CH02-Introduction to ER & FX Markets

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Risky Arbitrage: Uncovered Interest Parity
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Evidence on Uncovered Interest Parity

If both interest parity conditions hold:
◦ CIP:
ቤተ መጻሕፍቲ ባይዱ
◦ UIP:

then it must be the case that:
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Riskless Arbitrage: Covered Interest Parity

Riskless arbitrage
◦ Rate of return on identical investments in two different locations generates the same rate of return.
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Arbitrage and Spot Exchange Rates

Overview
◦ A goal of players in FX market is to exploit arbitrage opportunities (i.e., price differences). ◦ Market equilibrium implies no (riskless) profit opportunities
Defining the Exchange Rate
Can
be defined as:
1foreign unit (i )
(i) E # of domestic units ($) =$1.30 / i $
i
or, its “inverse” (ii) E # of foreign units (i) = 1i i 0.7692 / $ i
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Recent Exchange Rate Experiences
See IMF Classifications
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The Market for Foreign Exchange (FX)
Read:
◦ Spot Contracts (“spot rate”).
p market: Characteristics of the spot
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Evidence on Uncovered Interest Parity
◦ NOTE: researchers need to find a proxy for expectations
use surveys of FX traders expectations
◦ http://www.bank-banque-canada.ca/en/rates/ceri.pdf
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CERI Weights
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CERI and the C C-6
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Canadian-dollar effective Canadianexchange rate index

Are there arbitrage profits?
◦ In liberalized financial systems, riskless arbitrage opportunities have disappeared.
CIP holds, except for tiny spreads. CIP equation used to price forward contracts

Investor does not use a forward contract to cover against exchange rate risk. Instead, makes a forecast of expected exchange e rate E $/€, and bases decisions on this forecast.
◦ Derivatives
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The Market for Foreign Exchange (FX)

Key Players in FX Markets
◦ Private Actors
commercial banks major corporations (e.g., multinationals) nonbank financial firms (e.g., mutual funds)
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UIP: A Useful Approximation
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Arbitrage and Interest Rates

Summary—how spot & forward rates are determined by UIP & CIP.
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◦ There is a continuum of regimes:
Free floating vs. managed floating Crawls and bands allow some movement hard peg; sometimes this takes the form of a currency board, a very hard peg with special rules (as we shall see later). Some countries have no currency of their own (dollarization).

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Multilateral Exchange Rates

Nominal Effective Exchange Rate (NEER)
◦ = sum of trade shares multiplied by the exchange g for each country. y rate changes ◦ tell us how value of dollar has changed “on average” against entire basket of currencies.
Many investments do not have a fixed, guaranteed rate of return, so expected rate of return is the forecast of the rate of return.
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Risky Arbitrage: Uncovered Interest Parity
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Assets and their Attributes

Investors’ demand for assets depends on
◦ Rate of return ◦ Risk Ri k ◦ Liquidity
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Assets and their Attributes

BUT
◦ Investors are willing to trade off these attributes. ◦ Expectations matter
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Evidence on Uncovered Interest Parity
◦ UIP+CIP predicts 45 degree line. ◦ Surveys tend to find a positive slope, close to 1. ◦ BUT - lot of noise: traders have widely differing beliefs. ◦ UIP finds some support in these data.
$
1 domestic unit ($)
$1.30
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Examples of Exchange Rate Quotations
/symbols.php
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Multilateral Exchange Rates
Possible
for currency to appreciate relative to one currency, while depreciating relative to another. Need to move away y from bilateral exchange g rate, , to a multilateral exchange rate to find “average” change in currency.
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Arbitrage and Interest Rates

Overview of the two kinds of arbitrage
2. Risky arbitrage
◦ Investor does not cover risk: invests according to current & expected future spot exchange rates. ◦ No-arbitrage condition is known as uncovered interest parity (UIP).
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Arbitrage and Interest Rates

Overview of the two kinds of arbitrage
1. Riskless arbitrage
◦ Investor covers (future) exchange rate risk by using a forward contract. ◦ No-arbitrage condition is known as covered interest parity (CIP).