International Finance and Money - Uncovered Interest Rate Parity - Coursework Example

INTERNATIONAL FINANCE AND MONEY By of the of the School The concept on Uncovered Interest Rate Parity Uncovered Interest Rate Parity (UIRP) is a parity condition that states that the difference existing in interest rates between two nations is equal to the anticipated or likely change in the rates of exchange between the currencies of the two countries (Held, 1999: 217). According to Bekaert et al. (2007), Uncovered Interest Rate Parity predicts that currencies that have high yields are likely to depreciate. In addition, it predicts that, ceteris paribus, an increase in real interest rates should appreciate the currency (Bekaert et al. 2007). UIRP is therefore, one of the international finance’ cornerstones, that constitute a crucial building block of very vital exchange rate determination theories like overshooting model or target zone model and the monetary exchange rate model. UIRP involves exchange risk as well as speculation. Interest rate parity is seen to be uncovered when no-arbitrage condition is actually satisfied without using a forward contract in order to hedge against exchange rate risk exposure. Risk-neutral investors are often indifferent among the rates of interest available in two countries since the rate of exchange between such two countries are required to adjust in such a way that the returns resulting from investing domestically and returns from investing abroad are equal (Vyuptakesh, 2010: 93). The idea of UIRP is rather simple. For instance, having two options in the financial market: first option entails purchasing a domestic bond with a return of i and a second option entails purchasing a foreign bond that has a return of i* + x (both of which are in terms of domestic currency). i* and i are both certain and x is uncertain because it is the current and future expected change in the exchange rate (Kallianiotis, 2013: 62). For a risk-neutral investor, the law of one price condition for the UIRP will simply be x=i- i* or i= i*+x. This implies that the expected change in rate of exchange is equal to the interest rate gap between the two countries (Vyuptakesh, 2010: 93). Additionally, if the rate of interest in the US is 12% and that of Australia is 7%, the UIRP states that the Australian dollars is expected to depreciate against the US dollar by roughly 5%. Assumption needed for uncovered interest rate parity to hold Interest rate parities rest of some assumptions. There are several assumptions that are needed for UIRP to hold. The first assumption is free mobility of capital. There should be no official barrier to arbitrage across nations in order to enable investors to readily and easily exchange domestic assets for the foreign ones (Kallianiotis, 2013: 62). The second assumption states that assets should have perfect substitutability due to their similarities in liquidity and riskiness. The two assumptions are necessary in making the investors to hold assets that offer greater returns, be they foreign or domestic assets. Nevertheless, investors hold both foreign and domestic assets. Therefore, no difference is expected to exist between returns on foreign assets and returns on domestic assets (Held, 2009: 217). This does not imply that foreign investors as well as foreign investors earn equivalent returns; however, it implies that an investor on any side would look forward to earning the same returns from whichever decision. The third assumption is that there should be no transaction cost. There should be no market or natural barrier to arbitrage across nations. Transactions should have no charge or carry just a negligible charge. Fourthly, there should be no default risk. Financial investments should be safe against country risks, business defaults or any other risks. Finally, Moore & Roche (2012) states that there should be risk neutrality. Investors should not take into consideration the outcome of every outcome but instead take into consideration the long-run average return. Even though all other financial investment risks are assumed away, exchange risk is present here and the investors should be neutral against it. They should just care about average results even if the volatility (variance) of the returns of every investment is small or large. Implications of assuming UIP in the Flex Price Monetary Model (FPMM) of the Exchange Rate The Flex Price Monetary Model (FPMM) of the Exchange Rate maintains that there is no government intervention in the foreign exchange market. Capital flows and trade flows are the main factors that affect the exchange rate. There is no pre-determined official target for the exchange rate and the monetary authority can set interest rate as target variable for monetary policy objective. (Backus et al. 2010) maintains that assuming the UIRP here is likely to cause variations in the risk premium because the FPMM of the Exchange Rate presents the greatest risk for investors as the currencies are very volatile over the short term. This is caused mainly by the variations in degree of risk aversion, monetary policy, political risks as well as microstructure variations in the market. According to Sarantis (2006), the FPMM of the Exchange Rate gives the government or monetary authorities the flexibility in determining the interest rates because the interest rates need not be set to keep the value of the exchange rate within the pre-determined bands. This, therefore, creates interest rates differential thus resulting in arbitrage condition. The rate of exchange between two countries is anticipated to adjust in such a way that the returns resulting from investing domestically and returns from investing abroad are not equal. Investors then begin caring about the outcome of every outcome and not just the long-run average return. In addition, it leads to a rise in the rate of growth of money stock causing an immediate as well as discontinuous depreciation then followed with a very rapid rate of depreciation (Craighead et al. 2010: 725). It increases interest differentials which are linked to weakening currencies. On the other hand, Craighead et al. (2010) maintains that assuming UIRP in FPMM of the Exchange Rate causes higher