International Finance Lecture
International Finance
Konstantinos Mavromatis
UvA, Department of Economics
Today’s Focus
•
•
•
•
Forex Market Efficiency
UIP
CIP
Carry Trade and the Recent Financial Crisis
Forex market efficiency
• Fama, Eugene (J. of Finance, 1991):
– “I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information. [...] market efficiency per se is not testable. It must be tested jointly with some model of equilibrium, an asset-pricing model.”
• Implications:
– no excess returns under efficient forex markets
– market efficiency hypothesis (EMH) is a joint hypothesis of:
• (a) rational expectations (RE)
• (b) risk neutrality
• If EMH adjusted for risk, joint hypothesis of RE and a model of equilibrium returns
Cornerstone of forex market efficiency • If EMH holds, expected forex gain from holding one currency rather than another
(the expected change in the exchange rate) must be equal to the interest rate differential
– uncovered interest parity (UIP):
Δkset+k = it - it*
– where st is the log exchange rate at time t (domestic price of foreign currency)
– it and it* are the domestic and foreign interest rates on similar securities (with k periods to maturity)
– e superscript denotes the market expectation
– Δk is the k-difference operator, so Δkst+k = st+k - st
Covered interest parity (CIP)
• Very often forex efficiency is dealt with in terms of spot and forward exchange rates and using CIP (Keynes, 1923):
– under no barriers to arbitrage across international financial markets, the interest rate differential on two assets whose only difference is the currency of denomination, adjusted to cover the movement of currencies at maturity in the forward market, should be continuously zero
– algebraically: Ftk / St = (1 + it) / (1 + it*) where Ftk is the k-period forward rate (rate
agreed now for an exchange of currencies k periods ahead)
Why
Konstantinos Mavromatis
UvA, Department of Economics
Today’s Focus
•
•
•
•
Forex Market Efficiency
UIP
CIP
Carry Trade and the Recent Financial Crisis
Forex market efficiency
• Fama, Eugene (J. of Finance, 1991):
– “I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information. [...] market efficiency per se is not testable. It must be tested jointly with some model of equilibrium, an asset-pricing model.”
• Implications:
– no excess returns under efficient forex markets
– market efficiency hypothesis (EMH) is a joint hypothesis of:
• (a) rational expectations (RE)
• (b) risk neutrality
• If EMH adjusted for risk, joint hypothesis of RE and a model of equilibrium returns
Cornerstone of forex market efficiency • If EMH holds, expected forex gain from holding one currency rather than another
(the expected change in the exchange rate) must be equal to the interest rate differential
– uncovered interest parity (UIP):
Δkset+k = it - it*
– where st is the log exchange rate at time t (domestic price of foreign currency)
– it and it* are the domestic and foreign interest rates on similar securities (with k periods to maturity)
– e superscript denotes the market expectation
– Δk is the k-difference operator, so Δkst+k = st+k - st
Covered interest parity (CIP)
• Very often forex efficiency is dealt with in terms of spot and forward exchange rates and using CIP (Keynes, 1923):
– under no barriers to arbitrage across international financial markets, the interest rate differential on two assets whose only difference is the currency of denomination, adjusted to cover the movement of currencies at maturity in the forward market, should be continuously zero
– algebraically: Ftk / St = (1 + it) / (1 + it*) where Ftk is the k-period forward rate (rate
agreed now for an exchange of currencies k periods ahead)
Why