• Period saw a swing of opinion toward the view that
there is no need to worry about imbalances.
• Opinion swung back in the opposite direction in the
wake of the financial crisis and the debt crises which
followed from 2007 to 2012.
• Mainstream opinion expressed by the leading
financial press and economists, international bodies
like the IMF, and leaders of surplus and deficit
countries has returned to the view that large current
account imbalances do matter.
BOP Imbalances
• The conventional view is that current account
deficits are due to excess aggregate spending
(absorption) by domestic residents compared
with the domestic production
• (Y −E ≡X −M <0);
• Savers in surplus countries, runs ahead of the
available investment opportunities and is pushed
into the United States - resulting in excess
consumption and asset price inflation;
BOP Imbalances - Causes
• CA Effect
Y ↓, E ↑⇒TA< 0⇒Payments for foreign products ↑
⇒domestic debts ↑⇒ domestic securities ↑

• KA Effect
• ⇒M(X ∗) ↑⇒Y ∗ ↑ and S∗ ↑ ⇒ capital inflows
↑⇒KA > 0
Balance of Payment crises
• Also called a “currency crisis,” - a nation is
unable to pay for essential imports of goods and
services - the country is unable to serve its debt
repayments;
• Crisis - preceded by large capital inflows - rapid
economic growth, known as “bubbles”;
• level of debt - politics or unfair competition -
rapid drop in the value of the affected nation’s
currency;
Continue…
• debts are often denominated in a reserve
currency - exhausted its foreign reserves trying
to support the value of the domestic currency;
• can raise its interest rates - prevent further
declines in the value of its currency;
• can help those with debts denominated in
foreign currencies - depresses the local
economy;
Factors Affecting the Current and
Capital Accounts
• The current account drastically affects the
domestic economy of a nation;
• Factors are domestic and foreign;

− − − + + + +
• CAt = f (κt , πt , Yt , St , πt∗ , Yt∗ , TPt)
(1.6)
Continue…
• The capital account affects the domestic
economy of a nation through international
capital flows – domestic debts and deficits;
• Domestic capital can flow out of the country
searching for higher returns and lower risk;
+ − + − +
+
• KAt ≡−CAt = f (it −it∗ ,dt −dt∗ ,Dt −Dt∗ ,St −St∗, It −It∗ ,
ft − st ) (1.7)
Improving the Balance of Payments
through Exchange Rates or
Protectionism
• The trade account can be presented with the following
general function;
+ + − +
• TA= X −M = f1(p, Y ∗) − f2(p, Y ) (1.8)
• where Y = domestic income, Y ∗ = foreign income, and
p = the relative price level or terms of trade (TOT);
• The terms of trade are;
p = TOT = PM / PX = SP∗ / P (1.9)
Derivation
• By presenting the logarithm of a variable with its lower-
case letter (ln Xt ≡ xt ), equation (1.9) becomes;
• pt = tott = st + pt∗ − pt (1.9’)
• Thus, domestic exports (xt ) or foreign imports (mt∗ )
and domestic imports (mt ) or foreign exports (xt∗ ) can
be written with the following linear functions;
• mt∗ ≡ xt = α0 +α1pt +α2yt∗ +ε1t (1.10)
and;
• xt∗ ≡ mt = β0 +β1pt +β2yt +ε2t (1.11)
Continue…
Continue…
• Increase of exchange rate – imports expensive - exports
competitive – intend to correct the current account deficit;
• Often does not have a positive impact immediately, due to
the violation of the “Marshall-Lerner” condition;
• Tends to make investment flows into the capital account
more attractive if the interest rate in the United States
exceeds the depreciation of the dollar, so it will help with a
surplus there;
Continue …
• Decrease in exchange rate – imports cheaper - exports
competitive decreases– intend to correct the current account
surplus;
• S ↑ ($ ↓ )⇒ S ↑ P∗ / P = PM ↑ / PX = p ↑ (TOT ↑ )
⇒ M ↓ and X ↑⇒TA ↑
• The trade account is improved with a devaluation of the
domestic currency – if price elasticity of demand for imports (β 1)
and the price elasticity of supply of exports (α 1) are elastic;
Marshall-Lerner condition
• the Marshall-Lerner condition holds;
• |β1|+|α1| > 1 (1.12)
• currencies free-floating regime, tend to change the exchange
rate in the direction that will restore balance;
• Think what happens when - a country is exporting more than
it imports or a country is importing more than it exports;
Continue…
• One of the ultimate objectives of public
monetary policy is for the trade account to be in
balance (CA∼= 0);
• This can be done through devaluation;
• Through a tariff or import tax (t);

• SP∗ ↓/ P ↑ ⇒ X ↓ − M ↑= TA < 0⇒ SP∗(1+t)/P =

PM(1+t)/PX
• ⇒X ↑−M ↓⇒ TA↑⇒CA ↑
Continue…
• A foreign country—China, for example—very low cost of
production, (P∗) compared with the US domestic price (P);
• An enormous trade deficit (TA < 0) – domestic economy
competitive disadvantage – high imports vs low export;
• Imposition of a tariff (t) - trade deficit converts into
surplus due to high revenues from tariff;

• (TA> 0) and reduction of the budget deficit (BD ↓= T

↑−G);
Improving the Balance of Payments
by Adjusting Domestic Prices and
Demand
• exchange rates are fixed by a rigid gold standard
or incase of Eurozone - correcting imbalances is
to make changes to the domestic economy,
known as “internal devaluation.”;
• painless for the surplus country, but painful and
socially destructive for the deficit country;
• favorable trade balance - selling more than it
buys (X > M) - net inflow of gold - increase the
money supply, which leads to inflation;
Continue…
• Options are - taking the gold out of the economy
- sterilizes the inflationary effect - reduce
domestic credit - retaining its favorable balance
of payments;
• On the other hands – contrary to the above
situation where the BOP is in deficit leads to net
loss of gold – making nation’s exports more
competitive;
• deflationary effect – reasons of abandoned of
gold exchange standard (1914 - 1971)
Continue…
• Another method is the one that Troika (EU, ECB, and
IMF) imposed on the Eurozone nations - asked countries
to reduce their domestic prices - compete in the
international market;
• can be done by reducing wages and salaries, laying off
employees, increasing productivity and efficiency,
reducing the public sector, selling off state-owned
enterprises, and implementing other austerity
measures;
• internal devaluation destroys societies and human lives;
Continue…
• TOT ↑⇒ .S.P∗/P ↓ = .PM/PX ↓
⇒ X ↑−M ↓⇒ TA ↑
• Note: reduction of wages, salaries, personal
income, and other austerity measures for
improving competitiveness and reducing budget
deficits of nations have exactly the opposite
effect;
• We observe - reduces aggregate demand -
production falls drastically;
Continue…
• then, unemployment increases enormously - the
bankruptcy rate on businesses increases - deep
recession – government revenue falls;

• “Objective of a nation is not a budget and trade

surplus, but a surplus in the social welfare of its
citizens.”
Interaction of the Balance of
Payments with the Domestic
Economy
• total production of the nation (GNP) = domestic
product (GDP) + net income from abroad (NIA);
• GNP = GDP +NIA (1.13)
• The BoP affects the domestic economy of a
country;
• The national income (Y);
• Y ≡ T +C +S (1.14)
where Y = national income or gross national product
(GNP), T = taxes, C = consumption, and S = saving;
Continue…
• The gross national product (GNP);
• Y ≡ C +I +G +X −M
(1.15)
• The aggregate spending, or absorption, by
domestic residents (E) is defined as,
• E ≡ C +I +G (1.16)
Continue…
• using eqs. (1.14), (1.15), and (1.16);
• Y −E = T −G +S −I = X −M ≈ CA (1.17)
• current account surplus or deficit will be settled by the
central bank (Fed) through official settlements;
• Then, the foreign assets (FA) will be affected - the central
bank’s balance sheet is;
• GC +FA+DC ≡ C +R = MB (1.18)
• GC = gold certificates, FA = foreign assets (foreign
currencies, SDRs, etc.), DC = domestic credit
(government securities), C = currency (Federal Reserve
notes), R = reserves, and MB = monetary base.
Continue…
• Combining equations (1.17) and (1.18), we have,
• Y −E = (T −G)+(S −I ) = X −M ≈ CA = Δ(FA)
= Δ(MB)− Δ(GC)− Δ(DC) (1.19)
• (Y − E < 0) represent domestic production - country
spends more than it produces;
• (T − G < 0) represents the government budget,
which is shown in deficit;
• (S −I ) positive or negative - deficit current account
implies insufficient S relative to investment;
Continue…
• (X −M ≈ CA<0);
• deficit in the current account - country spends more
compared to its production - financed by offering
foreign assets [Δ(FA) ↓] - reduce the monetary base
[Δ(MB)↓] - money multiplier (mM) drastic negative
effect on the domestic money supply (Ms↓);
• MB mM =Ms (1.20)
• will affect interest rate (i↑), aggregate demand
(AD↓), production (AS↓), and growth (gGDP↓), and
unemployment will increase (u↑)
Continue…
• One way to offset the foreign sector effect on the
domestic economy- through sterilization policy -
offset the loss of foreign assets by increasing
domestic credit, so monetary base stays
constant;

• Δ(FA) ↓= Δ(MB)− Δ(G.C )− Δ(DC) ↑ (1.21)

Trade Balance and Exchange Rate
(The J-Curve)
• devaluation of their
currencies, to reduce the
trade account deficits, given
that the Marshall-Lerner
condition, equation (1.12),
holds (elastic domestic and
foreign demands for imports).
• At time t1, the depreciation of
the domestic currency takes
place, gradually the trade
balance improves, after time
t2; “the J-Curve adjustment.”
Continue…
• Sudden depreciation of the US dollar - an increase in the
trade deficit after time t1 - cost of imports will be higher in
dollars, due to its depreciation – cost of production
increase - reach period t2 - trade account improves;
• S ↑ ($ ↓ ) ⇒ (M ↑ and X~ )S−R ⇒TAS−R ↓
(international trade transactions are prearranged and
cannot adjust)
⇒ (M ↓ and X ↑ )L−R ⇒TAL−R ↑
(Md and Xs are more inelastic in the short-run than in the
long-run)
Continue…
• depreciation of the US dollar will have the
following effects on its trade account;
• TAt1 < 0⇒S ↑ ($ ↓ )
⇒ X~ −M ↑= (P~$X Q~X )−(S$/euro ↑ P~
euro
M Q~M)
⇒TA ↓↓
National Economies and Balance of
Payments: Some Historical Perspectives

• Refer to the handout module provided by the tutor

US Trade Account and Its Measures –
Empirical study
• US demand for imports (mt) and;
• US supply of exports (mt ) with respect to the EU;
• estimate the price (α1 and β1) and income (α2
and β2) elasticities;

• Note: (all the variables are in natural logarithms)

Equations price elasticity
• mt∗ ≡ xt = α0 +α1pt +α2yt∗ +ε1t (1.10)
• xt∗ ≡ mt = β0 +β1pt +β2yt +ε2t (1.11)
• And; pt = tott = st + pt∗ − pt (1.9’)

• Β1 = price elasticity of demand for imports

• α1 = price elasticity of supply of exports
• “Marshall-Lerner condition” holds or not???
Marshall-Lerner condition

• dT / dp = M( ε∗ + ε −1) > 0 for an increase in p ↑

• (devaluation of the currency) to increase (improve) T ↑

• ⇒ε∗ + ε −1 > 0;
• ⇒ ε∗ +ε > 1 (Marshall-Lerner condition)

• Note: Refer to the notes for detail derivation of M-L condition

Graphical representation
Oil Price and Risk on the Current
Account – Empirical investigation
• According to Ghosh and Kallianiotis (2011), there is an
evidence of oil prices, risk and other factor effects on C/A;

Mathematically it can express as;

