Download A Study of the Real Interest Rate Differential Mode and

A Study of the Real Interest Rate Differential
Mode and Nominal Inter-Bank Lending Rate
Differential as a determinant of the Swiss-Euro
exchange rate
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TABLE OF CONTENTS
Introduction ............................................................................................................................................................ 3
The Real Interest Rate Differential Model of Exchange Rate Determination ........................................................ 3
Theory .................................................................................................................................................................... 4
Real Interest Differential Model ......................................................................................................................... 4
Nominal Short-term Inter-bank lending Interest rate Differential ...................................................................... 5
Results of Testing ................................................................................................................................................... 6
Real Interest rate Differential (Long-run) ........................................................................................................... 6
Short-term Nominal Inter-bank lending Rates .................................................................................................... 9
Overall Analysis ................................................................................................................................................... 11
Conclusion ............................................................................................................................................................ 12
Bibliography ......................................................................................................................................................... 13
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INTRODUCTION
The Swiss franc Euro exchange rate is currently an interesting exchange rate with headlines
such as “Switzerland abandons floating exchange rate in dramatic 'currency war' twist”1. The
Swiss National Bank (SNB) operated a floating currency exchange policy until in September
2011 it deem it appropriate to drop that policy in substitute for a fixed exchange rate so as the
Swiss franc did not drop below 1.20 CHF/Euro.
CHF/Euro
1.8
1.6
CHF per Euro
1.4
1.2
1
0.8
0.6
0.4
0.2
0
THE REAL INTEREST RATE DIFFERENTIAL MODEL OF EXCHANGE
RATE DETERMINATION
With the movement of capital becoming ever more uncomplicated in recent decades due to
the development of technology and lifting of international barriers interest rate differentials
have become more important determinant of exchange rates. Well known models and studies
underscore the role of interest rates in determining real exchange rates. These include the
1
http://www.telegraph.co.uk/finance/currency/8745686/Switzerland-abandons-floating-exchange-rate-indramatic-currency-war-twist.html
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International Fisher Effect, The Sticky Price Model (Dornbusch & Mussa) and optimising
models (Grilli & Roubini)which highlight the effect of liquidity impulses on real interest
rates and consequently exchange rates.2 Basic economics tells us that if the interest rate
(return) of an asset such as Government bonds goes up, the currency needed to buy that asset
should appreciate relative to others with the increase in demand, ceteris paribus.
Empirical models have found that the trend in real long term yield spreads which accounts for
the influences of inflation is better at explaining exchange rate movements than the trend in
nominal short term yield spread which do not adjust for the effects of inflation. Real yields
will evidently show the mainstay structural shifts in savings and investments and the
activities of Central Banks. The long term aspect is better because long term rates tend to be
sustained, whereas short term rates can be transient and affected by speculative activities.
The relationship between interest rates and exchange rates under the Real Interest rate
Differential model is built on two main blocks being Purchase Power Parity (PPP) and
Uncovered Interest Rate Parity. Hoffmann & MacDonald through their paper on PPP and
Real Interest Rate Differential have found that there is little evidence to support PPP,
however there is a valid stationary relationship between interest rates and exchange rates, in
particular for small open economies such as the Swiss economy.
THEORY
REAL INTEREST DIFFERENTIAL MODEL
̅𝒔 + (𝒓𝑺𝒘𝒊𝒔𝒔 − 𝒓𝑮𝒆𝒓𝒎𝒂𝒏 )
𝒒𝒔 = 𝒒
The RID model is useful in the study of this particular exchange rate due to its large focus on
capital movement which Switzerland has been subject to over the past 12months. It stipulates
that the spot exchange rate of two currencies is determined based on the interest rate
differential between those two currency areas. As interest rates rise in a country, the increased
return will attract capital from international investors and there will be an inflow of capital.
The model looks at the difference between the interest rates of the two assets, the Real
Interest rate Difference (RID). If for example the RID was to fall. This could be caused for
Institute for empirical research in economics, University of Zurich Hoffmann & MacDonald
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two reasons either the Swiss interest rate has gone up on the 10 year bond or Germany’s
interest rate on their 10 year bond has gone down. The net result is the interest rate on the
Swiss bond is now relatively speaking after increasing relative to the German 10 year bond.
