Currency Valuation and Does Value Matter?
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1 Currency Valuation and Does Value Matter? Dr. Apoorva Javadekar CAFRAL November 7, 2017 Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
2 Overview of The Talk - Two Themes in FX Asset Pricing Framework to Value INR / USD Looks at the currency as an Asset Class INR has a similar risk profile as US equities (Non) Dependence of India s trade on Exchange rate Irrelevance of Real Exchange rate impact of Dollar Invoicing on Trade Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
3 Real Exchange Rate & INR Valuation Real Exchange Rate (RER) - A predominant measure to value currency RER }{{} Real Appreciation = } NER {{} + (π india π usa ) }{{} Nominal Appreciation Inflation Differential RER gives net change in country s trade competitiveness RER is a trade-specific measure ignores the importance of capital flows through equity and bonds ignores the fact that currency is itself an asset class Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
4 Historic View of INR Against Basket of Currencies Real appreciation and nominal depreciation Divergence due to high inflation ( ) and strong nominal performance ( ) 130 Real and Nominal Index for INR Against Basket of Currencies Nominal Appreciation Real Appreciation Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
5 Carry Profits in INR / USD Carry Trade: Invest in Indian risk-free assets to earn extra interest as compared to US riks-free rate Carry Profits π carry = (i india i usa ) (s }{{} t+1 s t ) }{{} Interest Profit INR Depreciation i india, i usa : risk free interest rates in India and USA s t = INR Per USD Strategy is risky as s t+1 unknown at time t Risk Averse Investors = Require risk-premium to hold carry strategy E [π carry ] = Risk Premium > 0 Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
6 Road map for Asset Pricing Perspective Existence of Carry Profits is not an indication of currency mispricing Long-Term carry profits reflect risk premium required by the investors. Two Objectives: Compute Carry profits for INR - USD pair Is the quantum of carry profits reasonable when viewed as risk premium? What is the risk in the currency? Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
7 Historical Carry Profits in INR / USD Convert 1 USD to INR in January 2004 or 2008 or What NER generates equalized returns across countries for various points in time? Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
8 Carry Profits to Risk Premium Sustained carry profits in INR / USD For 2004, Zero Carry Profit Rate = 90 INR / USD = Annual profits 3% Can we justify the carry profits as Risk - Premium? Only if we can find a source of risk that investors price Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
9 Similarity In US Equity and Carry Trade Payoffs from US equity and INR carry are highly correlated US PE m1 2005m1 2009m1 2013m1 2017m Carry Profits (%) US PE Ratio Carry Profits (INR /USD) Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
10 INR and US Equity - Common Drivers of Valuation Both US equity and INR Carry are inversely linked with US VIX Carry Profits INR Carry Trade VIX 2001m1 2005m1 2009m1 2013m1 2017m VIX US PE US PE Ratio and VIX 2001m1 2005m1 2009m1 2013m1 2017m VIX INR/USD Carry Profits US VIX US PE Ratio US VIX Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
11 FX Risk Premia - US Consumption Risk View Equity risk premium: equity performs poorly exactly when economic fundamentals and investor s consumption is low = US investors require risk-premium to hold foreign currencies which do not hedge their consumption or income risk. Evidence from Lustig & Verdlhan (AER, 2012): Carry profits increase with the correlation between currency returns and US consumption growth E t (π i carry) = βc i }{{} λ }{{} c exposure to US Risk price of risk = 2%-3% My calculations suggest that β india = 1.02 for aggregate US consumption and β india = 2.17 for non-durable goods A reasonable approximation to π carry 2 3% for India Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
12 Conclusions on Currency Valuation Failure of Uncovered Interest Parity (UIP) or equivalently existence of carry profits merely reflect the risk-premium on INR Real exchange rate (RER) is a poor measure as it considers only trade competitiveness INR earns an annual risk-premium of 2%-3%, which is a reasonable approximation given US consumption β to INR returns of 1.02 = INR fairly priced! Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
13 Currency and International Trade Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
14 Evaluating Real Exchange Rate? RER is a trade-weighted index of Bilateral exchange rates RER = N [ NER i (π india π i )] Trade Weight i i=1 RER Appreciates if Either NER appreciates against country i Or India s inflation is higher than country i Does changes in RER matter for Trade? Equivalently, does Bilateral Exchange Rates matter? Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
15 Two Facts About Trade Pricing India s 85% trade is Invoiced in USD Table: India s Trade Invoicing Pattern Exports % Imports % Currency US Dollar Japanese Yen Euro Quoted Dollar Prices are sticky (Gopinath, 2015) Exporters change Dollar Prices only once in a year on average Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
16 What Are the Consequences For Trade? USD Invoicing + Sticky USD prices = In the short-run Export volumes almost de-linked from INR / USD movement But Exporter s margins move with INR / USD Imports-driven inflation could be substantial Imports Driven Inflation - Some Evidence A 10% depreciation of Turkish Lira relative to trading partners leads to 9.3% increase in imports prices A 10% depreciation of USD relative to it s trading partners leads to 4.3% increase in imports prices India s Dollar invoicing share is far higher than Turkey s (around 60%). Hence we are more exposed to imports inflation risk. Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
17 Importance of Bilateral Rates For Exports? INR F C = INR USD USD F C Exports can take a hit even with stable USD prices if country i currency depreciates against USD But INR and it s EM trading partner currencies are positively correlated against USD = When INR appreciates against USD, partner currencies appreciate too We export roughly 22% to East Asia and 20% to Middle East No impact of INR / USD movement on exports to USA as USD cost is stable in the short run And we export 15% of our exports to USA Limited Role of Bilateral Rates or RER for Exports in Short-run! Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
18 INR / USD Impact on Exports in Long-Run? In the long-run, exporters will adjust USD quoted prices to restore their margins Decreased demand for Indian exports But INR appreciation in the long-run leads to More foreign capital to flow in the country Lowers the cost of foreign technology Hence improves the productivity and lower the cost of production Hence Long-run effect on exports is not necessarily negative. Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
19 Conclusion Import and Export Volumes are de-linked from exchange rate movements in the short-run But INR / USD movement causes a significant imports-driven inflation INR appreciation to hurt exports is a empirically and theoretically irrelevant a tagline in short-run In the long-run, USD quoted prices and productivity move in opposite direction and effect on exports volume uncertain Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
20 Thank You! Dr. Apoorva Javadekar (CAFRAL) Currency Valuation and Does Value Matter? November 7, / 20
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