Page 177 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 14 : Exchange Rate : Meaning and Components

Suppose (a) interest rate parity holds; (b) expected changes in exchange rates reflect expected inflation Notes
differentials; and (c) the expected real components of nominal interest rates can vary somewhat
independently across countries in response to purely domestic factors. These conditions, along with
either the Tobin-Mundell or Fama-Gibbons stories for negative correlation between the expected real
and expected inflation components of nominal interest rates, imply negative correlation between the
premium, P , and the expected change in the spot rate, E(S – = S ), in the forward-spot differential,
t t + 1 t
F – S .
t t
To complete this story, however, we need a subplot to explain how the expected real returns on the
nominal bonds of a country can vary in response to domestic factors that do not necessarily imply
variation in the risks of the bonds. Segmented international capital markets can produce this result,
but then the interest rate parity part of the story is likely to be lost. Alternatively, John Bilson suggests
that such independent variation in the expected real returns on the nominal bonds of different countries
can arise in open international capital markets when stochastic deviations from purchasing power
parity (PPP) lead to strong preferences for borrowing and lending contracts denominated in one’s
domestic unit of account. Stulz (1981) provides a formal version of this kind of model in which
deviations from PPP are due to the existence of nontraded goods. The Stulz model, in turn, can be
viewed as a generalization of the Stockman (1980) and Lucas (1978, 1982) models.
Self-Assessment
1. Choose the correct options:
(i) If the U.S. dollar depreciates in terms of the Euro:
(a) European goods would be cheaper for Americans.
(b) The relative price of U.S. exports would rise.
(c) Americans would have to pay fewer dollars for one Euro.
(d) American goods would be cheaper for Europeans.
(ii) What accounts for most of the activity in the foreign exchange market?
(a) Trading by financial institutions
(b) Currency trade among central banks
(c) Trading currency between importers and exporters
(d) Interbank trading
(iii) Which of the following is NOT a major currency trading center?
(a) Frankfurt (b) Tokyo
(c) New York (d) London
(e) Chicago
(iv) If a contract contains a promise that a specified amount of foreign currency will be delivered
on the specified date in the future, this is:
A swap.
(a) A foreign exchange option. (b) A futures contract.
(c) A forward contract. (d) A spot contract.
(v) A saver will prefer asset X to asset Y if:
(a) Asset X is less risky. (b) Asset X is more liquid.
(c) Asset X has a higher expected return. (d) All of the above.
(e) None of the above.
14.3 Summary

• Large positive autocorrelations of the difference between the forward rate and the current spot
rate indicate variation through time in either the premium component of F – S or in the
t t

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