A Primer in International Financial Economics

Transcription

1 FIN 463 International Finance Economics, Forecasting and Arbitrage Professor Robert Hauswald Kogod School of Business, AU A Primer in International Financial Economics The (foreign) exchange rate is the price of one country s currency in units of another currency. currency: the national money two countries are involved the FX rate is a price the price is quoted in terms of standard units Two analytic visions: aggregates vs. investors macroeconomic: focus on big economic picture microeconomic: analyze markets and their actions 9/4/2018 International Financial Economics - Robert B.H. Hauswald 2

2 The Value of the U.S. Dollar since /4/2018 International Financial Economics - Robert B.H. Hauswald 3 Value of the Euro in U.S. Dollars 9/4/2018 International Financial Economics - Robert B.H. Hauswald 4

3 Value of the U.S. Dollars in Euro 9/4/2018 International Financial Economics - Robert B.H. Hauswald 5 A Year in the EUR/USD Market 9/4/2018 International Financial Economics - Robert B.H. Hauswald 6

4 Terminology Appreciation: a currency s price rises in terms of foreign currencies Depreciation: a currency s price falls in terms of foreign currencies Devaluation/revaluation - applies only to fixed exchange rates: a currency s price is lowered/raised in terms of foreign currencies 9/4/2018 International Financial Economics - Robert B.H. Hauswald 7 Spot FX Trading In the interbank market, the standard size trade is about U.S. $15 million. up to USD 150m A bank trading room is a noisy, active place. The stakes are high. Large blocks, in-and-out The long term is about 10 minutes. strategy? 9/4/2018 International Financial Economics - Robert B.H. Hauswald 8

5 A Two-Tiered Market Interbank Market (Wholesale) About 100 to 200 (down from 700) banks worldwide stand ready to make a market in foreign exchange. Nonbank dealers account for about 40% (up from 20%) of the market. FX brokers who match buy and sell orders but do not carry inventory and FX specialists. Client Market (Retail): firms, central banks, etc. Market participants: banks, their customers, nonbank dealers, FX brokers, and central banks. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 9 Circadian Rhythms of the FX Market Electronic Conversations per Hour :00 10 am in Tokyo 3:00 Lunch hour in Tokyo 5:00 Europe coming in 7:00 9:00 Asia going out average 11:00 Lunch hour in London peak 1:00 Americas coming in 15:00 5:00 London going out 19:00 9:00 New Zealand coming in 11:00 6 pm in NY 9/4/2018 International Financial Economics - Robert B.H. Hauswald 10

6 Currency Symbols: ISO Codes In addition to the familiar currency symbols (,,, $) there are three-letter codes for all currencies. It is a long list, but selected codes include: CHF Swiss francs GBP British pound ZAR South African rand CAD Canadian dollar JPY Japanese yen EUR European Euro USD US Dollar 9/4/2018 International Financial Economics - Robert B.H. Hauswald 11 FX Rates 9/4/2018 International Financial Economics - Robert B.H. Hauswald 12

7 Spot Rate Quotations Direct quotation the U.S. dollar equivalent e.g. a Japanese Yen is worth about a penny Indirect Quotation the price of a U.S. dollar in the foreign currency e.g. you get 100 yen to the dollar See Exhibit 5.4 in the textbook 9/4/2018 International Financial Economics - Robert B.H. Hauswald 13 Direct and Indirect Quotes The direct spot quote for the pound is: 1 = $ Currencies May 16, Monday----- The indirect spot quote for the pound is: = $1 Note that the direct quote is the reciprocal of the indirect quote: $ Country/currency in US$ per US$ Euro area euro mos forward most forward mos forward British pound mos forward most forward mos forward /4/2018 International Financial Economics - Robert B.H. Hauswald 14

8 The Forward Market A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out-ofstock textbook, then you have entered into a forward contract. Other examples Problems? 9/4/2018 International Financial Economics - Robert B.H. Hauswald 15 Forward Rate Quotations The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. Longer-term swaps are available. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 16

