Prof. Volker Wieland: International Finance IF Skript 3 / 1
International Finance, SS 03International Finance, SS 03Course Summary and Figures, part 3Course Summary and Figures, part 3
Prof. Volker Wieland
Goethe University Frankfurt
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3. Basic Tools3. Basic Tools for Understandingfor UnderstandingExchange RateExchange Rate
3.1. Arbitrage and Interest Rate Parity Conditions
3.2. Demand and Supply: Balance of Payments
3.3. Purchasing Power Parity
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3.1. Arbitrage and3.1. Arbitrage and InterestInterest RateRate ParityParity
• Covered interest rate parity: Definition andillustration
• Covered interest arbitrage: Principle andexample
• Interest rate parity and equilibrium
• Forward rate as unbiased predictor of future spotrate
• Uncovered interest rate parity
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Yield Curves and Forward PremiumYield Curves and Forward Premium
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Covered Interest Rate Parity: IllustrationCovered Interest Rate Parity: Illustration
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Covered InterestCovered Interest Arbitrage:Arbitrage: ExampleExample
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Interest Rate Parity and EquilibriumInterest Rate Parity and Equilibrium
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Deviations from Covered InterestDeviations from Covered InterestRateRate ParityParity
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Forward Rate as Unbiased Predictor of Forward Rate as Unbiased Predictor of Future Spot RateFuture Spot Rate
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Levich TextbookLevich Textbook TestsTests
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Jung / Wieland, Jung / Wieland, Weltwirtschaftliches Archiv 1990Weltwirtschaftliches Archiv 1990
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Empirical EvidenceEmpirical Evidence
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3.2.3.2. TheThe Balance ofBalance of PaymentsPayments
• What determines the exchange rate?Demand and supply in the foreign exchange market
• The balance of payments is a statistical record that summarizes the economic transactions of aneconomy with ROW
Imports, exports of goods and services, income flows,capital flows, transfers, FX reserve balances
• The different forces influencing exchange ratesall induce transactions showing up in the BOP
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Generic Balance of PaymentsGeneric Balance of Payments
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Thailand‘s BOP: 84Thailand‘s BOP: 84--9191
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Thailand‘s BOP: 93Thailand‘s BOP: 93--9797
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Thailand‘s BOP: 94Thailand‘s BOP: 94--9999
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3.3. Prices and Exchange Rates3.3. Prices and Exchange Rates
• The law of one price or commodity price parity
• Absolute purchasing power parity
• Relative purchasing power parity
• Empirical evidence
• The real exchange rate
• Effective exchange rates
• Exchange rate pass-through
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TheThe Hamburger Standard 01/00Hamburger Standard 01/00
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TheThe Hamburger Standard 01/03Hamburger Standard 01/03
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TheThe Economist Standard (Economist Standard (LevichLevich 2000)2000)
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Purchasing Power Parity LinePurchasing Power Parity Line
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EmpiricalEmpirical Test: DeTest: De GrauweGrauwe (2000)(2000)
• Data: average yearly rates of inflation for 1970-99 and of change in exchange rate, 100 countries, Xrate vs $
• Regression equation: 2 CPIe C c π ε∆ = + +
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IMF Nominal and RealIMF Nominal and Real EffectiveEffectiveExchange Rate IndicesExchange Rate Indices
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