• cat = β0+β1TEDt +β2poilt+β3pGoldt+β4ndt
+β5tott+β6gdpt +β7gt +εt E.q
Perform the residual checks i.e., serial correlation and
heteroscedasticity tests.
Check for the co-integration relation among variables etc…
History of Exchange
rate
History of Currencies
History of Currencies
• World aggregate demand (AD), about one fifth,
represents exports (X) and imports (M) among
countries;
• We can address the flow of funds through the following
equation;
[B of P =CA+KA+OS=0];
• Exchange of one currencies among others – for
settling the huge transactions – critical role for
international economic and financial environment;
Continue…
• The currency exchanger had his bench (trapeza,
banco, banca, banque = moneychanger’s table) in the
middle of the marketplace (agora);
• E.R~ among currencies via “banker” (trapezitis);
• Greek philosopher Socrates had introduced many new
(“kaina daimonia”) sociopolitical “innovations and
beliefs,” and ;
• His student Xenophon introduced “Oeconomicos,” the
management of household (oecos = household and
nemo = manage);
Continue…
• Without a monetary unit (1 Dr., £1, $1, e1, etc.)
the international economies never go far the
distance;
• an exchange rate regime was necessary to
determine the relative value of these currencies
(the exchange rates);
• reserve currencies (foreign assets) were needed
to be transferred in settlement of deficits;
Fixed Exchange Rate
• eighteenth-century Europe - classical “gold standard”
(fixed exchange rate) - automatic adjustment mechanism
- “price-specie-flow” mechanism (Hume’s [1752] essay in
Cooper’s [1969]);
• Intern. Monetary System acceptance - Europe (1870) &
United States officially in the year 1879;
• “Mint parity theory” - fix the values of their currencies in
terms of gold;
• Before World War I, the mint parity of the US dollar was
$20.67/oz of gold and the British pound sterling
£4.2474/oz of gold;
Payments of Current Account
Deficits
• payment deficit caused a loss of reserves (gold) -
reduced the money supply and brought down the
price level;
• products got cheaper, more competitive, therefore
exports increased, and imports fell, and the BOP ↑;

• CA < 0⇒OFGold ⇒Ms ↓⇒P ↓

⇒TOT ↑= e~P∗/P↓ = PM/PX↑ (PM > PX)⇒Competitiveness ↑
⇒X ↑ &M ↓⇒ CA ↑
Continue…
• Countries did not follow a sterilized policy in gold
exchange standard - loss of reserves led to multiple
reduction of the money supply, due to the money
multiplier;
• For correlation and causality between Ms and P);
• GC +FA↓+DC = C +R ↓= MB ↓⇒MB ↓ mM =Ms ↓⇒ P ↓
• GC = gold certificate, FA = foreign assets, DC =
domestic credit, C = currency, R = reserves, MB =
monetary base, mM = money multiplier, Ms =money
supply, and P = price level;
Monetarist view
• The equation of exchange (quantity theory of
money) says:
• MV~ = PQ~ (1.1)
• M = money supply, V = velocity of money, P =
price, and Q = quantity of output (production);
• The balance of trade (TA) will improve -
depending on the price elasticity of demand for
imports (εM) and the price elasticity of supply of
exports or the foreign demand for imports (εM∗ );
Continue…
• Marshall-Lerner condition must be satisfied:
• |εM|+|εM∗ | > 1 (1.2)
• (εM with the negative sign)
• loss of reserves - central bank to raise the interest
rate - attract a capital inflow;
• This high interest rate - decline in aggregate
demand (AD), a fall in production (AS), and
consequently, to a fall in imports (M), which
improves the current account (CA),
Keynesian View
• According to the Keynesian view:

• Ms ↓⇒i ↑⇒CIF ⇒AD ↓ ( = C ↓+I ↓ )

⇒AS ↓⇒ Y ↓⇒M ↓⇒ CA ↑
• where, i = interest rate, CIF = capital inflow, AD =
aggregate demand, AS = aggregate supply, C =
consumption, I = investment, and Y = income.
Gold Standard before World War II
• During the War - fixed exchange rates fluctuated because
trade flows and free movement of gold were
interrupted;
• International speculators were selling the weak
currencies short;
• newly established Federal Reserve System (1913)
sterilized the gold inflows;
• Paper currencies were exchanged on the basis of
floating exchange rates;
• countries devalued their currencies;
• In 1925, a system of “gold exchange standard” came
Continue…
• The Wall Street crash of 1929;
• cessation of US capital outflows;
• 1931 came the crash of the Austrian banking system;
• September 21, 1931, Britain “went off gold.”;
• Some currencies floated - Others remained pegged to
gold;
• Some were depreciated in a bid to improve trade and
their domestic economies;
• the hyperinflation in some European nations -
currencies lost their convertibility;
After the Bretton Woods
• Intent on creating a new international economic order;
• The British thinker and negotiator – between UK & US -
John Maynard Keynes;
• Three international economic institutions were created -
the International Trade Organization (ITO); the World
Bank, and the International Monetary Fund (IMF);
• Bretton Woods Agreement established a US dollar–based
international monetary system- signed by 44 nations;
• currency within ±1% of par value;
• “subscription” charged by IMF - quota was 25 percent in
gold and 75 percent in the member’s own currency;
Pegged exchange rate against gold
• When a country was running a balance of payments
deficit, its central bank was losing reserves;
• United States was committed to trade gold with foreign
officials at a fixed price of $35/oz;
• End of World War II, United States had about 60 % of the
total world stock of gold;
• At the end of 2010, central banks and IMF held 18.67 %
- private hands held 81.33 %;
• United States had 26.4 %, Germany 11.02 %, and IMF
9.13 % of the total gold in the central banks and IMF;
Marshall Plan
• European Recovery Program (Marshall Plan);
• military allies for European economies(through NATO
membership);
• Organization for Economic Cooperation and Development
(OECD), was set up to administer the Marshall Plan aid to
Europe;
• European countries were encouraged by the United States
to liberalize their trade;
• European integration was created - free trade and the free
mobility of factors of production among member nations;
Continue…
• free trade and the free mobility of factors of production
among member nations - Belgium, France, Italy,
Luxembourg, the Netherlands, and West Germany – in
1957;
• the Bretton Woods system moved into its golden age at
the end of 1950s;
• there was a problem of long-run viability of the system by
converting dollars into gold;
• By 1960, total foreign dollar claims on the United States
were greater than the total value of the US gold stock at
$35 per ounce;
Continue…
• In 1962, France began to convert its dollar
reserves into gold, which signified the end of the
Bretton Woods Agreement.
• After France, other nations started selling their
dollar reserves thinking that the dollar was
overvalued.
Floating Exchange Rate
• System of floating exchange rates that appeared
in 1971 - adopted by many leading industrialized
nations;
• fall of the Bretton Woods System,
• the unsuccessful compromises with the
Smithsonian Agreement,
• the oil crises on the early 1970s,
• continued devaluation of the dollar,
Continue…
• official ratification took place in April 1978 –
wider bands,
• still had many difficulties maintaining exchange
rates within the ±2.25% boundaries,
• March 1973, these official boundaries were
eliminated,
• widely traded currencies were allowed to
fluctuate in accordance with market forces,
New “non-system”
• in January 1976 - legalized
by the Interim Committee
at the Jamaica meeting,
• exchange rates would be
determined (through
demand and supply of
currencies) by market
forces and without
government or central
bank interventions, as
graph 1.1 shows,
Continue…
• “managed” float or “dirty” float system,
• degree to which a home currency is managed varies across
nations,
• Some central banks smooth the exchange rate movement,
some establish implicit exchange rate boundaries,
• and others react to disturbances or use it as tool for their
domestic trade policy,
• price theory shows how price flexibility can clear competitive
markets,
• The exchange rate would be determined at the value of e0,
where demand for pound sterlings equals the supply,
Smithsonian Agreement
• set bands of ±2.25% for currencies to move relative
to their central rate against the US dollar,
• “tunnel” in which European currencies were allowed
to trade,
• if currency A started at the bottom of its band - could
appreciate by 4.5 %, while if currency B started at
the top of its band- could depreciate by 4.5 %,
• if both happened simultaneously, then currency A
would appreciate by 9 percent against currency B,
Continue…
• Basle Agreement in 1972 - European Economic
Community (EEC) members (France, West
Germany, Italy, Belgium, Netherlands, and
Luxembourg) established a “snake in the tunnel”
–
• bilateral margins between their currencies
limited to ±2.25%, implying a maximum change
between any two currencies of 4.5%,
Continue…
• The “tunnel” collapsed in 1973, when the US
dollar floated freely,

• Since March 1973, the exchange rates have

become floating, but not a freely floating
exchange rate system,

• our system, is today, a “managed” or “dirty”

floating system,
Empirical investigation
• Correlation and Causality
• Correlation is a measure of dependence between
two variables - correlation coefficient,(ρMs ,P),
• Query – does money supply cause prices or
predict prices?
• by using lagged values of Ms :
mt = α0 +α1mt−1+· · ·+αlmt−l +β1pt−1 +· ·
·+βlpt−l +ε1t
pt = α0 +α1pt−1 +· · ·+αlpt−l +β1mt−1 +· · ·+βlmt−l
Continue…
• Correlation vs causation analysis,
• Correlation vs Pairwise Granger Causality Tests
• Money supply (M2) and the prices (CPI),
• Note: All the variables must be scaled in natural log
• Check for the trends i.e. E.R~ of dollar against time,
• Linear trend analysis
• Log-linear trend analysis
• Correct for serial correlations i.e., E(εt ,εt−1) = 0;
The Foreign Exchange
Market
Functions, Geographical Range, and Size of the
Foreign Exchange Market
Forex Market
• Foreign exchange market is a form of international market
for the trading of all national currencies,
• as anchors of trading among a wide range of different
types of buyers and sellers,
• currency conversion, offering lines of credit in different
currencies, and providing instruments of hedging
exchange rate risk,
• supports direct speculation on the value of currencies and
arbitrage profits between different markets, based on
different exchange rates and interest rate differentials
among countries,
Forex Market Size
• huge trading volume, representing the largest asset
class in the world leading to high liquidity,
• geographically dispersed - market operating 24 hours
a day, except on weekends,
• starts from 20:15 GMT on Sunday until 22:00 GMT
Friday night,
• A market with low margins of relative profit - a very
large number of factors, information, and expectations
that affect exchange rates,
• uses leverage to enhance profit,
Continue…
• transfers purchasing power among participants in
different countries, supplies credit and instruments
for international trade and investment transactions,
and provides instruments of hedging (redistributing)
foreign exchange exposure (risk),
• the average daily turnover was $3.98 trillion in April
2010,
• $1.5 trillion was spot transactions and $2.5 trillion
was traded in outright forwards, swaps, and other
derivatives,
Forex Market trading cycle
• trade starts each morning from New Zealand and
Australia (Wellington and Sydney) - continues to
East Asia (Tokyo, Seoul, Manila) - moves to Hong
Kong and Bangkok, passes to the Middle East
(Bahrain and other centers);
• then, shifts to Europe (Frankfurt, Zurich, Paris, and
other centers) and reaches London;
• then, it proceeds to North America (New York,
Chicago, and later Los Angeles and San Francisco),
Continue…
• Highly liquid financial market – Traders include large
banks, central banks, governments, institutional
investors, currency speculators, corporations,
other financial institutions, and retail investors,

