Contact Information:

Brian David ButlerMiami Campus FacilitatorInternational Economics & Trade (Prof. Grosse)

Email: bdbutler@global.t-bird.eduCell: 786-457-0984Blog: http://blog.globotrends.com/ Wiki: http://kookyplan.pbwiki.com/brianbutler

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Global MBA International Finance & International Trade GM6212

2nd session.September 27, 2008

Last Class Now Next…

Define: Theories Apply- FX markets -PPP -hedging - Arbitrage -IFE -real life

Review last session:

• Many markets ….banks set the market • There is no such thing as “THE” exchange

rate…there are many• Arbitrage is the mechanism that equalizes

exchange rates across markets….Its how FX rates are set

For exam…Should be able to solve……Exchange rate arbitrage, Interest arbitrage

Topics to cover today:

1. Analysis of exchange rates & determinants• Law of one price• PPP – purchasing power parity• Big Mac index• IFE – international fisher effect• Interest parity

2. Economic crisis on Wall Street

E[XRS] – XRS

XRS

XRXRXRS

SF D F

F

R R1+ R

D F

F

I I1 + I

UFR

UNBIASED FORW

ARD RATE

IFE

INT’L FISHER EFFECTINTEREST RATE PARITY IRPP

AR

ITY

PU

RC

HA

SIN

G P

OW

ER

(Forward Premium) (Interest Differential)

FISHER E

FFECT

FE

(%Spot Rate*)

(Inflation Differential*)

THIS MODEL IGNORES GOVERNMENT CONTROLS AND TRANSACTIONS COSTS

* = Forecasted Value

XR = Domestic CurrencyForeign Currency

Exchange Rate Determination

Law of One Price• Identical goods - must sell for the same price

when their prices are expressed in terms of the same currency

• Assumptions:– Free from transportation costs– Free from import barriers, no tariffs

Law of One Price• Example:• Levis Jeans in NYC cost $50• Levis Jeans in London = 30 pounds

• What is the implied exchange rate?

Law of One Price• Example:• Levis Jeans in NYC cost $50• Levis Jeans in London = 30 pounds

• What is the implied exchange rate?

• Answer: $1.66 / pound

Law of One Price• But, what happens if inflation in the US brings the

dollar price up to $55 (a 10% US inflation)? What should happen to the FX rate? Does the US dollar appreciate?

• Levis Jeans in NYC cost $50 $55• Levis Jeans in London = 30 pounds• FX rate: $1.66 / pound• New rate ???? Will dollar appreciate?

• Levis Jeans in NYC cost $50 $55• Levis Jeans in London = 30 pounds• FX rate: $1.66 / pound

• Answer: new rate should be $1.83 / pound

• US dollar should DEPRECIATE with inflation.

10% change

• If the actual FX rate: $1.66 / pound• And expected FX rate : $1.83 / pound

• But, the currency doesn’t change… • Is the US dollar overvalued? Or undervalued?

• By how much exactly?

Law of One Price

• Over valued by 10%

• Because it only takes $1.66 to buy a pound….when it should take $1.83

E[XRS] – XRS

XRS

XRXRXRS

SF D F

F

R R1+ R

D F

F

I I1 + I

UFR

UNBIASED FORW

ARD RATE

IFE

INT’L FISHER EFFECTINTEREST RATE PARITY IRPP

AR

ITY

PU

RC

HA

SIN

G P

OW

ER

(Forward Premium) (Interest Differential)

FISHER E

FFECT

FE

(%Spot Rate*)

(Inflation Differential*)

THIS MODEL IGNORES GOVERNMENT CONTROLS AND TRANSACTIONS COSTS

* = Forecasted Value

XR = Domestic CurrencyForeign Currency

Purchasing Power Parity

E[XRS] – XRS

XRS

D F

F

I I1 + I

PA

RIT

YP

UR

CH

AS

ING

PO

WE

R(%Spot Rate*)

(Inflation Differential*)

It looks confusing, but is simple.

PPP states that …

% change in spot rate = inflation differential

That’s all.

PPP – purchasing power parity

Purchasing Power Parity

• Same as “Law of One price”…except…

– Law of one price = for one good only– PPP = basket of goods (ex; CPI measure inflation)

Purchasing Power Parity

Relates inflation to FX:

• If “price level” goes up (inflation)…then purchasing power down, and the currency should depreciate.

PPP- example

Question: How to use PPP to predict future FX rates?

Goal: Predict 1-year FX rate (USD / Brazilian Real)• Assume current Spot rate = R$2.80 BRL / USD• Expected inflation rates for next year = 2% in

USA and 6% in Brazil• What is expected FX rate in 1 year?• Should the BRL currency appreciate?

PPP

Key Formula (Simplified)• E[XR] = XR spot [ 1 + inflation

1 + inflation]

But, what units go on top / bottom…is it dollars per Euro? Or Euros per dollar?

• E[XR] = XR spot [ 1 + inflation 1 + inflation]

= R$ 2.8 BRL *[1 + .06 BRL$1.0 USD 1 + .02] USD

= R$ 2.9098 / USD

From Brazils perspective, is this appreciation? Or Depreciation of the BRL?

Problems with PPP

• What problems do you see?

• Is PPP any good in reality?

• What are the drawbacks?

• Why doesn’t it work?

Problems with PPP

• Very difficult to find identical products• Basket of goods in one country different than

in other• Many goods are not traded (even though they

are in the CPI) – labor rates, real estate, electricity

• Assumption of 0 transaction cost is unrealistic

Big Mac Index• Overcomes some of PPP’s limitations

– Identical product– Many countries– Standardized ingredients: bread, wheat,

beef, lettuce, condiments, etc.

