International Investment Theory of FOREX

J.D. Han

King’s University College

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• Bottom Line

International Capital Flows determine FOREX rates in such a way that

Capital Inflows increase the receiving country’s external value;

-> Capital Inflows lowers S for the receiving country

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1.International Investor and Arbitrage

• International Investors are doing arbitrage between markets.• Arbitrage means the following two activities: 1) Solely based on spot FOREX: If dollars are cheaper in New York than in London, people will buy them in New York and

stop buying them in London.

If triangular FOREX rate is in such a way that Canadian dollar is undervalued with respect to U.S. dollar, but not to Euro, What would the arbitrageur do?

You borrow U.S. dollar, buy Canadian dollars (with the U.S. dollars), and exchange them into Euro, covert the Euro revenue into U.S. dollar, and pay back the U.S. loans. You will have some profits.

2) Based on spot FOREX rate, future expectations, Forward Rate and international interest rate differentials: moving capital across countries for a higher return:

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2. Arbitrage for Rates of Returns on Domestic versus Foreign Investments

• What influences the demand for (willingness to buy) domestic or foreign currency for investors?

• If we assume that risk is the same between the two countries

• The return on domestic investment versus the return on investment in foreign country

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3. Two Interest Rates: Domestic and Foreign Investment Options

• Return on Domestic Asset = interest on Canadian dollar asset = i$

• Return on Foreign Investment

= interest on foreign (country) interest rate

+ capital gains or loss due to expected changes in FOREX rates

= i€ + (Se$/€ - S$/€)/S$/€

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Two Rates of Returns

• The difference in the rate of return on dollar deposits and euro deposits is

i$ versus i€ + (Se$/€ - S$/€)/S$/€

expected rate of return = interest rate on dollar deposits

interest rateon euro deposits

expected rate of return on euro deposits

expected exchange rate

currentexchange rate

expected rate of appreciation of the euro

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4. Equilibrium: “Uncovered Interest (Rate) Parity”

The foreign exchange market for international investors or arbitrageurs is in equilibrium when deposits of all currencies offer the same expected rate of return: uncovered interest (rate) parity.

No big unilateral/averanchal flow of capital

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5. Changes in FOREX rate and Capital Flows at disequilibrium

At Disequilibrium of Uncovered Interest parity Suppose i$ > i€ + (Se

$/€ - S$/€)/S$/€ .

- No investor would want to hold euro deposits, driving down the demand and price of euros.

- all investors would want to hold Canadian dollar deposits, driving up the demand and price of dollars.

- Capital Inflows to Canada

- The Canadian dollar would appreciate and the euro would depreciate, increasing the right side until equality was achieved.

- FOREX rate or S falls for Canada. Suppose i$ < i€ + (Se

$/€ - S$/€)/S$/€

- Capital Outflows from Canada

- S rises for Canadia

6. Dynamics Suppose that initially FOREX market is in

equilibrium and UCIP holds.

What will happen to S if there is a change in the following variables?

1) If i rises, S falls.

<- i rises mostly when M falls.

2) If if rises, S rises.

if rises mostly when Mf falls

3) If Se rises, S rises.

Se rises mostly when domestic country’s BP deficits rise.

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*The effects of changing interest rates on S:

an increase in interest rates paid on deposits denominated in a particular currency will increase the rate of return on those deposits.

This leads to an increase in capital inflows and in demand for the currency

The price of the currency goes up: an appreciation of the currency.

-> eg) A rise in dollar interest rates causes the dollar to appreciate; a rise in Yuan interest rates causes the Yuan to appreciate; A rise in euro interest rates causes the Euro to appreciate.

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*The Effect of an Expected Appreciation of the Euro or Se on S:

• If people expect the euro to appreciate in the future, then the expected return on euros therefore increases.

• Investment will pay off in a valuable (“strong”) euro. So people start buying Euro now, and the demand for Euro rises.

• The Price of Euro in terms of Dollars rises.

An expected appreciation of a currency leads to an actual appreciation

-> “self-fulfilling prophecy”

* The effect of changing domestic money supply on S

• Domestic Money supply rises

-> Domestic Interest Rate falls

-> Rate of Returns on domestic investment falls

-> Capital Outflows

-> (Excess) Demand for FOREX rises and demand for domestic currency falls

-> FOREX or S rises.13-12

*The Effect of changing foreign money supply on S

• In the short-run, if falls.

-> ROR for foreign investment falls

-> Demand for FOREX falls

-> Price of FOREX or S falls.

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7. Efficient FOREX Market:Unbiased-Forward-Rate Theory

• t Se t+1 = Ft+1

“The expected future spot rate is equal to the forward rate”

Forward Premium tells the expected change in S:

• Δ% Se = (Se – S)/S

If FOREX market is efficient, then Se = F

• Δ% Se = (F- S)/ S

Forward premium or discount is equal to the market’s expected change in the spot rate.

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*Test of FOREX Market Efficiency

•t Se t+1 = St+1+ e

Note that F has replaced Se

• Thus, Ft+1 = St+1 + e

Forward Rate is the best predictor for the future spot rate.

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7. ‘Covered’ Interest Parity

• Covered interest parity :

i $ = i€ + (F$/€ - S$/€)/S$/€ at eq.

where F$/€ is the Forward Exchange Rate.

• Alternatively,

i $ - i€ = (F$/€ - S$/€)/S$/€ at eq.

where (F$/€ - S$/€)/S$/€ is Forward Premium (+) or Forward Discount (-)

At Disequilibrium,

• When i $ - i€ > (F$/€ - S$/€)/S$/€,

Capital inflows occur, and S falls

if and only if the domestic and foreign investment are perfect substitutes.

.

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Dynamics

• If the FOREX market revises expectations of FOREX upwards, then what will happen to the spot rate S$/€ ?

• i

• If

• M

• Mf

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• At equilibrium, the rates of return on domestic (dollar) deposits, and the return on the non-risk or “covered” foreign investment are the same. How could you make easy, risk-free money in the foreign

exchange markets if covered interest parity did not hold? Covered positions using the forward rate involve little risk.

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8. Limitations of CIP and UCIP:

• Even when i $ < i€ +(F$/€ - S$/€)/S$/€,

Capital may not flow out and S may not rise if i€ rises due to an increased risk premium

• The Assumption of Domestic an Foreign Investments being Perfect Substitutes may not hold at all times.

• Quite often CIP and UCIP may not hold if domestic and foreign investments are imperfect substitutes.

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