FINS3616 Lecture Notes - Lecture 5: Purchasing Power Parity, Foreign Exchange Market, Menu Cost
4 – FOREX & Purchasing Power Parity
Speculation and risk in the foreign exchange market
• Testing unbiasedness hypothesis
Cat osere ho arket participants form their expectations, so must make
assumptions
(a) Investors act rationally (no mistakes or bias)
(b) Realised appreciation = expected appreciation + forecast error
• Weakest implication of unbiasedness hypothesis is the unconditional mean of the
realised appreciation = unconditional mean of the forward premium
No empirical differences, only weak since looking at averages
• Regression test – epirial eidee strogl suggests it doest hold
• Inefficient market implication:
Publicly available interest rate differentials contain information from which profit
can be obtained
Exploiting forward bias and carry trades – use regression results to calculate
expected return on forward position
Strateg alled carry trade’
(a) If forward discount – go long in foreign currency
(b) If forward premium – go short in foreign currency
Popular strategy among hedge funds
(a) Borrow (go short) in the currencies trading at the biggest forward premiums
to take advantage of the low interest rates and invest (go long) in the
currencies trading at the biggest forward discount to take advantage of the
high interest rates
• Have carry trades been profitable?
Many financial institutions and currency funds (often highly leveraged) held
abnormally high risk and were wiped out in the crisis
Some economists argue that market participants are just irrational
• Peso problem – epetig soethig draati to happe ad it doest at least ot
when expected)
Name from Mexico – rational investors anticipated devaluation of peso
Can peso problem explain carry trades performance?
(a) Yes: if one assumes agents become very risk averse when an unwind happens
(i.e. time-varying risk premiums)
Purchasing power parity and real exchange rates
• PPP – a simple model of the determination of exchange rates
• Baseline forecast for predicting exchange rate
• Plays a fundamental role in corporate decision making
Location of plants, pricing products, hedging decisions
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Document Summary
Speculation and risk in the foreign exchange market: testing unbiasedness hypothesis. No empirical differences, only weak since looking at averages: regression test e(cid:373)piri(cid:272)al e(cid:448)ide(cid:374)(cid:272)e stro(cid:374)gl(cid:455) suggests it does(cid:374)(cid:859)t hold. Publicly available interest rate differentials contain information from which profit can be obtained. Exploiting forward bias and carry trades use regression results to calculate expected return on forward position. Strateg(cid:455) (cid:272)alled (cid:858)carry trade" (a) if forward discount go long in foreign currency (b) if forward premium go short in foreign currency. Many financial institutions and currency funds (often highly leveraged) held abnormally high risk and were wiped out in the crisis. Some economists argue that market participants are just irrational: peso problem e(cid:454)pe(cid:272)ti(cid:374)g so(cid:373)ethi(cid:374)g dra(cid:373)ati(cid:272) to happe(cid:374) a(cid:374)d it does(cid:374)(cid:859)t (cid:894)at least (cid:374)ot when expected) Name from mexico rational investors anticipated devaluation of peso. Can peso problem explain carry trades performance? (a) yes: if one assumes agents become very risk averse when an unwind happens (i. e. time-varying risk premiums)
