IV. Stabilization policy
B. Foreign exchange markets
3. Exchange rate determination
b. The asset market approach to ER changes

(1) Theory: the interest parity condition (IPC)
    Context: People make investments across international markets.
    The IPC captures the outcome of that process
        Prediction: Asset flows equalize expected returns, including expected ER changes

Example: US and Japan, 12/06     E = Yen per US$ 3-month government bonds:     ius = 4.90%     ij = 0.47%     ? How could savers earn the same returns on these government bonds given the different i-rates?     Savers must think the Yen is undervalued and will rise in the future

This is what the IPC is all about.

    High interest-rate countries should have overvalued currencies (expected to depreciate)
        ifor = 6%, idom = 8% => %DEexp = -2% = forward discount for the $

    Recall that foreign currency traders use currency arbitrage to keep exchange rates in line with each other worldwide.

    Financial investors do the same for worldwide investment returns:
    process = interest arbitrage.
    Accomplished through interest arbitrage makes the return on financial investments converge worldwide

    Savers don't care about PPP--whether a currency is weak or strong per se does not bother them. If a currency doubles in value and then stabilizes at its new level, then a foreign bond will cost 2x as much as before, but its interest will be worth 2x as much also, so the rate of return is unchanged.

    Savers DO care about CHANGES in ERs during the period their funds are tied up abroad. That does affect the return they earn.

(2) Evidence concerning IPC

    Why it matters: IPC => policy changes which affect interest rates can have real foreign-sector effects

    Asset mobility has grown tremendously in recent years. Very little in the 1960s. In 1960, only 8 U.S. banks had foreign branches
    There is a great deal of asset mobility today. 100s of banks have foreign branches. Computerization and satellite communications have created a world-wide capital market.

    The Eurocurrency market links world financial markets.
    (Any deposit denominated in non-domestic currency = a eurocurrency deposit)
    Eurocurrency market allows firms to borrow outside formal, regulated banking systems. Central banks do not control activities of non-domestic currencies
    --USSR started it from fear of impoundment in 1964, near the end of the heyday of Bretton Woods fixed ER system. Size in 1964: $7-9B.
    --Boosted by U.S. banking regulations
    1963: interest equalization tax
    1965-8: voluntary, then in '68 mandatory controls on foreign bank lending
    1968-9: reg.Q (i-rate ceilings in U.S.) --> banks borrowed abroad
    1973: OPEC and floating rates

    Today, financial asset transactions dominate average daily foreign exchange market activity:

	LAT, 10/29/89	LAT, 3/19/95	2010
Trade	$20B	$34B	$50B
Total	$400B	$1,000B	$4,000B
KA src:	LAT, 10/29/89	LAT, 3/19/95	BIS (triennial survey)

    Most is just arbitrage, but much is due to other types of asset transactions.

Asset mobility in the real world: Covered interest arbitrage: invest abroad and use forward ER contracts to avoid ER risk

    2 options to calculate your total return:

    Option 1 (approximate): Given ifor, %DEfor (=-(%DEdom)):
        total return = ifor + %DEfor

    Option 2 (exact): 

    Do a real-world example from the worksheet together
    Do a second example from the worksheet: Comparing domestic and foreign returns in practice
    Result: Covered returns are typically quite comparable.

    The process for uncovered interest arbitrage is similar, but you don't make a forward contract.
    You just cash out at whatever the spot rate is the end of the holding period.