rates of interest in one country thus inducing investors to shift their capital to that country, resulting in inflow of capital. The capital inflow increases demand for that country’s currency, thereby appreciating it. This violates the principle that trade balance should always be zero in order that the capital account is always zero as well. Empirical evidence about Uncovered Interest Rate Parity Christensen (2000) holds that Uncovered Interest Rate Parity has been found to have empirical support and backing in correlation tests between forward premium and discount and the expected rates of depreciation in currency. Evidence suggests that whether UIRP holds depends on the examined currency. Deviations from Uncovered Interest Rate Parity are less substantial in the examination of longer time horizons. Sarantis (2006) on the other hand states that some monetary policy studies have presented explanations for the empirical fail of UIRP. A number of researchers have revealed that interest rate spreads have negative coefficients in UIRP regression tests in case a central bank manages or controls interest rate spreads as a strong response to the spreads of the previous periods. Another study demonstrated that UIRP’s empirical failures are explained by smoothing of interests rates by the central bank as the monetary policy of the central banks responds to exogenous shocks. The empirical failure of UIRP can be explained by considering violations to its fundamental assumptions. The violations include a time-varying premium and the irrational expectation. In summation, the studies present mixed evidence regarding the validity of the UIRP. Another branch of UIRP studies that is based on the intuition that UIRP is in fact a long-run relationship that is obscured by short-run exogenous shocks. Using tools such as cointegration analysis using long-run average data, economists discovered that the studies yield results that favor a long-run UIRP relationship (Sarantis, 2006). Studies have found that UIRP hold over very small time spans, covering only a few hours, with a very high frequency of exchange rate data between two countries. The main factor that can generate violations of UIRP There are several factors that can generate violations of UIRP. Violations of UIRP can be explained by the violations of the assumption of the free flow of capital and the ease with which the assets are substituted from two different countries. Therefore, in my opinion the main factor is government control. Government control of the exchange rate establishes an official hindrance to the arbitrage across countries thus hindering investors from readily exchanging domestic or home assets for the foreign ones. This may introduce transaction costs (market or natural hindrance to arbitrage across nations). According to Skinner & Mason (2011), the transaction cost introduces transaction band to the UIRP equation thus creating the violation. The capital controls by the government also add costs to the investments in other countries thus creating similar effects to the equation. The investor becomes risk averse because all financial risks are not assumed and the investors are not neutral against exchange risk. They begin caring about the outcome of every outcome and just the long-run average return because the volatility (variance) of the returns of every investment is extremely large. In addition, government control or intervention in the foreign exchange market creates a difference in rates of tax on foreign exchange gains/losses and interest income. This difference in tax rates contributes to the inability to substitute an investment in different countries. This violates the principle that no difference is expected to exist between returns on foreign assets and returns on domestic assets (Sarantis, 2006: 1178). The investments will therefore have different riskiness and liquidity thus making an investment in one country to be more preferable than an investment in the other. Government control of controls interest rate spreads through the central bank causes empirical failures of UIRP because interest rate spreads have negative coefficients in UIRP regression tests. The smoothing of the interest rates by the central government is responsible for the violations of UIRP as well. The exchange rates invariably appreciate (depreciate by less than the value that is implied by the forward premium (discount). this indicates that violations of Uncovered Interest Rate Parity are not simply confined to the basic currency blocks but they are ubiquitous. Deviations from UIRP are both time and size dependent. For example, at some points in time where differentials in interest rate have been relatively large, UIRP accurately predict sign of exchange rate changes and not magnitude (Craighead et al. 2010: 725). References Backus, D.K. et al., 2010. Monetary Policy and the Uncovered Interest Parity Puzzle. NBER working paper series. Available at: http://www.nber.org/papers/w16218. Bekaert, G., Wei, M. & Xing, Y., 2007. Uncovered interest rate parity and the term structure. Journal of International Money and Finance, 26, pp.1038–1069. Christensen, M., 2000. Uncovered interest parity and policy behavior: new evidence. Economics Letters, 69, pp.81–87. Craighead, W.D., Davis, G.K. & Miller, N.C., 2010. Interest differentials and extreme support for uncovered interest rate parity. International Review of Economics and Finance, 19, pp.723–732. Kallianiotis, J. N. (2013). International financial transactions and exchange rates: trade, investment, and parities.  Held, D. (2009). Global transformations: politics, economics and culture. Stanford, Calif, Stanford Univ. Press. Moore, M.J. & Roche, M.J., 2012. When does uncovered interest parity hold? Journal of International Money and Finance, 31, pp.865–879. Sarantis, N., 2006. Testing the uncovered interest parity using traded volatility, a time-varying risk premium and heterogeneous expectations. Journal of International Money and Finance, 25, pp.1168–1186. Skinner, F.S. & Mason, A., 2011. Covered interest rate parity in emerging markets. International Review of Financial Analysis, 20, pp.355–363.  Vyuptakesh, S. (2010). International Financial Management. 93 Read More