9 Forward Rate Quotation Example Consider the exchange rates shown to the right. For British pounds, the spot exchange rate is $ = 1.00 while the 180-day forward rate is $ = 1.00 What s up with that? Country/currency in US$ per US$ U.K./British pound mos forward most forward mos forward Can we conclude that market participants expect that the GBP will be worth more (in USD) in six months? Why or why not? 9/4/2018 International Financial Economics - Robert B.H. Hauswald 17 Alternative Exchange Rate Arrangements Fixed Exchange Rates Bretton Woods : fixed exchange rates, IMF Floating Exchange Rates market determined FX rates: anarchy and order Managed float and pegged exchange rates Financial crises in the 1990s Exchange rate mechanisms EMU and the Euro Currency boards: Hong-Kong, Bulgaria 9/4/2018 International Financial Economics - Robert B.H. Hauswald 18

10 Exchange Rate Economics How to gain an assessment of FX rate evolution: why does it matter? Several perspectives: Supply and demand: the market view monetary theories: the aggregate view asset and portfolio balance theories: the finance view The most important perspective of all: the market s perception and expectations 9/4/2018 International Financial Economics - Robert B.H. Hauswald 19 Exchange Rate Dynamics Overshooting or overreacting: volatility risk Randomness and random walks: hard to gauge Government intervention stirring things up with the best of intentions unsustainable FX regimes: adverse incentives Exchange rate mechanisms revisited from EMS to EMU: Euroland fixed or crawling pegs: SE Asia currency boards: Hong-Kong 9/4/2018 International Financial Economics - Robert B.H. Hauswald 20

11 Forecasting Exchange Rates Fundamental Approach long term, inflation matters Efficient Markets Approach framework for statistical analysis Statistical Approach Technical Approach black magic: negates market efficiency Performance of the Forecasters 9/4/2018 International Financial Economics - Robert B.H. Hauswald 21 How to Form an Opinion The challenge: shifting environment solution: economic and statistical support tools for forecasting and decision making models and theory The time horizon: theoretical prices in the short run, financial variables matter in the long run, real economic variables determine FX evolution Example of fundamentals: the law of one price Big Mac exchange rates: purchasing power parity use price indices to predict long run FX rates 9/4/2018 International Financial Economics - Robert B.H. Hauswald 22

12 Purchasing Power Parity Intuition: similar (traded) goods should cost the same, otherwise there exist unlimited business opportunities Relevance highlights imbalances between countries divergence between actual and theoretical FX rates one fundamental of exchange rate determination EUR Calculated as EUR $ P P SEUR $ P SEUR $ $ P Example: consumer bundle costs USD 600 or EUR 500 FX rate prediction? Measurement problems: how to calculate price levels? an illustration and its fallacy: the Big Mac currency alternatives? 9/4/2018 International Financial Economics - Robert B.H. Hauswald 23 Absolute Purchasing Power Parity Let PUS and PUK represent the weighted average price level for goods in the U.S. and U.K. market baskets respectively. Absolute PPP predicts that these two price measures will be equal after adjusting for the exchange rate: PUS = S($/ ) PUK Absolute PPP requires that the consumption baskets are identical across the two countries. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 24

13 Relative Purchasing Power Parity Often, we are interested in the level of the exchange rate that satisfies PPP. The PPP spot rate reestablishes PPP relative to a base period. It is the exchange rate that would just offset the relative inflation between a pair of countries since the base period. (a) (b) S PPP, t 1 S $/, t US, t 1 UK, t 1 US, t UK, t 9/4/2018 International Financial Economics - Robert B.H. Hauswald 25 P P P P Relative PPP: Example Data Base period nominal exchange rate = $1.50/ Prices of U.S. goods had risen by 8% Prices of U.K. goods had risen by 4% PPP spot rate = $1.50/ 1.08/1.04 = $1.5577/ a nominal exchange rate of $1.5577/ would reestablish PPP in comparison to the base period. Nominal exchange rates greater than $1.5577/ represent overvaluation ($ undervaluation), while rates less than $1.5577/ represent $ overvaluation ( undervaluation). 9/4/2018 International Financial Economics - Robert B.H. Hauswald 26

