Chapter 2

Foreign
Exchange
Parity
Relations

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 Introduction

 In this chapter we look at:

 Foreign exchange fundamentals; in particular
the balance of payments and exchange rate
regimes.
 Describe the factors that cause a nation’s
currency to appreciate or depreciate.
 International parity relations.
 Define and discuss the International Fisher
relation.

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 Introduction

 Discuss the implications of the parity

relationships combined.
 Exchange rate determination theories and their
potential implications.
 Discuss the asset markets approach to pricing
exchange rate expectations.

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 Supply and Demand for Foreign
Exchange
 In general, there are many types of
transactions that affect the demand and
supply of one national currency.
 From an accounting viewpoint, each
country keeps track of the payments on all
international transactions in its balance of
payments.

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 Exhibit 2.1: Foreign Exchange Market
Equilibrium

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 Balance of Payments

 The balance of payments tracks all financial

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

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 Balance of Payments

 An export, for example, creates a financial

inflow for the home country, whereas an
import creates an outflow.
 There are two main categories:
 Current account
 Financial account

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

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 Current Account
 It also covers:
 Services (such as services in transportation,
communication, insurance and finance).
 Income (interest, dividends and various investment
income from cross-border investments).
 Current transfers (flows without quid pro quo
compensation).
 A current account deficit is not necessarily a bad
economic signal as long as nonresidents are
willing to offset it by investment flows.

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 Financial Account
 Covers investments by residents abroad and
investments by nonresidents in the home country.
 It includes:
 Direct investment made by companies.
 Portfolio investments in equity, bonds and other
securities of any maturity.
 Other investments and liabilities (such as deposits or
borrowing with foreign banks and vice versa).

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 Financial Account

 The sum of the current and financial

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

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

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 Capital and Financial Account

 Similarly, Net Errors and Omissions (or

“statistical discrepancy”) are usually
aggregated with the capital and financial
account.
 To be sustained, a current account deficit
must be financed by a financial account
surplus.

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

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

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 Differences in Economic Performance

 Financial flows are attracted by high

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

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 Factors That Cause a Nation’s Currency
to Appreciate or Depreciate
 In a flexible exchange rate system, the
value of a currency is driven by changes in
fundamental economic factors.
 Amongst the factors are:
 Differences in national inflation rates.
 Changes in real interest rates.
 Differences in economic performance.
 Changes in investment climate.

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

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 Exchange Rate Regimes

 Historically, there have been three different

regimes:
 Flexible (or Floating) Exchange Rates
 Fixed Exchange Rates
 Pegged Exchange Rates

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 Flexible (Floating) Exchange Rate
Regime
 One in which the exchange rate between two
currencies fluctuates freely in the foreign
exchange market.
 Advantage
 The exchange rate is a market-determined price that
reflects economic fundamentals at each point in time.
 Governments are free to adopt independent domestic
monetary and fiscal policies.
 Disadvantage
 Quite volatile exchange rates.

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

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 Currency Board

 Today some countries try to maintain a

fixed exchange rate regime against the
dollar or euro.
 This is done through a “currency board”
 The supply of home currency is fully
backed by an equivalent amount of that
major currency.

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 Pegged Exchange Rate Regime
 Characterized as a compromise between a flexible
and a fixed exchange rate.
 The exchange rate is allowed to fluctuate within a
(small) band around a target exchange rate (“peg”) and
the target exchange rate is periodically revised to
reflect changes in economic fundamentals.
 Advantages
 Reduces exchange rate volatility in the short run.
 Also encourages monetary discipline for the home
country.
 Disadvantage
 Can induce destabilizing speculation.

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 International Parity Relations

 The parity relations of international finance

are as follows:
 Interest rate parity relation
 Purchasing power parity relation.
 International Fisher relation.
 Uncovered interest rate parity relation.
 Foreign exchange expectation relation.

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 International Parity Relations: Definitions

 The term spot rate (S) refers to the exchange rate

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

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 Interest Rate Parity Relation

 Interest rate parity is the relation that the

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

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 Interest Rate Parity Relation

 Exact relation
F/S = (1 + rFC)/(1 + rDC)
 Linear approximation
ƒ = F/S -1  rFC - rDC

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

 PPP states that the spot exchange rate

adjusts perfectly to inflation differentials
between two countries.
 There are two versions of PPP:
 Absolute PPP
 This claims that the exchange rate should be equal
to the ratio of the average price levels in the two
economies.
 Relative PPP
 Focuses on the general across the board inflation
rates.
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 Purchasing Power Parity (PPP) Relation

 Relative PPP
 This claims that the percentage movement of
the exchange rate should be equal to the
inflation differential between the two
economies
 The PPP relation is presented as:
 Exact
S1/S0 = (1 + IFC)/(1 + IDC)
 Linear approximation
s = S1/S0 – 1  IFC - IDC
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 Purchasing Power Parity (PPP) Relation

 PPP says that what you gain with lower

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

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 International Fisher Relation

 Claims that the interest rate differential between

two countries should be equal to the expected
inflation rate differential over the term of the
interest rate.
 The International Fisher Relation can be
represented as:
 Exact
(1 + rFC)/(1 + rDC) = (1 + E(IFC))/(1 + E(IDC))
 Linear approximation
rFC – rDC  E(IFC) - E(IDC)

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 Example

 Question: How are the nominal and real

interest rates calculated?
 Answer: Nominal interest rate is observed
in the marketplace. The real interest rate is
calculated from the observed interest rate
and forecasted inflation.

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 Uncovered Interest Rate Parity Relation

 This is a theory combining purchasing power

parity and the international Fisher relation.
 It refers to the exchange rate exposure not covered
by a forward contract.
 It claims the expected change in the indirect
exchange rate approximately equals the foreign
minus the domestic interest rate.
 It can be represented as:
 Exact
E(S1)/S0 = (1 + rFC)/(1 + rDC)
 Linear Approximation
E(s) = E(S1)/S0 – 1  rFC - rDC
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 Foreign Exchange Expectation Relation

 This relation states that the forward

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

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

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 Exhibit 2.3: International Parity
Relations Linear Approximation

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 Exchange Rate Determination

 The following approaches are proposed:

 Fundamental value based on relative PPP
 Balance of Payments Approach
 Asset Market Approach

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

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 Exhibit 2.4: Fundamental Value for
the Japanese Yen

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

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 Sources of Data for BOP

 Customs data
 Central bank stats
 Bank reports of transactions

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 BOP Components

 Current Account
 Capital account
 Financial account
 Official reserve account

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 Exhibit 2.5: Balance of Payments
and the Dollar Exchange Rate

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

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

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 Exhibit 2.6:

Exchange
Rate
Dynamics

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