• United Kingdom accounted for 36.7 % - United

States accounted for 17.9 % - Japan accounted
for 6.2 % - currency derivatives represent 4% of
OTC;
Continue…
• Foreign exchange futures contracts were introduced in
1972 at the Chicago Mercantile Exchange,
• foreign currency options were introduced in 1982 by
the Philadelphia Stock Exchange and followed by the
Chicago Mercantile Exchange,
• By 2010, retail trading accounted for up to 10% of the
spot turnover, or $150 billion per day,
• Due to London’s dominance in the market, a particular
currency’s quoted price is usually the London market
price,
Forex Market Participants
• At the top is the interbank market, which is made up of the
largest commercial banks and securities dealers,
• Interbank market, spreads, - the difference between the bid
(buying foreign currency) and ask or offer (selling) prices,
are razor sharp and not known to players outside the inner
circle,
• The difference between the bid and ask prices widens (e.g.,
from 0–1 pip6 to 1–2 pips for a currency such as the euro
[EUR]), as you go down the levels of access,
• due to volume - a smaller difference between the bid and
ask price, which is referred to as a “better spread”,
Continue…
• Commercial Companies;
• Central Banks and Treasuries;
• Foreign Exchange Fixing;
• Hedge Funds, Speculators, Arbitragers, and Others;
• About 70–90 percent of the foreign exchange transactions are
speculative,
• Investment Management Firms;
• an investment manager bearing an international equity portfolio
needs to purchase and sell several pairs of foreign currencies etc,
Continue…
• Retail Foreign Exchange Traders;
• participate indirectly through brokers or banks - regulated in the
United States by the Commodity Futures Trading Commission
(CFTC), and National Futures Association (NFA);
• NFA members – subject to min net capital requirement compared
to Futures Commission Merchants (FCMs) and Introducing
Brokers (IBs);
• brokers operate from the United Kingdom under
Financial Services Authority (FSA) regulations,
• Two main types of retail FX brokers - brokers and
dealers or market makers,
Continue…
• Non-Bank Foreign Exchange Companies;
• offer currency exchange and international payments
to private individuals and companies;
• Do not offer speculative trading, but rather exchange
currency with payments;
• in the United Kingdom, 14% of currency
transfers/payments are made via foreign exchange
companies;
Continue…
• Money Transfer/Remittance Companies and
Bureaux de Change;
• High-volume, low-value transfers, generally by economic
migrants back to their home country - 2007, the Aite Group
estimated $369 billion of remittances;
• four largest markets (India, China, Mexico, and the Philippines)
receive $95 billion;
• largest and best-known provider is the Western Union with
345,000 agents globally, followed by the UAE Exchange;
Forex Trading Characteristics
• Lately, technological advancements in
telecommunications have changed the interbank market,
• there are still transactions executed by phone and face to
face,
• September 2002 - Continuous Linked Settlement (CLS)
system was introduced to eliminate losses in settlements,
• the over-the counter (OTC) nature of currency markets - a
number of interconnected marketplaces,
• there is not a single exchange rate, but rather a number
of different rates (prices),
Continue…
• Major trading exchanges include the Electronic Broking
Services (EBS) and Reuters,
• 2007 - joint venture of the Chicago Mercantile Exchange
and Reuters, called FXMarketSpace (FXMS) , failed,
• Society for Worldwide Interbank Financial
Telecommunication (SWIFT) - information about financial
transactions,
• headquarters are located in La Hulpe, Belgium, near
Brussels - ISO 9362 Bank Identifier Codes (BICs) are
popularly known as “SWIFT codes”,
Forex Currency Quote
• September 2010 - SWIFT linked more than 9,000 financial
institutions in 209 countries - over 15 million messages
per day,
• April 2010 - most traded currencies by value - US dollar,
84.9 %, euro 39.1 %, the yen 19.0 %, and pound sterling
12.9 %,
• ISO 4217 international three-letter code of the currencies
- XXXYYY or XXX/YYY, (XXX) is the base currency and
(YYY), called the counter currency (or quote currency),
• EURUSD (EUR/USD) 1.2585, meaning 1 euro=1.2585 dollars
(1.2585 $/€) “Direct or in American terms.”
Forex Transactions - Spot
• US dollar as the base currency (e.g., USDJPY, USDCAD,
USDCHF). For example, 79.5330 ¥/$ “Indirect or in
Japanese terms”,
• spot transaction is a two-day delivery transaction (except
in the case of trades between the US dollar, Canadian
dollar, Turkish lira, euro, and Russian ruble,
• foreign exchange spot transactions is t + 2 days,
• settle at t +1 - “direct exchange” between two currencies;
it has the shortest time frame - involves cash - interest is
not included - date of settlement is referred to as the
value date,
Forex Spot
• foreign exchange spot transaction, also known as FX spot –
exchange rate at which the transaction is done - spot exchange
rate (St),
• average daily turnover of global FX spot transactions - $1.5
trillion, counting 37.4 % compared to all,
• American bank - Monday transfer of €1,000,000 to a bank in
Paris, spot rate 1.2563 $/€ - On Wednesday US bank transfer
€1,000,000 to Paris - French bank transfer $1,256,300 to the
US bank in New York at the same time,
• Dollar transactions are settled through the computerized
Clearing House Interbank Payments System (CHIPS) in New
York,
FX Spot – Methods of Execution
• (1) Direct - Executed between two parties directly and not
intermediated by a third party, executed via direct telephone
communication or direct electronic dealing systems,
• (2) Electronic broking systems - Executed via automated
order matching system for foreign exchange dealers –
Examples of such systems are Electronic Broking Services
(EBS), avoiding the need for a human broker,
• (3) Electronic trading systems - Executed via a single-bank
proprietary platform or a multibank dealing system,
• (4) Voice broker - Executed via telephone communication
with a foreign exchange voice broker,
Forward Transactions
• Money does not actually change hands until some
agreed-upon future date – Deal with forex risk;
• A buyer and seller agree on an exchange rate, the
forward exchange rate (Ft ), normally quoted for
value dates of one, two, three, six, and twelve
months,
• The party agreeing to buy the underlying currency in
the future assumes a long position, and the party
agreeing to sell the currency in the future assumes a
short position,
Continue…
• price agreed upon is called the delivery price -
used to hedge risk - as a means of speculation -
take advantage of the quality of the underlying
instrument, which is time sensitive,

• US bank sells three-month forward £10,000,000 to

a British bank for US dollars at the forward
exchange rate quoted today as, F3=1.5826$/£,
and it will receive $15,826,000 three months later,
Swap Transactions
• The most common type of forward transaction is
the swap,
• not standardized contracts and are not traded
through an exchange,
• forex swap, or FX swap is a simultaneous
purchase and sale of currencies,
• foreign exchange swap consists of two legs: a
spot foreign exchange transaction and a forward
foreign exchange transaction,
Continue…
• forward-forward swap - where both transactions
are for (different) forward dates, A dealer sells
£10,000,000 forward for dollars for delivery in
three months at F3=1.5826$/£ and
simultaneously buys £10,000,000 forward for
delivery in six months at F6=1.5817$/£,

• difference between the buying price and the

selling price is equivalent to the interest rate
differential (it − it∗ ) between the two currencies,
Continue…
• early 1990s is the non-deliverable forward (NDF) that is
an outright forward or futures contract,
• NDFs are prevalent in some countries where forward FX
trading has been banned by the government (usually
as a means to prevent exchange rate volatility),
• Most NDFs are cash-settled in US dollars - between one
month to one year etc,
• Initially NDFs used for currency hedging, but more than
70 percent of them are used in trading for speculative
purposes,
Currency Futures
• Currency futures are standardized forward
contracts and are usually traded on an exchange
created for this purpose.,
• The average contract length is roughly three
months,
• Futures contracts are usually inclusive of any
interest amounts,
Foreign Currency Options
• A foreign currency option - FX option is a
derivative, where the owner has the right, but
not the obligation to exchange money (to buy,
call option; or to sell, put option) denominated in
one currency into another currency at a
previously agreed-upon exchange rate (strike
price) on a specified date by paying an option
price (premium),
Speculation
• Economists including Milton Friedman have argued that
speculators ultimately are a stabilizing influence on the
market and perform the important function of providing a
market for hedgers and transferring risk from those people
who do not wish to bear it, to those who do like to gamble (risk
takers),
• Joseph Stiglitz, consider this argument to be based more on
politics and on an extreme free market philosophy than on
true economics,
• For example, in 1992, currency speculation forced the Central
Bank of Sweden to raise interest rates for a few days to 500
percent per annum, and later to devalue the krona,
Forex - Quotations
• foreign exchange quotation (quote) is a statement of
willingness to buy or sell one currency (which is in
the denominator) by offering a number of units of the
currency, which is in the numerator,
• USD/CAD ($/C$) currency pair, the Canadian dollar
would be the quote currency, and the US dollar would
be the base currency,
• In the retail market, quotes are given as the home
currency price of a foreign currency (i.e., 0.9782 $/C$
and 1.2503 $/€),
Direct and Indirect quotes
• A direct quote (in American terms) is the home
currency price of a unit of foreign currency
(dollars/unit of euro),
• S1=1.2503 $/€, which says that we need 1.2503
dollars per 1 unit of euro,
• An indirect quote (in European terms) is the foreign
currency price of a unit of home currency (euros/unit
of dollar),
• S2=0.7998 €/$, which says that we need 0.7998 euros
per 1 unit of dollar,
 Continue…

• Forward rates are falling compared to the spot rate - the

market expects the dollar to appreciate,
• US dollar is at a forward premium (fp$) and the British
pound at a forward discount (fd£),
Continue…
• rule of thumb - currency of the country with higher
interest rates will be at a discount and vis-a-versa,
• it < it∗ ⇒ fp$ and fd£
• or
• fp$ and fd£ ⇒it < it∗

• Similarly, Swiss franc is at a forward discount

(fdSF ) - it < it∗
Outright Quotes
• When the exchange rate is quoted in terms of
points, we can determine the outright quotes,
• British pound ($/£) exchange rate,
• 1.5640/4 5/4 10/8 19/15
• spot bid price = 1.5640
• ask bid = adding 4 = 1.5644
• If the bid points exceeds the ask points, we
subtract (–) the points from the outright spots to
get forward rates, and vis-a-versa.
Continue…
• For example - the Australian dollar (A$) in terms of
points,
• outright quotes for this exchange rate ($/A$):
• 0.9730/5 25/27 74/71 130/135

• F1: 25 <27, then we add (+) these point to the spot

rates,
• F3: 74 >71, then we subtract (–) these points from the
spot rates,
• F6: 130 <135, we add (+) the points to the spot rates,
Forward Quotations in Percentage
Terms
• Forward quotations as a percent-per-annum
deviation from the spot rate,
• (1) Direct Quotations:
• When quotations are on a direct basis (i.e., $/£),
an approximate formula for the percent-per-
annum (% p.a.) premium or discount is as
follows:
• fd or fp = [F −S / S] (12/n) 100
(2.1)
Continue…
• percent-per-annum forward premium (fp) or
forward discount (fd) facilitates comparing
premiums and discounts in the forward market
with interest rate differentials between the two
countries,
• fdGBP or fp$ = −0.205%p.a.
• British pound is at a 0.205 percent per annum discount
(the pound sterling is depreciated),
• forward dollar is selling at a 0.205 percent per annum
premium (the dollar is appreciated),
Indirect Quotations
• when quotations are on an indirect basis (i.e.,
SF/$),
• fdSF or fp$ =−0.912% p.a.
• forward Swiss franc is selling at a 0.912 percent per
annum discount - (the Swiss franc is depreciated),
• The dollar is at a 0.912 percent per annum premium
(the dollar is appreciated),
Sources of Foreign Exchange Market
Information
• Yahoo.Finance (http://finance.yahoo.com/currency).
• Moneyline Telerate, Reuters (http://www.reuters.com/),
• Bloomberg (http://www.bloomberg.com/),
• X-Rates (http://www.x-rates.com/),
• Rates FX (http://www.ratesfx.com/rates/),
• United States – The Wall Street Journal (
http://online.wsj.com/public/page/news-currencycurrencies-tradin
g.html
).
• In Europe - The Financial Times
(http://www.ft.com/intl/markets/currencies).
Cross Rates
• exchange rate between two currencies (e3) from their
common relationship (e1 and e2) with a third currency,
• For example, the exchange rate between US dollar and
Canadian dollar is given as e1=0.9605$/C$ and the
exchange rate between US dollar and euro is e2=1.2435$/e,
• We need the exchange rate between Canadian dollar and
euro, the cross rate (e3),
• e3 = e1/e2 = 0.9605/1.2435 $/CS:$/€
=0.7724 €/C$.
Continue…
• The Wall Street Journal quotes the following two
spot rates:
• S1=1.0351$/SF and S2=177.99¥/$,
• the cross rate between the Japanese yen and the
Swiss franc (S3),
• S3 = S1. S2
= 0.727¥/SF
Simple Intermarket Arbitrage
• exchange rate - in Zurich is 1.5360 $/£, and the
exchange rate in New York is 1.5365 $/£,
• Converting $1,000,000 to £ in Zurich (buying £) and
converting that ($1,000,000: 1.5360
$/£=£651,041.667) into $ (selling £) in New York
(£651,041.667 × 1.5365 $/£=$1,000,325.521),
• profit of $325.521 is the arbitrage profit,
Intermarket Triangular Arbitrage
• look at three different markets by using the cross rates
and check on opportunities for intermarket arbitrage,
• Citibank (New York) is quoting spot $/£ as: 1.5370 $/£.
• Barclays Bank (London) is quoting spot £/SF as: 0.6725 £/SF.
• And Credit Swiss (Zurich) is quoting spot $/SF as: 1.0365 $/SF.
• $1,000,000 sells amount spot to Citibank - receives
$1,000,000/1.5370 $/£=£650,618.087, sold to Barclays Bank
at the cross rate of 0.6725 £/SF, receiving
£650,618.087/0.6725 £/SF = SF967,461.840, sell to Credit
Swiss at the exchange rate of 1.0365 $/SF and receives
SF967,461.840 × 1.0365 $/SF = $1,002,774.197.
Empirical Investigation
• Correlation and Causality between Interest Rates
and Spot Rates
• Correlation and a Pairwise Granger Causality test between
the exchange rate (St ) and the interest rate (it ),

