Integrated MarketsIntegrated MarketsPart IIPart II

Uncovered Interest Uncovered Interest ParityParity

THE INTEREST RATE AND THE THE INTEREST RATE AND THE EXCHANGE RATEEXCHANGE RATE

A note of concrete realityA note of concrete reality1971: 1971: ¥/$ = 360¥/$ = 3602004: ¥/$ = 1102004: ¥/$ = 110Average Average depreciation of $ depreciation of $ 4% 4% per year; average with many per year; average with many zigs and zags zigs and zags

Dollar DepreciationDollar DepreciationPowerful track recordPowerful track recordBut with much uncertaintyBut with much uncertaintyMany market participants Many market participants believe it will continuebelieve it will continue

But with fluctuationBut with fluctuation

Track RecordTrack RecordThe track record is a givenThe track record is a givenMarket participants expect the Market participants expect the $ to depreciate by 4%$ to depreciate by 4% They expect the yen to They expect the yen to appreciate by 4% appreciate by 4% Does anybody have any better Does anybody have any better information?information?

Actually, yesActually, yesThe 4% is very long-runThe 4% is very long-runThere are frequent zigs & zags, There are frequent zigs & zags, some of them last over several some of them last over several years years The long-run is made out of a series The long-run is made out of a series of intermediate runs which in turn of intermediate runs which in turn are made out of series of short-runsare made out of series of short-runs

The Long = The Long = ΣΣShortShort

That 4% is composed of an That 4% is composed of an average of many forward rates average of many forward rates Some were above 4%, some belowSome were above 4%, some belowSome were even negative when the Some were even negative when the $ was expected to appreciate$ was expected to appreciateExpectations may have zigged & Expectations may have zigged & zagged but zagged but averagedaveraged about 4% about 4%

Moving OnMoving OnGiven these historical facts, let’s Given these historical facts, let’s assume that iassume that i$$

= 5%= 5%Therefore, iTherefore, i¥¥ = 1% = 1% Aren’t these two numbers close to Aren’t these two numbers close to accurate? accurate? Maybe that’s what would induce Maybe that’s what would induce you to hold dollarsyou to hold dollars

Things to RememberThings to Remember

There is rapid and easy capital There is rapid and easy capital mobility between USA & JPNmobility between USA & JPNBoth US & Japanese markets are Both US & Japanese markets are relatively free from influences other relatively free from influences other than supply and demand than supply and demand Risk factors may be somewhat Risk factors may be somewhat different, but we can ignore them different, but we can ignore them without much inaccuracywithout much inaccuracy

Law of One PriceLaw of One PriceThe law of one price should The law of one price should prevailprevailInterest rates on equivalent Interest rates on equivalent Japanese and US securities Japanese and US securities should be equal should be equal But they differ at 1% & 5%But they differ at 1% & 5%

Shopping ListShopping ListWe have dollars valued at $100We have dollars valued at $100In US securities, we get $105 next In US securities, we get $105 next year year Let’s buy 100 Japanese securities Let’s buy 100 Japanese securities First we buy must buy First we buy must buy ¥100¥100In Japanese securities, we get In Japanese securities, we get ¥101 ¥101 next yearnext year

What Do You Expect?What Do You Expect?If our expectations are correct, the If our expectations are correct, the ¥ ¥ will havewill have gained 4% over the dollar gained 4% over the dollar The 101 units will buy approximately The 101 units will buy approximately 105 units of US currency105 units of US currencyWe gain 5% either wayWe gain 5% either wayIf it isn’t true, supply and demand will If it isn’t true, supply and demand will make it somake it so

Japan’s PerspectiveJapan’s PerspectiveWith 100 units of With 100 units of ¥, JPN markets will ¥, JPN markets will yieldyield 101 units next year 101 units next yearIn $US, at 5% we obtain 105 units $US In $US, at 5% we obtain 105 units $US next year next year But that 105 will have lost about 4% in But that 105 will have lost about 4% in value, so it buys only 101 units of value, so it buys only 101 units of Japanese currency at the end of the Japanese currency at the end of the yearyear

ExpectationsExpectationsThis was based on expectations; we This was based on expectations; we can’t be sure it will happencan’t be sure it will happenIt ain’t over ‘til it’s overIt ain’t over ‘til it’s overBut markets respond to such But markets respond to such phenomena phenomena This proposition can’t really be true This proposition can’t really be true unless covered interest parity holdsunless covered interest parity holds