Big Mac Index•

Big Mac IndexExample:

If a Big Mac costs:• $3.57 in US…• R$ 7.5 in Brazil

What is the implied exchange rate? (R$/$)

Big Mac IndexIf a Big Mac costs:• $3.57 in US…• R$ 7.5 in Brazil

Implied exchange rate? = R$2.1 / USDBut, actual FX rate = R$1.58 / USD

So, is the Brazilian Real overvalued? / under valued? By how much?

Big Mac Index

Implied exchange rate? = R$2.1 / USDBut, actual FX rate = R$1.58 / USD

1.Brazilian Real is “over” valued…– Because with one USD you should be able to

purchase $2.1 worth of Big Macs in Brazil, but you can only purchase $1.58….

– By how much? (2.1 – 1.58) / 1.58 = 33% over valued

Big Mac Index• How can you use this index to make business

decisions?• What are the Limitations: ????? Discuss

E[XRS] – XRS

XRS

XRXRXRS

SF D F

F

R R1+ R

D F

F

I I1 + I

UFR

UNBIASED FORW

ARD RATE

IFE

INT’L FISHER EFFECTINTEREST RATE PARITY IRPP

AR

ITY

PU

RC

HA

SIN

G P

OW

ER

(Forward Premium) (Interest Differential)

FISHER E

FFECT

FE

(%Spot Rate*)

(Inflation Differential*)

THIS MODEL IGNORES GOVERNMENT CONTROLS AND TRANSACTIONS COSTS

* = Forecasted Value

XR = Domestic CurrencyForeign Currency

Exchange Rate Determination

E[XRS] – XRS

XRS

D F

F

R R1+ R

IFE

INT’L FISHER EFFECT

(Interest Differential)

(%Spot Rate*)

Looks confusing, but is simple.

IFE states that …

% change in spot rate = interest differential

That’s all.

IFE

IFE

Key Formula (simplified)

• E[XR] = XR spot [ 1 + interest 1 + interest]

But, what units go on top / bottom…is it dollars per Euro? Or Euros per dollar?

Lets do an example…..

IFE - example

Goal: Predict 6-month FX rate (USD / Swiss Franc)

• Assume current Spot rate = 1.10 SF / $USD• Annualized interest rates on 6-month deposit• US = 3.1 %• Swiss = 2.8%• What is expected FX rate in 6 months?• Should the US currency appreciate?

• E[XR] = XR spot [ 1 + interest 1 + interest]

= 1.10 SF *[1 + .028/2 SF$1.0 USD 1 + .031/2] USD

= 1.098375 SF / USD

Is this appreciation? Or Depreciation of the USD?

Interest Rate Parity (p323-5)

•FX market in equilibrium ONLY when interest rate parity exists

•When deposits of all currencies offer the same EXPECTED rate of return

•Rate + expected (appreciation / depreciation) = rate

•Example: US / Euro. If US interest = 5%, EU = 10%, but US dollar is expected to appreciate +5% = balance

Credit Crisis timelinehttp://en.wikipedia.org/wiki/Subprime_crisis_impact_timeline

September 7, 2008: Federal takeover of Fannie Mae and Freddie Mac[25][26] September 14, 2008: Merrill Lynch sold to Bank of America amidst fears of a liquidity

crisis and Lehman Brothers collapse[27] September 15, 2008: Lehman Brothers files for bankruptcy protection[28] September 16, 2008: Moody's and Standard and Poor's downgrade ratings on AIG's

credit on concerns over continuing losses to mortgage-backed securities, sending the company into fears of insolvency.[29][30]

September 17, 2008: The US Federal Reserve loans $85 billion to American International Group (AIG) to avoid bankruptcy.

September 19, 2008: Paulson financial rescue plan unveiled after a volatile week in stock and debt markets.

September 25, 2008: Washington Mutual was seized by the Federal Deposit Insurance Corporation, and it's banking assets were sold to JP MorganChase for $1.9bn.

Credit Crisis – key points1. Banking business model

– Borrow short, lend long

2. Federal guarantee in exchange for regulation3. What is the problem today?

– Banks don’t trust each other, stop lending– Libor rates spike– Flight to safety – everyone buying Treasuries

4. What should the government do?– Lender of last resort – pump money back into system

Credit Crisis – how it relates to our class?

1. We learned last class:– Companies can borrow from Eurocurrency

market – Lower rates, due to less regulation– Market = trillion + per day (hundreds of trillions

per year)

Credit Crisis – how it relates to our class?

2. Effect on currency markets– Fundamentals out the window– Driver of FX = macro themes

• Repatriation of US dollars to US • Flight to quality• Unwinding of carry trade• TED spread

Credit Crisis – how it relates to our class?

LIBOR = root of problem– Libor rates shoot up. Banks stop lending. – Causing troubles for banks, companies looking

for short term finance.– Remember bank business model (borrow short,

lend long)

Near collapse – Last Thursday 9/18/08

According to one analyst on CNBC, we were a “few hundred trades away from a complete collapse” of the money market.

• Interbank lending grinds to near-standstill - Sep-17• Money markets fund sector shocked - Sep-17• Interbank loans at standstill - Sep-20

Fed to the rescue

Fed steps in:1. Ban on short selling2. Extend federal guarantee to money market mutual

funds (US money market funds aided Sep 19 2008)3. “Paulson Plan” - $700 bn plan to buy up “toxic”

debt

But the problems continue…

“The violent shifts in Libor levels have prompted some commentators to say that Libor is broken,” said JP Morgan. “The more relevant – and frankly scarier – question to contemplate is: ‘what if Libor is not broken? What is Libor telling us about the state of the global money markets?”: FT.com, September 26 2008