• List of variables to check the direction of causality,

• spot exchange rate ($/€), three-month T-bill rate in United
States, AAA corporate bond rate in the United States, BAA
corporate bond rate in the United States, and 10-year
government bond rate in the EU,
Exercise
• following quotes for the Russian ruble (RUB or p.) spot, one
month forward, three month forward, and six month forward to a
US multinational corporation treasurer ($/RUB):
• 0.03029/31 5/7 10/9 15/13
• (1) Calculate the outright quotes for one month (F1), three month
(F3), and six month (F6) forward.
• (2) If the treasurer of the firm wished to buy Russian rubles six
months forward, how much would he pay in US dollars?
• (3) If he wished to purchase US dollars three months forward,
how much would he have to pay in Russian rubles?
Continue…
• (4) If the treasurer wished to sell Russian rubles one
month forward, how much would he receive in dollars?
• (5) Assuming that Russian rubles are being bought by
the treasurer, what is the premium or discount, for the
one-, three-, and six-month forward rates in annual
percentage terms?
• (6)What do the above quotations imply in respect of the
term structure of interest rates in the United States and
in Russia?
Solution
• $/RUB 0.03029/31 5/7 10/9 15/13
< (+) > (−) > (−)
• (1) Outright Quotes:
Bid Ask (Offer)
S 0.03029 0.03031
F1 0.03034 0.03038
F3 0.03019 0.03022
F6 0.03014 0.03018
Continue…
• (2) To buy Russian rubles six months forward, he would
pay $0.03018.
• (3) To purchase US dollars three months forward, he
would he have to
• pay 0.03019 $/RUB, which are:
= 1 / 0.03019
= RUB 33.1236.
• (4) To sell Russian rubles one month forward, he would
receive $0.03034.
Continue…
• (5) We use the “ask” price: (we have direct quotes, here);
• thus, fp or fd = F −S / S (12/n) 100 (%p.a. )

• Fp1RUB or fd1$ = 0.03038−0.03031 / 0.03031 (12/1) 100=

2.772% p.a.
• fp3$ or fd3dRUB = 0.03022−0.03031 / 0.03031 (12/3)
100= −1.188% p.a.
• fp6$ or fd6dRUB = 0.03018−0.03031 / 0.03031 (12/6)
100= −0.858% p.a.
Term Structure interest rates
• (6) The term structure of interest rates in the United States
(it ) and in Russia (i∗t) is presented graphically in graph
A2.1.
• The interest rate in the United States will be above the
Russian one by 2.772 % (for the one month); then,
• US interest rate will be below the Russian by 1.188 % (the
dollar at a forward premium for the three month); and,
• Finally the interest rate in the United States will be below
the Russian interest rate by 0.858 % (for the six month).
Graphical presentation
Case test
• Quotes for the Euro (EUR) spot, one month forward,
three month forward, and six month forward;
• EUR / USD = EURUSD = $ / € = $ 0.9968/70 19.47/20.11
63.84/65.81 138.80/139.60
• (1) Calculate the outright quotes for one month (F1),
three month (F3), and six month (F6) forward,
• (2) If the treasurer of the firm wished to buy Euro six
months forward, how much would he pay in US dollars?
• (3) If he wished to purchase US dollars three months
forward, how much would he have to pay in Euro?
Continue…
• (4) If the treasurer wished to sell Euro one month
forward, how much would he receive in dollars?
• (5) Assuming that Euros are being bought by the
treasurer, what is the premium or discount, for the one-,
three-, and six-month forward rates in annual
percentage terms?
• (6)What do the above quotations imply in respect of the
term structure of interest rates in the United States and
in Europe?
Foreign Exchange Rate
Determination
Exchange Rate Theories, public policies, oil prices
and Euro-zone debt crisis
Exchange Rate Theories
• Asset market view of exchange rate determination
has been expanding since the mid-1970s,
• For more than 30 years, and generations of
economists and practioners are learning and applying
them to their theoretical research and their trade
practices,
• assume that there is perfect capital mobility among
countries - exchange rate will adjust instantly to
equilibrate the international demand for stocks of
national assets,
The Balance of Payments Approach
• Empirical implication is that floating exchange rates
exhibit high variability,
• Econometric analysis gives specific empirical
implications of the various theories,
• Trade takes place - the demand and supply schedules
shift up or down - balance of payments equation;
• B of Pt = CA [StPt∗ / Pt, Yt ,Yt∗ , Π t , Π t∗] + KA(it −i∗t)
(3.1)
Where-as, Πt = shift factor such as tariffs, subsidies,
interventions etc.,
• An increase in the demand
for euros (€) shifts the
demand schedule from D€
to D€` and the original
equilibrium exchange rate
s0 (at the intersection of the
demand and supply
schedules) increases to s1.
• The euro is appreciated and
the US dollar is
depreciated. A reduction in
supply of euros is—a shift
of the supply schedule to
the left from S€ to S€` (from
E1 to E2).
Solving for the exchange rate (st)
• st = α0 +α1(pt −pt∗ )+α2(yt −yt ∗)+α3(it −it∗ )+α4(Πt − Πt∗ )+εt (3.2)

• α1 > 0 - increase in pt reduces xt and the CAt deteriorates -

↓domestic currency - spot rate will increase, st↑;
• α2 > 0 - growth in domestic real output, increase imports (mt)
and the CAt deteriorates; ↓domestic currency depreciates (st↑);
• α3 < 0 an increase in the domestic interest rate, will cause
capital inflows in the country, ↑demand for domestic currency,
↑ domestic currency (st↓);
• α4 < 0 intervention (domestic trade policy) will have as its
objective improvement of the CAt, ↑domestic currency (st↓).
Other variables
• Think of using other pairs of variables;

• national debt differential: ndt − ndt∗ ,

• investment differential: lnIt − ln It∗ ,
• saving differential: lnSt −lnSt∗ ,
• wage differential: wt −wt∗ , etc.)
The Asset Market Models
• in the 1970s - asset market model determined
floating exchange rate;
• Theoretical assumptions- perfect capital mobility,
Domestic and foreign bonds are assumed to be
perfect substitutes;
• implies covered interest parity,
• it −it ∗ = fdt or fpt = ft −st (3.3)
• implies uncovered interest parity,
• it −it∗ = Δ set = set+1− st (3.4)
The Monetary Approach
• uncovered interest parity does hold it −it∗ =
set+1− st , the supply of bonds is irrelevant – ER
determination shifted to money markets;

• ‘monetary approach’ – focuses on the demand

for and supply of money instead trade and
capital,
The Monetarist Model (Flexible
Prices)
• Assumption implies purchasing power parity (PPP) – Pt = Pt∗St
• perfect price flexibility is considered and the model
assumes PPP, it is called the “monetarist model”;
• st = pt −pt∗ (Logarithm form of PPP) (3.5)
• domestic real demand for money equation is,
• mtd −pt = α +βyt −γ it +ε1t (3.6)
• foreign real demand for money equation is,
• mt∗d−pt∗ = α +βyt∗−γit∗ + ε2t (3.7)
elasticities are assumed to be the same in both countries (constrained
model)
Equilibrium in Money Markets
• Assuming equilibrium in the money markets, we
have,
• mtd −pt = mts −pt = mt −pt (3.8)
And;
mt∗d−pt∗ = m*ts −p*t = m*t −p*t (3.9)
• By combining eqs. (3.6), (3.7), (3.8), and (3.9) to eq.
(3.5), we have,
• st = (mt −mt∗ )−β(yt −yt∗ )+γ (it −it∗ )+εt (3.10)
constrained model of exchange rate determination (with three
constraints)
Unconstrained Monetary Model
• Unconstrained - the elasticities to be different in each country,
• st = α0 +α1mt +α2mt∗+α3yt +α4yt∗+α5it +α6it∗+εt (3.11)

Where; α0=the constant term, α1 > 0=the domestic money

elasticity of the exchange rate, α2 < 0=the foreign money
elasticity of exchange rate, α3 < 0=the domestic real income
elasticity of exchange rate, α4 > 0=the foreign real income
elasticity of exchange rate, α5 >0=the domestic interest rate
semi-elasticity of the exchange rate, α6 <0=the foreign interest
rate semi-elasticity of the exchange rate, and εt =the error term or
residual or disturbance.
Likelihood Ratio
• Determine the log likelihood statistic (lnLc) of the
constrained model and the log likelihood statistic (lnLu) of
the unconstrained model. The resulting likelihood ratio
statistic,
• −2( lnLc −lnLu) ≈ χ2(q) (3.12)
• Alternative specifications of the basic monetarist model, eq.
(3.10);
• (1) The uncovered interest parity:
• it −it∗= set= set+1−st (3.13)
• (2) The covered interest parity:
• it −it∗= ftd or ftp = ft −st (3.14)
Continue…
• (3) Expected depreciation of the currency is
equal to expected inflation differential:
• Δ ste= πte−πet∗ (3.15)

• (4) The monetarist view: the expected growth of

money (mte) is equal to the expected inflation
(πte):
• mte− mte∗= πte−πet∗ (3.16)
Factors effecting ER
• st = (mt −mt∗ )−β(yt −yt∗ )+γ (set+1−st)+εt (3.10.1)
• ↑ domestic money supply - ↑ the supply of domestic currency (dollars) ↓ US dollar, and the spot
rate increases (st↑);

or st = (mt −mt∗ )−β(yt −yt∗ )+γ (ft −st)+εt (3.10.2)

• ↑ domestic real income – excess domestic demand for money stock, equilibrium achieved
through reducing expenditure, and domestic prices fall, ↑ domestic currency (st↓);

or st = (mt −mt∗ )−β(yt −yt∗ )+γ (πte−πet∗)+εt (3.10.3)

• ↓ domestic currency (expected) – ↑ domestic interest rate to cover the forward discount with
higher interest rate – causal effect (set+1 ↑ ⇒ (it ↑ −it∗L-R ).

or st = (mt −mt∗ )−β(yt −yt∗ )+γ (mte−met∗)+εt (3.10.4)

• ↑ domestic money supply (expected)- ↑ the supply of domestic currency (dollars) ↓ US dollar,
and the spot rate increases (st↑);
The ER Dynamics or Overshooting
Model (Sticky Prices)
• Monetarist model assumes instantaneous adjustment
in all markets- An important modification was set forth
by Dornbusch (1976);
• in the short run, the real exchange rate and the
interest rate can diverge from their long-run levels,
• Exchange rate dynamics or “overshooting” can occur
in any model, in which some markets do not adjust
instantaneously,
• This sticky price version is a Keynesian model of the
monetary approach,
Continue…
• Model of exchange rate determination - changes in the
nominal money supply are also changes in the real money
supply [Ms↑/P* = = Ms /P↑, because prices are sticky, so
the effect is real;
⇒DBonds ↑⇒PBonds ↑⇒ i ↓⇒K outflow
⇒SS−R ↑↑↑⇒ X ↑
• In the short run - prices are sticky, a monetary expansion
has a liquidity effect - interest rate falls – begins capital
outflow - ↓currency instantaneously - cancels out the
interest differential - known as “overshooting” of the spot
exchange rate;
Equilibrium S-R

• in period t1 – unanticipated Ms↑ - new equilibrium btw

prices and quantities - due to price stickiness - prices of
goods increase gradually toward the new equilibrium in
period t2, in ES-R,
• Then, a new long-run equilibrium will be attained in the
domestic money, currency exchange, and goods
markets,
• Exchange rate will initially overreact (overshoot), due
to a monetary shock - economy will reach its new long-
run equilibrium in all markets in period t2,
Model Equations L-R

