Finance 4000

Money and Capital Markets

Eighth class

• Foreign Exchange Markets

  
  
  

  • From last time, Purchasing Power Parity is a long-run relationship satisfied by for foreign exchange rates

    
    
    

    • Countries with flexible exchange rates

      
      
      

    • Relative price levels determine exchange rate

      
      
      

    • Shorter time period than decades?

      
      
      

  • A different relationship based on an arbitrage argument

    
    
    

    • Uncovered interest rate parity

      
      
      

      • Interest rate differentials

        
        
        

      • Cannot make riskless profits based on the obvious

• Covered Interest Parity

  
  
  

  • A real arbitrage argument

    
    
    

    • An arbitrage opportunity is the ability to make a certain gain at zero risk

      
      
      

    • The argument

      
      
      

      • If covered interest parity did not hold, there would be an arbitrage opportunity

        
        
        

      • Arbitrage opportunities will be relatively rare and will not persist

        
        
        

      • Hence, covered interest parity will hold

• • Compare buying bonds issued by domestic and foreign governments

    
    
    

    • domestic bonds denominated in dollars

      
      
      

    • foreign bonds denominated in pounds sterling

      
      
      

    • Suppose a U.S. resident

      
      
      

      • really care about dollar payment received

        
        
        
        
        
        
        

  • Buy U.S. bonds worth $1000

    
    
    

    • Invest $1000 at t

      
      
      

    • Interest rate in U.S. is i^d

      
      
      

    • Get (1+i^d)$1000 at t+1

• • Buy U.K. bonds

    
    
    

    • Sell dollars today for pounds sterling to buy U.K. government bonds

      
      
      

    • Exchange rate is E_t[f/d]

      
      
      

    • Get E_t$1000 to buy U.K. bonds today

      
      
      

    • Get (1+i^f)E_t$1000 when mature in pounds sterling

      
      
      

      • Could use future exchange market to get dollars

        
        
        

      • To avoid risk, use forward exchange market

        
        
        

        • Today, can promise to sell pounds sterling at t+1

          
          
          

        • Someone else promises to give us dollars

          
          
          

        • The exchange rate is the forward exchange rate, F_t

• • • Get dollars equal to (1+i^f)E_t $1000 F_t^-1 when mature
  • So

    
    
    

    • (1+i^d)$1000 at t+1 from buying U.S. bonds with no risk

      
      
      

    • (1+i^f)E_t $1000 F_t^-1 from buying U.K. bonds with no risk

      
      
      

    • If these amounts are not the same, I can get certain profits -- arbitrage profits

      
      
      

    • Buy bond with higher income and sell the other short

      
      
      

    • If I'm willing to assume that there are no arbitrage profits, then

      
      
      

    • (1+i^d)$1000=(1+i^f)E_t $1000 F_t^-1

      
      
      

or

• • • 

      
      
      

    • is the proportional appreciation of the domestic money

• Uncovered interest parity

  
  
  

  • 

    
    
    

    • is the expected proportional appreciation of the exchange rate

      
      
      

    • is the exchange rate at t+1 expected by people at t

      
      
      
      
      
      
      

• How important is this?

  
  
  

  • Covered interest parity is very consistent with the evidence

    
    
    

  • Uncovered interest parity is reasonably consistent with the evidence

• Can use covered interest parity to think about the effects of simple changes on exchange rates

  
  
  

  • Graph with

    
    
    

    • E_t on the vertical axis

      
      
      

    • Interest rates and proportional changes in exchange rates on horizontal axis

      
      
      

  • Effect of increase in foreign interest rate with expected exchange rate and domestic interest rate unchanged

    
    
    

  • Effect of increase in domestic interest rate with expected exchange rate and foreign interest rate unchanged

    
    
    

  • Effect of increase in expected exchange rate with domestic and foreign interest rate unchanged

• Asset markets

  
  
  

  • Money markets

    
    
    

    • Term less than or equal to a year when issued

      
      
      

    • Not really "money"

      
      
      

  • Capital markets

    
    
    

    • Term greater than a year when issued

      
      
      

    • Bonds and stocks

      
      
      

  • Mortgage markets

    
    
    

    • Mortgages and securities backed by mortgages

      
      
      

    • Mortgage is a loan secured by real estate

• Common aspects of asset markets

  
  
  

  • Someone receives funds at issuance in exchange for promised payments or possible payments in the future

    
    
    

  • The value today is the stream of payments discounted to today at some interest rate or discount rate

    
    
    

  • People often buy and sell the securities after issuance

    
    
    

  • Sometimes they are re-packaged

    
    
    

    • Securitized

      
      
      

    • Credit card loans and car loans

      
      
      

  • If promised payments, what happens in the event of default?

    
    
    

    • Collateral

      
      
      

    • Guarantees by third parties

• • Is prepayment possible?

    
    
    

    • An option for the issuer
      • hence has value to issuer

        
        
        

    • Corporate bonds

      
      
      

    • Mortgages

      
      
      

  • How are the securities priced at issuance?

    
    
    

    • Treasury auction

      
      
      

    • Other similar securities exist

      
      
      

    • IPOs and investment banks

      
      
      

      • theglobe.com

        
        
        

  • How are the securities traded?

    
    
    

    • Organized exchanges

      
      
      

    • Brokers

      
      
      

    • Dealers

      
      
      

  • Regulations on information, trading