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Exchange Rates vs. Interest Rates Sources of Potential Profit

Exchange Rates vs. Interest Rates Sources of Potential Profit. Prepared by: Branko Ð api ć , Christian Helland, Jeong-Jun Lee, Wook-Jong Lee, Lizabeth Monta ñ o, Walter Zevallos. Exchange rate: Price of one currency in terms of another, conventional way- home currency per foreign

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Exchange Rates vs. Interest Rates Sources of Potential Profit

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  1. Exchange Rates vs. Interest RatesSources of Potential Profit Prepared by: Branko Ðapić, Christian Helland, Jeong-Jun Lee, Wook-Jong Lee, Lizabeth Montaño, Walter Zevallos

  2. Exchange rate: • Price of one currency in terms of another, conventional way- home currency per foreign • A depreciation (appreciation) of a country’s currency makes its goods cheaper (more expensive) for foreigners, and makes foreign goods more expensive (cheaper) for domestic residents. • Key players in the market: commercial banks, corporations, nonbank financial institutions (insurance companies, pension funds), central banks.

  3. Assumptions: • Currently hold dollar denominated deposits • Risk and liquidity is the same between currencies Our Goal: • Find the relationship between the interest rates and exchange rate • Predict the near future movement so we can maximize our wealth

  4. How is exchange rate determined? • The Asset Approach – based upon “interest rate parity” • Monetary Approach – based upon “purchasing power parity” The key element > Expected Rate of Return Investors care about • Real rate of return • Risk • Liquidity

  5. The basic equilibrium condition in the foreign exchange market is interest parity. Uncovered interest parity R$=R¥+(Ee$/¥-E$/¥)/E$/¥-Risk Premium Covered interest rate parity (risk-free) R$=R¥+(F$/¥-E$/¥)/E$/¥

  6. Historical Interest Rates & Historical Exchange Rates Dollar Interest spread Yen

  7. Explaining the Spread (Dollar vs. Yen) Interest spread Interest parity Change in Exchange rate

  8. Intuition of the Model Interest parity Positive Deposit in $US 0 Deposit in Foreign Currency Negative Time Time

  9. Modeling the Yen: ADF Test Statistic -4.022379 1% Critical Value* -3.9964 5% Critical Value -3.4283 10% Critical Value -3.1372 *MacKinnon critical values for rejection of hypothesis of a unit root.

  10. Modeling Yen Parity:

  11. Actual Upper Band (95% confidence) FAVORABLE $US REGION FAVORABLE YEN REGION Actual Lower Band

  12. FORECASTING YEN PARITY:

  13. Conclusion

  14. Questions?????

  15. Backup slides (Exchange rate only) Modeling Yen with an ARMA(8,0)

  16. Showing dYen to be a Stationary Series

  17. Actual and Fitted Yen Model

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