• The money demand function,

• mt = p~t +α+βyt −γ it +ε1t (3.6`)
• The uncovered interest parity,
• it −it∗ = Δ set = set+1 − st (3.4`)
• The long-run PPP,
• St~ = pt~ − pt~∗ (3.5`)
Continue…
• The long-run monetarist exchange rate equation,
• st~ = (mt~ −mt~∗)−β(yt~ −yt~∗)+γ (Δ pet~ − Δ pet~∗)+εt
(3.17)
• System is stable – Income growth is exogenous,
random with E(gy ) = 0, and monetary growth follows
a random walk,
• In L-R , the relative price level and exchange rate -
increase at the current rate of relative money growth;
• (gmt−gmt∗ or ˙mt − ˙mt∗ )
ER Growth
• Then, eq. (3.17) becomes,
• st~ = (mt~ −mt~∗)−β(yt~ −yt~∗)+γ (gmt−gmt∗ )+εt (3.18)
• S-R , exchange rate close that gap with a speed of
adjustment of ɵ (theta), L-R , exchange rate expected to
increase;
• set+1−st = − ɵ (st − st~ ) + gmt−gm∗t (3.19)
• By combining (19) with (4 `), we obtain,
• it −it∗ = − ɵ (st − st~ ) + gmt−gm∗t (3.20)
• growth of money equal to the expected inflation
• gmt−gm∗t = πte−πet∗ (3.21)
Continue…
• st − st~ = − 1/ɵ [(it −πte) – (it∗−πet∗)] (3.22)
• Gap between the exchange rate and its equilibrium
value is proportional to the real interest rate
differential,
• tight domestic monetary policy - interest differential ↑
equilibrium level, an incipient capital inflow - domestic
currency ↑- st ↓,
• by combining eq. (3.18) with eq. (3.22),
• st − st~ = − 1/ɵ [(it −πte) – (it∗−πet∗)] +εt (3.23)
Overshooting Equation
• General monetary equation of exchange rate
determination,
• st~ = (mt~ −mt~∗)−β(yt~ −yt~∗)+γ (gmt−gmt∗ ) − 1/ɵ [(it −πte)
– (it∗−πet∗)] +εt (3.24)
• If the monetarist model is correct, the last variable must
have a coefficient of zero, which means that the speed of
adjustment (ɵ) is infinite, the expected long-run inflation
differential (πte−πet∗) is zero.
• Equation (3.24) becomes,
• st~ = (mt~ −mt~∗)−β(yt~ −yt~∗) − 1/ɵ [(it– it∗)] +εt (3.25)
(Note: It is the Dornbusch equation)
Portfolio-Balance Approach
• Correlation between current account deficits (CAt ) and
exchange rates (st) - (ρCA,s > 0),
• (CAt ) largely dominated by imports of oil - imports of
industrial and manufacturing products (small countries),
• a sharp increase in world oil prices raises the demand for the
dollar,
• Economists argue that the huge US national debt, the Middle
East crises, and the easy money policy of the Fed have
depreciated the dollar,
• dollar depreciates or depreciates depending on “bad” or
“good” news,
Current Account component
• the unexpected component (CAu) of the current
account (CA = CAe +CAu) has a large effect;
• CAt+1 = CAet+1+CAut+1 (3.26)
• Whereas,
• CAt+1=the actual current account balance, CAet+1 = the
expected current account balance based on
information today [CAet +1 = E(CAet +1 |It )], and CAut +1
=the unexpected part of the current account balance,
the “surprise,” the “news,” the risky part of the CAet +1,
Transfer of Wealth
• CA surplus - transfer of wealth from foreign
residents to domestic residents (and a transfer of
unemployment from the domestic economy to
the foreign one - (Wt↑) can appreciate the
currency (St↓),
• (1) It can raise domestic expenditure by
increasing domestic consumption:
+
• Ct = f (Wt ) (3.27)
Aggregate demand
• 2) ↑ AD, which will affect production and income - ↑
income will increase the demand for money (Mtd,):
• Mtd, = α0 +α1Wt +α2Pt −α3it +εt (3.28)
• (3) If domestic bonds and foreign bonds are
imperfect substitutes - hold wealth in the form of
domestic bonds, then:
+
• Btd= f (Wt ) (3.29)
• Where, Btd =demand for domestic bonds.
Risk Premium
• Imperfect capital substitutability means that there is a
risk premium (RPt ),
• RPt = fdt −E(Δst ) = it −it∗ − E(Δ st ) = (ft −st )−(set+1 − st)
(3.30)
• Investors allocate their bond portfolios between the
two countries in proportions that are functions of the
expected rates of return (iet −iet∗ ),
• Shock in the economy, in the form of a change in
wealth, produces a wealth effect - substituting a high-
return financial asset for the low-return alternative,
Continue…
• A simple version of the portfolio balance model;
• Demand for money:
• Mtd = m(it , i∗t ,Wt ) (3.31)
• Demand for domestic bonds:
• Btd = b(it , i∗t ,Wt ) (3.32)
• Demand for foreign bonds evaluated in the
domestic currency:
• StBt∗d = f (it , i∗t ,Wt ) (3.33)
Equilibria
• The supply of these assets is given as follows: Mts
, Bts , and Bst∗ , and we assume equilibria,
• Mtd =Mts =Mt (3.34)
• Btd= Bts = Bt (3.35)
• Btd∗ = Bts∗ = Bt∗ (3.36)

• financial portfolio makes up the total wealth (Wt );

• Wt = Mt + Bt + StBt∗ (3.37)
Continue…
• Domestic interest rate (it ) and exchange rate (St ) must adjust
so that the assets are willingly held by investors
(maximization of their return);
• Current account surpluses increase the net domestic holdings
of foreign (bonds) assets (Bt∗ );
• From e.q., 3.33 and 3,37 the exchange rate (St ) of the
portfolio balance model will be;
• St = s(Mt ,Bt ,Bt∗ , it , it∗) (3.38)
• foreign interest rate (it∗ ) is determined by the foreign asset
market,
• it∗ = r(Mt∗ ,Bt∗) (3.39)
Relationship between exchange
rates, assets supplies, and interest
rates
+ + − + − +
• St = s(Mt ,Bt , Mt* ,Bt∗,it , it∗) (3.40)
• expansionary monetary policy, ↑ M
t, = demand for foreign
currency↑ Wt, demand for domestic bonds would raise their
price, ↓ it, ↑, domestic currency ↓, St ↑,
• And, also ↑ domestic debt , ↑ bond supply = ↓ price and ↑ it ,
we have condition (it > it∗), so we have ↑ domestic currency,
• Now, ↑ Bt∗ due to current account surplus ↑ Wt ↑ demand
for domestic assets, ↑ prices and ↓ it, domestic currency ↓, St
↑.
Efficiency in the Foreign Exchange
Market and Exchange Rate
Movement
• The government policy makers need to design
macropolicies for achieving the goal of maximization of
their social welfare through efficient resource allocation.
• International investors and financial managers need to
assess foreign asset returns and risks in order to make
optimal portfolio decisions.
• The foreign exchange market efficiency hypothesis is
the proposition that prices (exchange rate movements)
fully reflect information available to market participants.
Hypothesis testing
• Numerous studies have been tested for
speculative efficiency and arbitraging efficiency;

• (1) the forward discount is a good predictor of the

change in the future spot rate, implying covered
interest parity (CIP), uncovered interest parity (UIP),
and rational expectations to hold, and
• (2) the forward discount tends to be equal to the
interest differential, implying that CIP holds,
The Efficiency of the Foreign
Exchange Market
• Early 1970 - efficient market hypothesis (EMH) - by
Eugene Fama - financial markets are “informationally
efficient”,
• Market efficiency is associated with the rationality of
market expectations,
• we designate Rt+1 as a series of asset returns next
period and Re t+1 as market expectations of these
returns,
• E[Rt+1 −Re t+1 |Πt ] =0 (3.41)
• (Π =πληρoφoριαι, very broad information)
White noise
• In case there are systematic forecast errors in Re
t+1 Investors inspect the forecast errors εt+1 and the
resulting error becomes “white noise.”
• Eq., (3.41) can be used to express the spot
exchange rate as follows,
• E[st+1 −set+1 | Πt] = 0 (3.42)
• Equation (3.42) states that the expectation errors will be
zero on average, difficulty lies in forming the optimal
forecast value that results in residuals displaying no
informational content.
The Random Walk Hypothesis
• Let the current value of st be equal to last
period’s value plus a white-noise term;
• st = st−1 +εt or st −st−1 = εt (3.43)
• The random walk model is clearly a special case
of the AR(1) process:
• st = α0 + α1st−1 + εt , when α0 = 0 and α1 = 1
• Investor does not need all the information in Πt =
experience, empirical knowledge, market conditions, true
wisdom, and have very high information costs etc,…
Continue…
• Economists have observed that the exchange rate follows a
random walk process, thus; set+1 = st
• substituting eq. (3.44) into eq. (3.42) and using information
It , we get,
• E[st+1 −st |It ] = 0 (3.45)

If the foreign exchange market is efficient, the current

exchange rate will reflect all the available information and
the unexpected change in the spot rate (st+1 −st ) is
essentially caused by the random shock εt+1.
Market rationality
• Market rationality suggests that the investor finds no
particular pattern from the history of εt+1. This random
walk (market efficiency) can be tested as follows:
• st = α0 +α1st−1 +εt (3.46)
• If α0 ∼= 0 and α1 ∼=1, the foreign exchange market is efficient.

Exchange rates respond to “news” (surprises), which are

unpredictable. Thus, exchange rates move randomly
because they respond sensitively to the unexpected events
that randomly hit the markets.
The Unbiased Forward Rate
Hypothesis
• Another way to measure the expected exchange rate is to
use the forward exchange rate,
• “The Unbiased Forward Rate Hypothesis” (UFRH) - implies
that the investor is risk neutral, transaction costs are
insignificant, and the arrival of important informational
events is random,
• set+1 = ft (3.47)
• and a smaller information set It,
• E[st+1 −ft |It ] = 0 (3.48)
• A nonzero value, E[st+1 −ft |It ] ≠ 0 , suggests the rejection of
the unbiased forward rate hypothesis
Testing UFRH
• This UFRH (market efficiency) can be tested as
follows:
• st = α0 +α1ft−1 +εt (3.49)
• If α0 ∼= 0 and α1 ∼=1, the foreign exchange market is
efficient.

• Last period’s forward rate predicts the current spot rate.

Prices reflect all relevant available information; thus, the
residuals in eq. (3.49) should contain no information and,
therefore, should be serially uncorrelated [E(εt ,εt−1) = 0]
Risk Neutrality
• Under the assumption of risk neutrality, if the forward
exchange rate is an unbiased predictor of the future spot
exchange rate [ft = st+1]; then, the constant term should
be closed to zero [α0 ∼= 0] and the slope coefficient
(actually, elasticity) should be closed to unity [α1∼=1],
• At period t −1 summarize all relevant information
available at that period, these exchange rates should also
contain the information that is summarized in data
corresponding to period t − 2 and so on, then
• st = α0 +α1ft−1 + α2ft−2 +…… + εt
(3.50)
The Composite Efficiency
Hypothesis
• Combines the previous two hypotheses (the
random walk and the unbiased forward rate
hypotheses). It suggests that the expected
future spot exchange rate is a weighted average
of the current spot rate and the forward rate, as
follows,
• set+1 = wst +(1−w) ft
(3.51)
• where, w=the weight of the spot rate.
Testing CEH
• Composite efficiency hypothesis (CEH) contains
two sets of information affecting the future spot
exchange rate: first, past historical information
and second, rational expectations of the market
participants.

