CHAPTER III EXCHANGE RATES, INTEREST （第三章汇率、利息）.pdf

CHAPTER III EXCHANGE RATES, INTEREST RATES, PRICES AND EXPECTATIONS This chapter presents simple models of exchange rate determination. These models apply arbitrage arguments in different contexts to obtain equilibrium relations that determine exchange rates. In this chapter, we define arbitrage as the activity that takes advantages of pricing mistakes in financial instruments in one or more markets, facing no risk and using no own capital. The no own capital requirement is usually met by buying and selling (or borrowing and lending) the same or equivalent assets or commodities. The no risk requirement is usually met by doing the buying and selling (or borrowing and lending) simultaneously. Obviously, arbitrageurs will engage in this activity only if it is profitable, which means there should be a pricing mistake. Financial markets are said to be in equilibrium if no arbitrage opportunities exist. The equilibrium relations derived in this chapter are called parity relations. Because of the underlying arbitrage argument, parity relations establish situations where economic agents are indifferent between two financial alternatives. Thus, parity relations provide an “equilibrium” value or a “benchmark.” These benchmarks are very useful. For example, based on a parity benchmark, investors or policy makers can analyze if a foreign currency is “overvalued” or “undervalued.” I. Interest Rate Parity Theorem (IRPT) The IRPT is a fundamental law of international finance. Open the pages of the Wall Street Journal and you will see that Argentine bonds yield 10% and Japanese bonds yield 1%. Why wouldnt capital flow to Argentina from Japan until this differential disappeared? Assuming that there are no government restrictions to the international flow of capital or transaction costs, the barrier that prevents Japanese capital to fly to Argentina is currency risk