14 Purchasing Power Parity and Exchange Rate Determination The exchange rate between two currencies should equal the ratio of the countries price levels. S($/ ) = P $ P Relative PPP states that the rate of change in an exchange rate is equal to the differences in the rates of inflation: π$ e = $ - implies S$ S$ 1 π If U.S. inflation is 5% and U.K. inflation is 8%, the pound should depreciate by 3%. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 27 Evidence on PPP PPP probably doesn t hold precisely in the real world for a variety of reasons. Haircuts cost 10 times as much in the developed world as in the developing world. Film, on the other hand, is a highly standardized commodity that is actively traded across borders. Shipping costs, as well as tariffs and quotas can lead to deviations from PPP. PPP-determined exchange rates still provide a valuable benchmark. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 28

15 Prices and Exchange Rates In reality, seemingly homogeneous goods may differ in a number of important respects which undermine tests of the Law of One Price. One test of the Law of One Price is the Big Mac index, which has been published annually in The Economist since It was devised as a light-hearted guide to whether currencies are at their correct level, based on PPP. 9/4/2018 International Financial Economics - Robert B.H. Hauswald Burgernomics Ratio of Big Mac Prices in US$ Relative to U.S. Price U.S. Price is $2.51/Big Mac Israel Switzerland Denmark Britain Japan South Korea Sweden France United States Argentina Chile Euro Area Germany Taiwan Mexico Italy Spain Canada Singapore Indonesia New Zealand Brazil Australia Thailand Czech Rep Russia South Africa Hong Kong Poland Hungary China Malaysia Source: The 9/4/2018 Economist, April 29, International 2000 Financial Economics - Robert B.H. Hauswald 30

16 Big Mac PPP Deviations: Overvaluation or Undervaluation 9/4/2018 International Financial Economics - Robert B.H. Hauswald 31 Big Mac Update 2018 The six most expensive countries (July 18, 2018) 1. Switzerland $6.57 (6.50 CHF) 2. Sweden $5.83 (51.00 SEK) 3. United States $5.51 (5.51 USD) 4. Norway $5.22 (42 NOK) 5. Canada $5.08 (6.65 CAD) 6. Euro area $4.75 (4.56 EUR) The six least expensive countries (July 18, 2018) 1. Egypt $1.75 (31.37 EGP) 2. Ukraine $1.91 (50 UAH) 3. Russia $2.09 (130 RUB) 4. Malaysia $2.10 (8.45 MYR) 5. Indonesia $2.19 (31,500 IDR) 6. Taiwan $2.27 (69 TWD) 9/4/2018 International Financial Economics - Robert B.H. Hauswald 32

17 Books With the rise of e-commerce, investigating the Law of One Price becomes easier and violations more puzzling. A Wall Street Journal article highlighted the case of a popular book that sold for $16.20 at Amazon.com (U.S.), for $13.52 at Amazon.co.uk (Britain), and for $27.00 at Amazon.de (Germany). Instructor has three amazon accounts! 9/4/2018 International Financial Economics - Robert B.H. Hauswald 33 Purchasing Power Parity: Caveat PPP conditions do not imply anything about causal linkages between prices and exchange rates or vice versa. Both prices and exchange rates are jointly determined by other variables in the economy. PPP is an equilibrium condition that must be satisfied when the economy is at its longterm equilibrium. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 34

18 Statistical Approach Involves econometrics to develop models that use a variety of explanatory variables. This involves three steps: step 1: Estimate the structural model. step 2: Estimate future parameter values. step 3: Use the model to develop forecasts. The downside is that fundamental models do not work any better than the forward rate model or the random walk model. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 35 Technical Approach Technical analysis looks for patterns in the past behavior of exchange rates. wall charts of intra-day prices identify patterns and extrapolate future prices Clearly it is based upon the premise that history repeats itself. thus it is at odds with the EMH So, why does it work? does it? depends who is talking disciplined learning: 20 years of history hard to beat 9/4/2018 International Financial Economics - Robert B.H. Hauswald 36