• One problem might still exist: What will be the

value of each one of the weights on the spot and
forward rates?
Exchange Rate
Volatility and
Predictability

Standard deviation of the spot

exchange rate between the US
dollar and the euro has been,
σs=±2.8% per month, as graph
3.1 shows,
Negative “news” change our
expectations (make us, mostly,
pessimistic) and are the prime
cause of fluctuations in asset
prices. Consequently, new
(“news”), the resulting
fluctuations in price (exchange
rate) cannot be predicted by
lagged forward exchange rates,
which are based on past
information.
Continue…
• Exchange rate movements can be exploited using the following model:
• st = Φt +δEt (st+1 −st) (3.52)
• where, Φt represents only the economic fundamentals, i.e., refer to (3.10),
• Assuming that expectations are rational in eq. (3.52), the current
exchange rate and current expectations of future exchange rates are
linked, and both depend on expectations concerning the future
fundamentals (EtΦt+1).
• Based on the above argument, we expect a high correlation between
movements of spot and forward rates,
• And, market’s best forecast of the future spot rate is the current spot
rate. This phenomenon reveals that exchange rates follow a random
walk process.
Exchange Rate Expectations and
Unanticipated Events (“News”)
• Rational expectations hypothesis (REH) developed
initially by John F. Muth (1961) and theorized by
Robert Lucas (early 70’s)- states that expectations
reflected in market behavior will be optimal forecasts
using all available information,
• The predominant cause of exchange rate movements
is the unanticipated “news” (surprises), then;
• st = “the expected exchange rate” + “the unexpected part
of the exchange rate”
• st =ste +stu
Interest rate differentials and news
• The spot rate can be expressed as a function of factors,
which are known in advance and are summarized by the
lagged forward rate, plus a function of the “news” and a
serially uncorrelated error term, as follows:
• st = α0 +α1ft−1 + α2“News”t +…… + εt (3.53)
• Important variables that are affecting the exchange rate
can be the interest rates in the two countries because
they are market determined, and “news” affects them
promptly, then we have;
• st = α0 +α1ft−1 + α2[(i t −i t ∗ )−E t-1(i t −i t ∗ )] +…… + εt
(3.54)
Test for REH
• IRP, the expected interest differential can be computed from a
regression by using lagged values of the spot and forward
rates, and lagged values of the interest differential, as follows,
• Et−1(it −it∗ ) ≡(it −it∗ ) = β0 +β1st−1 +β2st−2 +β3ft−2 +β4ft−3+β5(it−1 −it−1∗)
+β6(it−2 −it−2∗)+εt (3.55)
• Now, we take the difference between the actual interest
differential minus the computed expected interest differential,
which represents the “news.”
• If α0 ∼= α1 ∼= 0 and α2 ∼=1, the foreign exchange market is efficient,
• In the case that α2 ≠ 0, this means that the current exchange rate is
affected by expectations i.e. ‘News’.
Money Market and Exchange Rate
• Kallianiotis (2010) have used the spot exchange
rate as an independent variable in the money
market equilibrium equation, as follows;
• Mt /Pt = L(Qt , it ,St ) (3.56)
• LQ > 0, Li < 0, LS > 0

• Where, Mt =the money supply, Pt =the price level, Qt

=real income, it =nominal rate of interest, and St
=the spot exchange rate.
EMH
• $t(dollar is depreciated), ↓ demand for US dollar
(investors and speculators do not want to hold a
weak currency) - ↑ US interest rate to increase in
order to attract foreign investment,
• By taking natural logarithm of the variables, we have:
• st = β0 −β1qt +β3it +β4(mt −pt )+εt (3.57)
• Efficient markets approach emphasizes the efficiency of markets
reacting to information, rather than market structure.
• The rational expectations approach, in contrast, emphasizes the
structure of the model that explains fundamental market reactions.
International Perspective
• Money demand, money supply, and exchange rates
should be analyzed from an international perspective,
• Mdt −pt = β0 +β1qt −β2it +εt (3.58)
• mst−pt = exogenous (3.59)
• where,
Mdt =the ln of money demand, pt =the ln of price level, mst =the
ln of money supply, β1 =the income elasticity of demand for real
balances, β2 =the interest rate semi-elasticity of demand for
real balances, it =the opportunity cost of holding money, qt
=the ln of a measure of real economic activity (income).
Aggregate disturbances
• Fluctuations in real incomes lead to aggregate
disturbances in the money markets. we can get
the spot exchange rate as follows,
• st = f [(mt −mt ∗), (mdt−pt )−(m∗dt−p∗t ), set+1|It ]
(3.60)
• Where,
mt −m∗t=the nominal stock of money differential in the
two countries and (mdt−pt )−(m∗dt−p∗t)=the real
demand for money differential in the two countries.
Continue…
• Exchange (MV = QP) in natural logarithm (ln)
terms,
• mt +vt = qt +pt (3.61)
and the PPP (S = P/ P∗ ) in natural logarithms,
• st = pt −pt∗ (3.62)
And, Also
• st = (vt −vt ∗)+(mt −mt∗ )−(qt −q∗t) (3.63)
Continue…
• In first differences;
• st - st -1= [(vt −vt ∗)-(vt-1 −vt-1 ∗)]+[(mt −mt∗ )-(mt-1
−mt-1∗ )−[(qt −q∗t)-(qt-1 −q∗t-1)] (3.64)
where,
• vt =the ln of velocity of money, mt =the ln of stock of
money, qt =the ln of the real output (income),
Exchange Rate and Risk (Freezing
Funds Risk
Premium, Wars, Debt Crises)
• This current ex ante analysis includes an international
portfolio balance theory and its implications are used for
exchange rate determination,
• Hypothesis that real money demand depends not only
on real income, the conventional transactions variable,
but also on interest rate and on exchange rate, eq.
(3.56), the speculative demand,
• Diversification for portfolio investors can maximize their
expected return (ite ) and minimize its risk(σ2i) through
investing in numerous currencies,
Nominal interest rate
• The nominal interest rate for a foreign investor
(investing abroad) must be as follows (with ex ante
calculation), depending on whether the currency is
at a forward discount or at a forward premium:
• ieiAt+1= ie∗t+1+fpet+1 (3.65)
or
• ieiAt+1= ie∗t+1+fdet+1 (3.66)
And, also,
• fpet+1 +fdet+1 = ft - st ∼= set+1 - st (3.67)
Continue…
• For a domestic investor, the risk-free rate of interest has
two components:
• ieDt+1= ret+1 + πet+1 (3.68)
• where, iD =the nominal interest rate (return) for investing
domestically, iA=the interest rate (rate of return) for
investing abroad, r=the real rate of interest, π =the
inflation rate, fd=the forward discount of the currency,
fp=the forward premium, s=the ln of spot exchange rate,
f =the ln of forward exchange rate, (e) the expected
value of the variable, and an asterisk (*) denotes the
foreign country.
Ex ante interest rates
• Ex ante interest rates can be measured by using a combined regression-time series
model as a function of lagged values of interest differential, lagged values of
exchange rate, lagged values of inflation differential, and an autoregressive moving-
average model (lagged values of the dependent variable and lagged values of the
error term):

iet+1 i e
= Dt+1+ i* e
t+1
Interest rate risk
• Bollerslev’s (1986) model is used, which is an extension of
Engle’s (1982) original work,
• This process is the Generalized ARCH (p, q), called the GARCH (p,
q), in which the variance is given by,

• Now, the utility function of an investor, by investing on home (iAD

i or iED ) and foreign (iAA i or iEA ) securities,
• Max U = u [E(it+1),σ2i (3.71)
Continue…
• Domestic investors (iAD i or iED ) and foreign (iAA i or iEA ) - ↑
demand for this country’s assets - ↑ currency demand
(currency appreciation), $t↓,
• E(iADt+1 )= ieDt+1 (3.72)
• E(iEDt+1 )= i*eDt+1 (3.73)
• E(iAAt+1 )= i*et+1 + fpet+1 (3.74)
• E(iEAt+1 )= iet+1 + fdet+1 (3.75)
Where,
fpet+1 ≡ hfpt+1 = historical forward premium; fdet+1 ≡ hfdt+1 =
historical forward discount
Expected Return to variability
• The objective is to maximize them;
• Max E(RVR) = E(it+1) /σi (3.76)
• International Finance postulates - “The currency with
the higher interest rate will sell forward at a discount,
and the currency with the lower interest rate will sell
forward at a premium.”
• Currency is at a premium (S ↓ and $ ↑ ), the interest
rate will decline (i ↓ ), - correlation exists between St+1
and it+1. The causality between it, and St (I ⇒S) is tested
too.
Hodrick-Prescott (HP) filter
• Here, the goal is to forecast the rate of return in different
financial assets and their risk and to derive the long-term trend
of these interest rates by using the Hodrick-Prescott (HP) filter.
• In a country when the interest rate increases and the risk falls
(increase in RVR), its currency will appreciate.
• Two-sided linear filter that computes the smoothed series I
(HPTREND) of i (iAD, iED ,iAA, iEA ) by minimizing the variance of i
around I, subject to a penalty that constrains the second
difference of I. Then,

• λ=14,400 (because data are monthly), as Hodrick and Prescott

(1997) mention.
Continue…
• A current account deficit is matched by a capital
account surplus.
• In other words, a country with a current account deficit
surrenders claims on future income (physical assets,
stocks, and bonds) to foreigners,
• Arabs and the other Muslim investors, shocked by the
war (Iraq - war) and afraid that the US government
might freeze their funds, transferred them to Europe.
Safety reward
• Then, the interest rate in the United States must be:
• iUSt > i∗EUt +fd$t +FFRPt (3.78)
• And,
• iUSt + SRt> i∗EUt +fd$t +FFRPt (3.79)
• Where,
• SRt = safety reward.

• Thus, investors still find that dollar-denominated claims

are an attractive element of any international portfolio.
War Dummy variable
• st = α0 +α1poilt +α2ndt +α3tdt +α4pGoldt +α5WD+εt (3.80)
where, poil =price of oil, nd=national debt, td=trade deficit,
pGold=price of gold (measurement of uncertainty),WD=war
dummy (taking values of zero [0] before the third month of 2003
and one [1] after that date).
In other words, financial economists try to establish a
relationship between exchange risk premiums and the
measure of risk. One popular approach is the consumption-
based international asset pricing model – “choosing an
optimal path of consumption and assets that yield uncertain
return”.
Risk Premiums
• Chiang (1991) has developed a model to link the risk
premiums in foreign exchange markets to the equity risk
premiums in the stock markets,
• The equation can be the following:
• st+1 −st −(it −it∗ ) =δ0 +δ1(RPe m,t+1 −it )+δ2(RP∗em∗,t+1−i∗t )+εt+1
(3.82)

where, it =the three-month T-bill rate, δ1 > 0, δ2 < 0, RPe m,t+1

−it =the expected equity risk premium in the domestic
market, and RP∗em∗,t+1−i∗t =the expected equity premium in
the foreign market.
Oil Prices and Exchange Rate
• An oil price increase offers an interesting example
of possible conflict between an asset market and a
goods market view of the exchange rate,
• Another equation, beyond eq. (3.80), which takes
into consideration the price of oil and the Euro-
zone debt crisis, can be the following:
• st = α0 +α1poilt +α2ndt +α3tdt +α4pGoldt +α5WD α6EDCD +εt
(3.83)
• Where, EDCD=European debt crisis dummy (taking zero [0]
before the tenth month of 2009 and one [1] after).
Monetary, Fiscal, and Trade Policies
and Exchange Rate
• Public policies can be fiscal (through taxes and government
spending), monetary (with the use of interest rate and money
supply), and trade (by intervening in the foreign exchange market)
- all these policies affect the value of the currency and exchange
rate.
• Task: Run a vector autoregression (VAR) estimate to see the effect
of monetary (and fiscal) policies on the three most interrelated
time series (s, iFFF , i∗ONDF) and to analyze the dynamic impact of
random disturbances on the system of our variables,
• Spot exchange rate (st ), the expected (forecasted) federal funds rate
(iFFFt ), and the expected (forecasted) overnight deposit rate (i∗ONDFt ), the
iFFt and i∗ONDt as exogenous (policy instruments) variables.
Empirical Investigation
• BOP Approach to determine ER,
• st = α0 +α1(pt −pt∗ )+α2(yt −yt ∗)+α3(it −it∗ )+α4(Πt −
Πt∗ )+εt (3.2)
• By taking monthly data between the United
States and the Euro-zone;
• Note: Expressing all the variables in natural logarithms
(st ), except interest rates,
Co-efficient signed Test
• α1 > 0 - increase in pt reduces xt and the CAt
deteriorates - ↓domestic currency - spot rate will
increase, st↑;
• α2 > 0 - growth in domestic real output, increase
imports (mt) and the CAt deteriorates; ↓domestic
currency depreciates, (st↑);
• α3 < 0 an increase in the domestic interest rate, will
cause capital inflows in the country, ↑demand for
domestic currency, ↑ domestic currency (st↓);
• α4 < 0 intervention (domestic trade policy) will have as
Empirical Investigation
• Monetary Model Approach
• 1. Constrained Model
• st = (mt −mt∗ )−β(yt −yt∗ )+γ (it −it∗ )+εt
(3.10)
constrained model of exchange rate determination (with three
constraints)

• 2. Unconstrained Model
• st = α0 +α1mt +α2mt∗+α3yt +α4yt∗+α5it +α6it∗+εt (3.11)
Note: Correct the serial correlation by using a MA(q) process!!!
Coefficient Signed Test
Where as;
• α0=the constant term,
• α1 > 0=the domestic money elasticity of the exchange rate,
• α2 < 0=the foreign money elasticity of exchange rate,
• α3 < 0=the domestic real income elasticity of exchange rate,
• α4 > 0=the foreign real income elasticity of exchange rate,
• α5 >0=the domestic interest rate semi-elasticity of the exchange rate,
• α6 <0=the foreign interest rate semi-elasticity of the exchange rate,
and;
• εt =the error term or residual or disturbance.
Likelihood ratio statistic
• −2( lnLc −lnLu) ≈ χ2(q) (3.12)
• Compare the likelihood ratio test statics with χ2(q) critical value.

