Exchange Rates vs. Exchange Rates vs. Interest RatesInterest Rates

Sources of Potential ProfitSources of Potential ProfitPrepared by: Branko Prepared by: Branko ÐÐapiapićć, ,

Christian Helland, Jeong-Jun Lee, Christian Helland, Jeong-Jun Lee, Wook-Jong Lee, Lizabeth MontaWook-Jong Lee, Lizabeth Montañño, o,

Walter Zevallos Walter Zevallos

Exchange rate:Exchange rate: Price of one currency in terms of another, Price of one currency in terms of another,

conventional way- home currency per foreign conventional way- home currency per foreign A depreciation (appreciation) of a country’s A depreciation (appreciation) of a country’s

currency makes its goods cheaper (more currency makes its goods cheaper (more expensive) for foreigners, and makes foreign expensive) for foreigners, and makes foreign goods more expensive (cheaper) for domestic goods more expensive (cheaper) for domestic residents. residents.

Key players in the market: commercial banks, Key players in the market: commercial banks, corporations, nonbank financial institutions corporations, nonbank financial institutions (insurance companies, pension funds), central (insurance companies, pension funds), central banks.banks.

Assumptions:Assumptions: Currently hold dollar denominated Currently hold dollar denominated

depositsdeposits Risk and liquidity is the same between Risk and liquidity is the same between

currenciescurrencies

Our Goal:Our Goal: Find the relationship between the interest Find the relationship between the interest

rates and exchange rate rates and exchange rate Predict the near future movement so we Predict the near future movement so we

can maximize our wealthcan maximize our wealth

How is exchange rate determined?How is exchange rate determined? The Asset Approach – based upon “interest rate The Asset Approach – based upon “interest rate

parity”parity” Monetary Approach – based upon “purchasing Monetary Approach – based upon “purchasing

power parity”power parity”

The key element > Expected Rate of ReturnThe key element > Expected Rate of Return

Investors care about Investors care about Real rate of returnReal rate of return RiskRisk LiquidityLiquidity

The basic equilibrium condition in the The basic equilibrium condition in the foreign exchange market is foreign exchange market is interest interest parityparity..

Uncovered interest parityUncovered interest parity

RR$$=R=R¥¥+(E+(Eee$/¥$/¥-E-E$/¥$/¥)/E)/E$/¥$/¥-Risk Premium -Risk Premium

Covered interest rate parity (risk-free)Covered interest rate parity (risk-free)

RR$$=R=R¥¥+(F+(F$/¥$/¥-E-E$/¥$/¥)/E)/E$/¥$/¥

0

5

10

15

20

25

1980 1985 1990 1995 2000 2005

Year

Prim

e Int

eres

t Rate

s (%

)

0

0.002

0.004

0.006

0.008

0.01

0.012

0.014

1980 1985 1990 1995 2000 2005

Year

Dolla

r per

Yen

Historical Interest Rates & Historical Exchange RatesHistorical Interest Rates & Historical Exchange Rates

Dollar

Yen

Interest spread

 

Explaining the Spread (Dollar vs. Yen)Explaining the Spread (Dollar vs. Yen)

-0.1

-0.05

0

0.05

0.1

0.15

1980 1985 1990 1995 2000 2005

Year

Inte

rest

& E

xch

ang

e S

pre

ad (

%)

Interest spread

Change in Exchange rate

Interest parity

Time

 

Time

Interest parity

0

Deposit in Foreign Currency

Deposit in $US

Negative

Positive

Intuition of the ModelIntuition of the Model

-0.10

-0.05

0.00

0.05

0.10

0.15

0.20

82 84 86 88 90 92 94 96 98 00 02

YEN

ADF Test Statistic -4.0223791% Critical Value* -3.99645% Critical Value -3.428310% Critical Value -3.1372

*MacKinnon critical values for rejection of hypothesis of a unit root.

Modeling the Yen:Modeling the Yen:

0.000

0.002

0.004

0.006

0.008

0.010

82 84 86 88 90 92 94 96 98 00 02

YENSQRES

Dependent Variable: YEN Method: Least Squares Date: 05/28/03 Time: 00:08 Sample(adjusted): 1981:04 2003:03 Included observations: 264 after adjusting endpoints Convergence achieved after 3 iterations

Variable Coefficient Std. Error t-Statistic Prob.

C 0.047896 0.008555 5.598605 0.0000 AR(1) 0.542057 0.051315 10.56336 0.0000 AR(3) 0.243507 0.050569 4.815339 0.0000

R-squared 0.510284 Mean dependent var 0.050273 Adjusted R-squared 0.506531 S.D. dependent var 0.042274 S.E. of regression 0.029696 Akaike info criterion -4.184296 Sum squared resid 0.230167 Schwarz criterion -4.143660 Log likelihood 555.3271 F-statistic 135.9808 Durbin-Watson stat 1.983671 Prob(F-statistic) 0.000000

Inverted AR Roots .87 -.16+.50i -.16 -.50i

0

5

10

15

20

25

-0.100 -0.075 -0.050 -0.025 0.000 0.025 0.050 0.075

Series: ResidualsSample 1981:04 2002:03Observations 252

Mean -1.02E-14Median 0.002468Maximum 0.078261Minimum -0.095963Std. Dev. 0.029716Skewness -0.428058Kurtosis 3.372108

Jarque-Bera 9.149682Probability 0.010308

Modeling Yen Parity:Modeling Yen Parity:

 

Actual Upper Band (95% confidence)

Actual Lower Band

FAVORABLE $US REGION

FAVORABLE YEN REGION

FORECASTING YEN FORECASTING YEN PARITY:PARITY:

0

5

10

15

20

25

-0.05 0.00 0.05 0.10 0.15

Series: YENSample 1981:01 2003:03Observations 267

Mean 0.051276Median 0.051011Maximum 0.167879Minimum -0.061779Std. Dev. 0.043081Skewness 0.080556Kurtosis 2.697487

Jarque-Bera 1.306867Probability 0.520256

CurrencyCurrency Rest of the Year Rest of the Year ForecastForecast

ConfidenceConfidence

Dollar vs. YenDollar vs. Yen DollarDollar Strongly favorableStrongly favorable

Dollar vs. PoundDollar vs. Pound Can’t tellCan’t tell IndifferentIndifferent

Dollar vs. NOKDollar vs. NOK NOKNOK Slightly favorableSlightly favorable

Dollar vs. FrancDollar vs. Franc DollarDollar Slightly favorableSlightly favorable

ConclusionConclusion

 

Questions?????Questions?????

 

Modeling Yen with an ARMA(8,0)

Backup slides (Exchange rate only)Backup slides (Exchange rate only)

 

Showing dYen to be a Stationary Series

 

Actual and Fitted Yen Model