19 Performance of the Forecasters Forecasting is difficult, especially with regard to the future. As a whole, forecasters cannot do a better job of predicting future exchange rates than the forward rate let s learn about the forward rate, then! The founder of Forbes Magazine (who might have been this illustrious person?) once said: You can make more money selling advice than following it. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 37 Summary and Outlook Forecasting FX rates is hard several approaches: none works all the time when in doubt, rely on the economics Today: key insight - international price parities the Law of One Price: purchasing power parity similar goods should command similar prices extract implied FX rate Two principles at work: NFL, price extraction economic equilibrium requires absence of arbitrage extract implied FX rate (price) from equilibrium 9/4/2018 International Financial Economics - Robert B.H. Hauswald 38

20 Real Exchange rates definition Appendix The Fisher Effect The International Fisher Effect generalization of Fisher Effect FX Determination and Market Efficiency Empirical tests of PPP 9/4/2018 International Financial Economics - Robert B.H. Hauswald 39 Real Exchange Rates An index of the real exchange rate is defined as: Spot (Real, t) = Spot (Nominal, t). Spot (PPP, t) Example Today s spot exchange rate is $1.80/ PPP spot rate is $1.50/ Real exchange rate index = 1.80/1.50 = 1.20 At 1.20, the is overvalued on a PPP basis. 1.0 British good can be exchanged for 1.2 U.S. goods. So, sellers of British goods have lost competitiveness on international markets. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 40

21 The Fisher Effects An increase (decrease) in the expected rate of inflation will cause a proportionate increase (decrease) in the interest rate in the country. For the U.S., the Fisher effect is written as: i $ = $ + E( $ ) Where $ is the equilibrium expected real U.S. interest rate E( $ ) is the expected rate of U.S. inflation i $ is the equilibrium expected nominal U.S. interest rate 9/4/2018 International Financial Economics - Robert B.H. Hauswald 41 International Fisher Effect If the Fisher effect holds in the U.S. i $ = $ + E( $ ) and the Fisher effect holds in Japan, i = + E( ) and if the real rates are the same in each country $ = then we get the International Fisher Effect E(e) = i $ - i. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 42

22 Efficient Markets Approach Financial Markets are efficient if prices reflect all available and relevant information. If this is so, exchange rates will only change when new information arrives, thus: S t = E[S t+1 ] and F t = E[S t+1 I t ] Predicting exchange rates using the efficient markets approach is affordable and is hard to beat. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 43 Testing Absolute PPP A parity condition can be viewed as a 45 line passing through the origin with the LHS and RHS variables plotted on the x and y axes. Thus, parity conditions can be tested by running the simple linear regression: LHS t = + RHS t + t Parity holds when the data cannot reject a null hypothesis where = 0, = 1, and the error terms have classical properties. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 44

23 Testing Relative PPP To examine the relative PPP condition, we can compare the exchange rate change to the contemporaneous inflation differential: s t = + (p $ p DM ) t + t It seems that PPP is a poor explanation of exchange-rate changes on a period-by-period basis. However, there is a tendency for PPP to reassert itself as time passes (mean reversion). 9/4/2018 International Financial Economics - Robert B.H. Hauswald 45 % Deviations Quarterly Deviations from Relative PPP CPI: Germany and the United States, = = 0.15 R 2 = N = 107 (0.007) (0.83) D W = 1.83 Spot Rate Changes Average Inflation Difference (US-German) Inflation 9/4/ International Financial Economics Robert 1989 B.H Hauswald

24 PPP and Hyperinflation During a hyperinflation period, even the demanding regression-style test tends to support PPP. This is due in some degree to dollarization. Long-run data indicated that the real exchange rate did not evolve as a random walk, but demonstrated a clear tendency to revert back to its central value. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 47 Prices and Exchange Rates Empirical tests confirm that... PPP is a poor descriptor of exchange rate behavior in the short run, where the rates are quite volatile and domestic prices are somewhat sticky. But in longer-run analysis, it appears that PPP offers a reasonably good guide. 9/4/2018 International Financial Economics - Robert B.H. Hauswald 48