• Run the other specifications of eq. (3.10), which are eqs.

(3.10.1), (3.10.2), (3.10.3), and (3.10.4).
• Compare the results from these specifications and
interpret the results in accordance with the theoretical
understanding.
Overshooting Model Test
• st~ = (mt~ −mt~∗)−β(yt~ −yt~∗)+γ (gmt−gmt∗ )
− 1/ɵ [(it −πte) – (it∗−πet∗)] +εt
(3.24)

• Check for the monetarist model if it is correct or

not - i.e., the last variable must have a
coefficient of zero, which means that the speed
of adjustment (ɵ) is infinite.
• If not the case, we have “overshooting”!!!
Empirical Investigation
• Portfolio-Balance Approach
+ + − + − +
• St = s(Mt ,Bt , Mt* ,Bt∗,it , it∗) (3.40)
• Compare the results with the theoretical implication!!!
• Check for the serial correlation and make correction with MA(q).
• Check for co-efficient signs!!!
Empirical Investigation
• Random Walk Testing
• s = α +α s
t 0 1 t−1 +εt (3.46)

• Unbiased Forward Rate Hypothesis (UFRH)

• st = α0 +α1ft−1 +εt (3.49)
• st = α0 +α1ft−1 + α2ft−2 +…… + εt (3.50)

Note: If α0 ∼= 0 and α1 ∼=1, the foreign exchange

market is efficient.
Empirical Investigation
• Exchange rate predictability
• st = Φt +δEt (st+1 −st)
(3.52)
Where, Φt represents only the economic fundamentals, i.e., refer to
(3.10)

• Expectations and News

st = α0 +α1ft−1 + α2[(i t −i t ∗ )−E t-1(i t −i t ∗ )] +…… + εt
(3.54)
Et−1(it −it∗ ) ≡(it −it∗ ) = β0 +β1st−1 +β2st−2 +β3ft−2
Exchange Rate and
Parity Conditions
International Finance Theories
International
Parity Conditions
(IPC)
International parity
conditions - two
economies are in
equilibrium,
International
parities can all be
presented in one
graph, as it is
shown in Graph
2.1.
The data presented
reflects the U.S.
and Euro-zone on
September 6,
2012.
IPC
• Note:
PPP=Purchasing Power Parity, FE=Fisher Effect, IFE=International
Fisher Effect, IRP=Interest Rate Parity, FRUPFSR=Forward Rate as
an Unbiased Predictor of the Future Spot Rate, FDEID=Forward
Discount equal to the Expected Inflation Differential;
St =spot exchange rate, st =ln of spot exchange rate,
Ft+n=the n-month forward rate, ft+n=the ln of the n-month
forward rate, πet =expected inflation, it =short-term
interest rate (Federal Funds and overnight deposit rates),
fd =forward discount, fp=forward premium, n=number of
months, and an (*) denotes the foreign country.
Prices and Exchange rates
• “Classical economic theory” believes that inflation is a
monetary phenomenon, which can be derived from the
equation of exchange (M V` = Q`P)
Where, M is the money supply, V is the velocity of money, Q is index of
expenditures or real output, and P is the average price level of goods.
• If identical products or services can be sold in two different
countries, and no restrictions exist on the sale (tariffs, etc.)
or transportation cost of moving the products between
countries, the products’ price should be the same in both
countries’ markets - called the “law of one price” (Efficient
markets)
Balassa-Samuelson Effect
• Argues that the law of one price is not applicable to all
goods internationally, because some goods are not
tradable,
• Make a typical consumption basket cheaper in a less
developed country,
• Even if some goods in that basket have their prices
equalized by international trade,
• Also the consumption might be cheaper in less developed nations,
Commodity Price Parity (CPP)
• Assume that;
• Commodity markets are perfect;
• There are no costs for exporting goods from one country
to another,
• In such a setting there exists a non arbitrage
relationship between exchange rates and the prices of
individual goods at home or abroad, then we have,
• Pjt = St P∗jt (2.1)
Where Pjt = the dollar price of commodity j in the domestic market
(US), P∗jt = the euro price of commodity j in the foreign market (the
Eurozone), and St = the spot exchange rate ($/€).
CPP Not Holds
• Reasons being;
• Transaction costs: There are tariffs (t), transportation
costs, insurance fees, and other transaction costs,
which cause a deviation from CPP,
• 2. Nontraded goods: Many goods are non tradable, such
as housing, services (theater tickets, haircuts, lawyers’
fee, etc.), and others, so CPP does not hold in this case,
• 3. Quantitative restrictions: “voluntary” import
restrictions, and other such barriers to trade, it is
impossible to import more units once the import ceiling
has been reached,
Continue…
• 4. Imperfect competition: exclusive dealerships lead to
segmented markets across countries, manufacturers
make parallel imports difficult so that they can profit
from price discrimination; entry costs also hinder
arbitrage; prices of some goods may be sticky in a
market,
Law of One Price
• If the law of one price were true for all goods and services,
the PPP exchange rate could be found from any individual
set of prices, as follows:
• St = Pjt /P∗jt (2.2)
where St = spot exchange rate in period t, Pjt = domestic price of
product j in period t, and P∗jt = the foreign price of product j in period
t,

• Can determine the “real” or PPP exchange rate that should

exist if markets were efficient. For example:
• St = Pjt /P∗jt = $12.625 / ∈ 10 = 1.2625 $/∈ (2.3)
Absolute PPP
• Exchange rate between two countries will be identical to
the ratio of the price levels (Pt and Pt ∗),
• The assumptions are that (2.1) commodity markets are
perfect, and (2.2) there are representative consumption
bundles that are comprised of many goods,
• Thus, this is a theory of exchange rate determination
(nominal exchange rate),
• St P∗jt = Pjt (2.4)
Continue…
• And the absolute PPP is given as follows:
• St = Pjt /P∗jt (2.5)
where Pjt = the domestic price level (consumer price
index, CPIt ), P∗t= the foreign price level (CPI∗t ), and St
= the spot exchange rate.

• Differences in weighting (price levels) will cause

absolute purchasing power parity to deviate from its
expected value.
Relative PPP
• Relative purchasing power parity (PPP) describes
differences in the rates of inflation between two
countries,

• The percentage change in the value of the

currency (spot exchange rate) should, then,
equal the difference in the inflation rates
between the two countries,
Derivation Relative PPP
• To derive the relative PPP, the assumptions of the
absolute PPP are relaxed by first taking the natural
logarithm of the variables in equation (2.5) and
then the difference between the logarithms of two
consecutive periods to determine the growth of
the variables;
• Based on absolute PPP, St = Pt / P∗t (2.5’)
• we get:
• lnSt =ln Pt −ln P∗t ⇒( lnSt −ln St−1)=( ln Pt −ln Pt−1)−( ln
P∗t−ln P∗t−1),
Continue…
• the relationship of the relative PPP;
• ˙st = ˙pt − ˙p∗t (2.6)
• which can also be written as;
• %ΔSt =% Δ Pt −% Δ P∗t (2.7)
• or in a better form, the relative PPP is;
• ˙st = πet−π∗et (2.8)
• where ˙st ,˙pt ,˙p∗t , πet , π∗et = Growth of the spot
exchange rate, domestic and foreign price level,
expected domestic and foreign inflation etc…
Relative PPP
Graph 2.2 shows the
relative PPP—the
equilibrium position
between a
change in the exchange
rate and the relative
inflation rates in the
United
States and the Eurozone.
˙ st = πet−π∗et ⇒
−1%= 1.4%−2.4%
Test of PPP
• Conducted by running the following regressions
on equations (2.5) and (2.6):
• 1. Absolute PPP:
• St = α0 +α1 (Pt/P∗t) + εt (2.9)
• If α0 = 0 and α1 = 1, the absolute PPP holds.
• 2. Relative PPP:
• ˙st = β0 +β1(˙pt − ˙p∗t ) + εt (2.10)
• If β0 = 0 and β1 = 1, the relative PPP holds.
PPP Test Validity Issues
• 1. The price indexes that are used for the tests, as the
WPI (PPI), CPI, and others,
• 2. The tests should be based on comparing a similar
market basket of goods in each country with all its
trading partners,
• 3. PPP theory requires expected inflations (πet and π∗et
), and we do not know what the market forecast is for
the different inflations, but the data that are available
are realized inflation rates (or existing differential of
interest rates, as a proxy for expected inflations),
Continue…
• 4. Some governments or central banks interfere in
the foreign exchange market or in the trade process,
• 5. Many other factors, besides relative prices,
influence the balance of trade or the current account.
• 6. Changes in domestic (Yt) and foreign (Y∗t )
incomes are also important. Then, income elasticity
of demand for imports (ηM) affect trade and the value
of the currencies (exchange rates),
Nominal, Real, and Effective
Exchange Rate
• The nominal exchange rate (St ) is defined as the number of units
of the domestic currency that can purchase a unit of a given
foreign currency (i.e., S = 1.2988 $/€),
•↓ this variable, ↑ nominal appreciation of the currency ($) and
vis a versa,
• the real exchange rate (Rt) is the nominal rate divided by the
relative price level (price indexes) in the two countries, as follows:
• R t = St
Pt/P∗t
• = StP∗t / Pt = TOTt = PMt/ PXt (2.11)
Continue…
• If PPP holds, the Rt = 1, because StP∗t = Pt and in this case,
PM = PX , thus, the real exchange rate or the terms of trade
allows us to compare the competitiveness of one country
against another,
• If Rt < 1 the domestic country is less competitive and vis a
versa,

Now, the real effective exchange rate (Refft ) is the weighted

average of a country’s currency relative to an index or
basket of other major currencies adjusted for the effects of
inflation.
Continue…
• So we have,

• Where,
• Refft = the real effective exchange rate (index), wt,j = the weight
assigned according to the amount of trade of each foreign
country with the home country, and Rt,j = the real exchange
rate,

• If Refft < 1, country being less competitive

Deviations from PPP
• Theory of PPP was first popularized by the economist
Gustav Cassel after World War I to answer the question
of what the new exchange rate parities should be, after
the interruption of the fixed exchange rate system,
• Of course, prices of goods and services do not change
instantaneously after a monetary shock (price inertia),
thus, we experience deviations from PPP,
• st −st−1 = θ (pt −p∗t−st−1) (2.14)
• where θ = the speed of adjustment of prices (0 ≤ θ ≤ 1).
• If θ = 1 (instantaneous adjustment of prices), PPP holds.
Continue…
• If price elasticity is greater than one (elastic demand) in
absolute value (|εM∗ | > 1) exports will fall and imports will
increase, if the domestic price elasticity for imports is elastic
(|εM| > 1),
• Then, if a country’s exports and imports are price elastic, as
is the case for the United States in the last 30 years, a
relatively high rate of inflation in the United States will cause
a large negative impact on the trade balance unless it’s
offset by depreciation of the US dollar,
• Thus, if the trade account deficit increases, the currency will
depreciate (st ↑ ),
Exchange rate pass through
• Exchange rate-pass-through - It is The degree to which the
prices of imported and exported goods change as a result of
exchange rate changes,
• On Contrary, as Eiteman, Stonehill, and Moffett
(2013, p. 192) mention - Many current account
deficits do not respond to changes in the value
of the currency (depreciation),
• The reason is the price elasticity of demand for
imports (εM),
Example – French car
• Renault Clio is priced at €22,000,
• Exported to the United States, its price will be Pot =
$26,400,
• From eq. (2.4) St P∗jt = Pjt = 1.2000$ /ee22,000= $26,400
• If Euro appreciated by 15% the ER becomes
1.2000(1+0.15) = 1.3800 $/ € and 100% pass-through
exchange rate becomes, 1.3800 $/ € € 22,000 = $30,360,
• Now, Renault in the United States became PNt = $28,900,
• which means that the degree of pass-through is partial,
PNt /Pot = $28,900/$26,400 = 1.095 or 10.95%,
Continue…
• The degree of pass-through is partial,
• % ΔPt /% Δ St = 10.95% / 15%
= 0.73 or 73%
• The Renault Company absorbed the remaining 27% of
the exchange rate change (i.e., depreciation of the
dollar),
• An inelastic demand (|εM| < 1) will have a high degree of
pass-through.
Interest Rates and Exchange Rates
• The relationship between interest rates, other domestic
monetary policies, and currency exchange rates is
complex, but at the core it is all about supply and demand,
• US Treasury bonds, high interest rate, high demand for
dollars, dollar will appreciate (St↓),
• In recession, low interest rates, money into safer assets,
but lower credit risk, dollar appreciates against Euro, (St↓),
• If an economy’s GDP is rising faster than its monetary
base, its currency value is increasing, and this will likely be
reflected in the exchange rate,
The Fisher Effect
• sometimes called Fisher hypothesis or Fisher parity,
is the proposition by the American economist Irving
Fisher that the real interest rate is independent of
monetary measures, especially the nominal interest
rate. The Fisher equation is;
• (1+it ) = (1+rt) (1+πet ) (2.15)
• where it = the nominal interest rate in a country, rt
= the real interest rate, and πet = the expected
inflation,
• or it = rt +πet + rtπet (2.16)
Continue…
• And, compound term in developed countries is close to
zero (rtπet ≈ 0), eq., (16) becomes,
• it = rt +πet (2.17)
• If rt is assumed to be constant, it must rise when πet
rises, thus, the Fisher effect states that there will be a
one-for-one adjustment of the nominal interest rate to
the expected inflation rate,
• By taking the Fisher equation in two different countries
and subtracting;
• it = rt +πet (2.17’)
• i*t = r*t +πe*t (2.18)
• i - i* = (r - r* ) +(πe - πe* ) (2.19)
Continue…
• Assuming that the real rates of interest are equal
in both countries (rt = r*t ), we have from
equation (2.19) the following parity;
• it - i*t = (πet - πe*t ) (2.20)
• If inflation permanently rises from a constant
level to a higher constant level, that currency’s
interest rate would eventually catch up with the
higher inflation. These changes leave the real
return on that currency unchanged,
The Fisher Effect
(FE)
The Fisher effect can
be seen in Graph 2.3,
The Fisher effect is
evidence that in the
long run purely
monetary
developments,
Will have no effect
on that country’s
relative prices,
The International Fisher Effect
• The relationship between the expected percentage
change in the spot exchange rate (%ΔSt) over time and
the differential between two comparable interest rates
in these two countries (it − i∗t ) is known as the
international Fisher effect (IFE),
• The hypothesis specifically states that a spot exchange
rate is expected to change equally in the opposite
direction of the interest rate differential, as follows;
Continue…
• The causality can be determined as (St+1↑ ($ ↓) ⇒ it↑), from
eq., (2.21),
−0.5% = (1.2609−1.2625 / 1.2625) 12/3 100
= (0.231826−0.233094) 12 / 3 100
= 0.25% − 0.75%
• This uncovered interest rate parity (CIP) (uncovered
interest arbitrage) creates distortions in the foreign
exchange market by speculators and the %ΔSet > (it − i∗t
),
The International
Fisher Effect (IFE)
Graph 2.4 gives the
IFE line,
The Real Interest Rate Parity (RIRP)
• This can be accomplished by taking the IFE in real terms, as
follows:
• %ΔSet = ˙set = set +1- st = it − it∗ (2.21’)
• Subtracting the percentage change of the price level in the
two countries from the above equation, we receive:
• ΔSet−(Δ Pet− Δ P∗et ) = (it − Δ Pet )−(i∗t−P∗et )
• Or, ΔRet = rt −r∗t = 0 (2.22)
• where Ret = expected change in the real exchange rate, rt =
the domestic real interest rate, and r∗t = the foreign real rate
of interest,
• If equation (2.22) is equal to zero, the RIRP holds,
International Parity Identity (IPI)
• Another way of addressing RIRP;
• ΔRet = ˙set + π∗et− πet = (it− πet ) – (i*t - π∗et) = rt – r*t (2.23)
• Kallianiotis and Sum (1993) determine an international
parity identity (IPI) as follows;
• it− i*t = rt – r*t + fdt - fdt + ˙set - ˙set + πet - π∗et (2.24)
• Then we have IPI;
• ˙set + π∗et − πet = (rt – r*t ) – (it− i*t - fdt )- (fdt - ˙set ) (2.25)
Whereas, left-hand side = ΔRet , which are the expected terms of trade
(PPP), (rt – r*t ) = (RIRD), (it− i*t - fdt ) = CIP, (fdt - ˙set ) = foreign
exchange market surprises (FXMS),
Conditions - Hypotheses
• (rt – r*t ) = (RIRD) = 0, “international financial market is
integrated”,
• (it− i*t - fdt ) = CIP = 0, money market is efficient,
nominal interest differential exists between countries,
which makes the market competitive,
• (fdt - ˙set ) = (FXMS) = 0, currencies are perfect
substitutes, and the foreign exchange market is
efficient,
• Then we have,
• ΔRet = tot˙et = 0 (2.26)
Continue…
• The international parity identity (IPI)—reveals that an
equilibrium in the bonds market plus an equilibrium in
the money market plus an equilibrium in the foreign
exchange market are the presuppositions for an
equilibrium in the goods market,
• will benefit individuals and the social welfare of the
nation, i.e.,

• Equilibrium in the in the goods market ≡ equilibrium in the

bonds market + equilibrium in the currency market +
equilibrium money market
Interest Rate Parity
• The IRP theory provides the link between the international money markets and the
foreign exchange markets; it is a no-arbitrage condition representing an equilibrium
state under which investors will be indifferent to interest rates available for securities
of similar risk and maturity in two countries,
• Two important assumptions for the theory of interest rate parity are: (1) capital mobility
and (2) perfect substitutability of domestic and foreign assets,
• Mathematically can be expressed as;
Example – Interest rate differential
• US it = 3.25% p.a; CAD i*t = 3.00% p.a; Spot St = 1.0264
$/C$; 6-months forward exchange rate, Ft+6 = 1.0277
$/C$,
• it− i*t = 3.25% - 3.00%
= 0.25%.
Where, Forward premium or discount is;
fpC$t OR fd$t = Ft+6 - St 12 100 = (set - st) 12 100
St n n
= 0.253%!!!
Example – MNC Investment
• MNC - the choice to invest in the US money
market or in the Eurozone money market,
• The exchange rate risk can be eliminated by
using the forward markets, a “covered
investment strategy”,
• But high Intern. Finance – requires taking care of
the idiosyncrasies, unanticipated risks, waste
(use) of resources, and complexities of our
markets and instruments,
Covered Investment
Strategy
US-Treasury bills
$RUS = 1+i (2.28)
Eurozone (EMU) Treasury bills
$REMU = 1+i* (2.29)
For each dollar ($1) invested;

For each Euros (€1) invested;

Sell forward the future (€) for $;

$REMU = F (1+i*) (2.30)

S
Covered Interest Differential (CID)
• Question remains - which is the superior investment
strategy? i.e., between eq (28) and eq (30);
• Take the difference as shown below;
• REMU - RUS= F (1+i*) – (1+i ) (2.31)
• S
• By setting CID = 0, we have CIP or IRP equation as;

• Or
Distinct Forms
• 1- uncovered interest rate parity (CIP) or uncovered
interest arbitrage (UIA)-which refers to the parity
condition that uninhibitedly exposes investors to foreign
exchange risk;
• 2- covered interest rate parity or covered interest
arbitrage (CIA) - refers to the condition in which a forward
contract has been used to cover (i.e., hedge the foreign
exchange exposure) the exchange rate risk;
• Economists have found empirical evidence that covered
interest rate parity generally holds, though not with
precision;
Continue…
• When both covered and uncovered interest rate parity hold,
they expose a relationship suggesting that the forward rate
is an unbiased predictor of the expected future spot rate;
• When uncovered interest rate parity and purchasing power
parity hold together, they contribute to the relationship
named real interest rate parity;
• Which suggests that expected real interest rates represent
expected adjustments in the real exchange rate (i.e., goods
markets).
This relationship generally holds over longer terms and
among emerging market economies.
Uncovered Interest Arbitrage
• UIA – an arbitrage trading strategy where an investor
capitalizes on the interest rate differential between two
countries,
• uncovered interest arbitrage involves no hedging—the
transaction is “uncovered”—of foreign exchange risk,
• The opportunity to earn profits arises from the reality – IRP
conditions does not constantly hold, and investors have a
realistic forecast of the future spot exchange rate,
For Example - UIA
• US can take advantage of low interest rate in London (i∗P =
0.50% p.a.) to raise capital, US interest rate (iP = 3.250% p.a.),
• £1,000,000.00 (Loan) invest @ $ 1.6249 get $ 1,624,900, invest
further @ 3.25% p.a. will get $1,677,709.25,
• After an year end St+12 @ $1.6200 convert back into £
1,035,622.99
• Repayment of Loan is £1,000,000 + @0.5% p.a. = £1,005,000

• Profit from Money market (London) = £35,622.99 (Arbitrage Profit)

Covered Interest Arbitrage
• CIA happens when interest rate parity does not hold (i.e., the
market is not in equilibrium) between two nations,
• The spot exchange rate is : St = 1.2967$/€, the three-month
forward rate is : Ft+3 = 1.3000$/ €, the US three-month
interest rate (T-bill) is : it = 3.25% per annum,
• The Eurozone three-month interest rate (T-bill) is: i∗t =
0.75% per annum, the total transaction costs are : CT =
0.15% of the transaction amount.
• The transaction size (amount used for the arbitrage) is:
LT = € 1, 000, 000.
Continue…
• Does the IRP hold? If not, how could the arbitrageur take advantage
of the situation? And how much will the arbitrage profit be?

Thus, IRP does not hold; the market is not in equilibrium

- borrow from the market with the lower cost (the
Eurozone) and invest in the market with the higher
return (US).
Graphical representation
F-discount /F-premium - Relationship with
Expected Future rate & Expected
Inflation
• International transactions involve commodities/goods
and services that are moved from one country to the
other, and their prices play a major role in demand,
trade balance, the entire balance of payments, and the
exchange rate (i.e., the relative price of currencies)
between the two countries that are comprised in trade.,
• Also, there are financial transactions in assets, and
capital inflows and outflows between nations in which
their mobility depends on interest rates and the
exchange rate between the two economies involved.,
Unbiased Forward rate Hypothesis
• The conditions of rational expectations, full
information, efficiency, and risk neutrality, the
forward exchange rate is an unbiased predictor of the
expected future spot exchange rate.,
• The following equation illustrates the unbiasedness
hypothesis.,
• Ft+n = Set+n (2.34)
• or ft+n = set+n (2.35)
• or ft+n −st = set+n−st (2.36)
• or E [ st+n −ft+n |It ] = 0 (2.37)
Assumptions
• The assumptions are that all relevant information
is quickly reflected in both the spot and the
forward exchange markets,
• transaction costs are low, and
• instruments denominated in different currencies
are perfect substitutes for one another.,
• To test this unbiased forward rate hypothesis, we
can run the following regression:
• st = α0 +α1ft−1 +εt (2.38)
• If α0 ∼= 0 and α1 ∼=
1; then, st = ft−1
(the forward rate last
period is an unbiased
predictor of the
current spot rate) and
consequently the
current forward rate
is an unbiased
predictor of the future
spot rate.,

• The graph of the

unbiased forward rate
can be seen in Graph
2.6
Failures of Hypothesis
• rationales for such failures - One rationale centers
around the relaxation of risk neutrality,
• forward rate as being equal to an expected future spot
rate and a risk premium (rpt ):
• ft+n = set+n+rpt (2.39)
• or ft+n −st = set+n−st +rpt (2.40)

Fama (1984) concluded that large positive correlations of

the difference between the forward exchange rate and the
current spot exchange rate signal variations over time in the
premium component of the forward-spot differential (Ft
−St).,
The Forward Discount & Expected
Inflation Differential
• Judging from the understanding that forward discount/premium (fdt or
fpt ) and expected inflation differential (πet - πe*t ) btw two
countries;
• FE: it - i*t = (πet - πe*t ) (2.20’)
• And IRP:
• fpt OR fdt = Ft+n - St 12 100 = (ft+n - st) 12 100 (2.27’)
St n n
• fpt OR fdt = Ft+n - St 12 100 = (ft+n - st) 12 100 = πet - πe*t
(2.41)
St n n
Continue…
• This relationship requires full price flexibility in
the monetarist view and must be a good
approximation in the long run.

• Thus, information about the expected inflation

rates can be used to project the forward discount
—or expected depreciation—of the currency.
Other Relevant Cases
Tutor will handover the handouts on the topics and attendees expected
to present with empirical evidences;

• Foreign Exchange Market Efficiency

• Anomalies in Market Efficiency
• Exchange Rate Expectations
 Foreign Currency
Derivatives
Forward, Future, Options, NDFs, SWAPS as Hedging Tools