In turn there is an increased demand for the Swiss franc by international investors due to the
increasing interest rate of Switzerland. Thus in theory the RID model of exchange rate
determination predicts a positive relationship between the real exchange rate and real interest
rate differential.
NOMINAL SHORT-TERM INTER-BANK LENDING INTEREST RATE
DIFFERENTIAL
This examination is to see whether the short-term lending rates show any correlation in the
exchange rate determination. In theory the inter-bank rate which includes inflation should
reflect economic and market conditions and market sentiment which are inherently tied to
exchange rate determinations
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Fig.1
6
0.6
Tuesday, November 15, 2011
Thursday, December 15, 2011
Thursday, September 15, 2011
Saturday, October 15, 2011
Monday, August 15, 2011
Wednesday, June 15, 2011
Friday, July 15, 2011
Friday, April 15, 2011
Sunday, May 15, 2011
Tuesday, February 15, 2011
Tuesday, March 15, 2011
Saturday, January 15, 2011
Wednesday, December 15,…
Monday, November 15, 2010
Wednesday, September 15,…
Friday, October 15, 2010
Sunday, August 15, 2010
Thursday, July 15, 2010
Tuesday, June 15, 2010
Thursday, April 15, 2010
Saturday, May 15, 2010
Monday, February 15, 2010
Monday, March 15, 2010
Friday, January 15, 2010
Tuesday, December 15, 2009
-0.5
Sunday, November 15, 2009
Thursday, October 15, 2009
Tuesday, September 15, 2009
Saturday, August 15, 2009
Wednesday, July 15, 2009
Monday, June 15, 2009
Friday, May 15, 2009
Wednesday, April 15, 2009
Sunday, February 15, 2009
Sunday, March 15, 2009
Thursday, January 15, 2009
Monday, December 15, 2008
RESULTS OF TESTING
REAL INTEREST RATE DIFFERENTIAL (LONG-RUN)
Real Interest Rate Diferential Swiss - German
(%)
0
1
-1
-1.5
-2
-2.5
-3
-3.5
-4
CHF/Euro
1
0.95
0.85
0.9
0.8
0.75
0.7
0.65
Looking at the seismic moves of the exchange rate and real interest rate differential the
results are interesting. We can indicate some increase in the exchange rate relative to an
increase in the real interest rate differential, denoting the positive correlation which the RID
theory supports.
However this is not an immediately correlated. The time needed for the markets to react to
interest rate movement of capital can be seen. We can see with the red connectors in the
weeks following an interest rate augmentation there is an appreciation of the Swiss franc
Euro exchange rate. This represents the inflow of funds into the Swiss monetary zone to take
advantage of increasing returns. Au contraire, the purple arrows in the middle of 2009 show
the depreciation of the exchange rate as a result of (but not solely) the corresponding interest
rate declines representing the positive relationship in the form capital outflows.
Despite recognizing a number of correlation points along the time series between December
2008 and December 2011 there does not appear to be consistency within the correlations. The
black box in the Real Interest Differential graph the period of July 2009 to August 2011
highlights a decrease in the RID. This if the theory was to hold true this movement should be
recognized with a depreciation of the exchange rate in the months of September and/or
October, but this is not the case. In fact we see the currency appreciate.
The size of the movement in exchange rate relative to the increase in interest rate shows the
vigor of the correlation between the variables. A 1% increase in the RID would on average
cause a corresponding 4.059449% increase in the CHF/Euro exchange rate over the past 3
years.3 When we study the reverse movement when the RID decreases there is less of a
reaction in the exchange rate based on a movement of the same magnitude when increasing
with a 3.019681% decrease in the FX rate based on a 1% drop in the RID on average over the
3 years.4 Thus the variables are positively correlated but illustrate a stronger correlation when
the RID is increasing, this may be due to inflationary effects on the exchange rate in the long
run. However the CPI Index for Switzerland does appear to be reasonably stable thus other
factors would have to be considered (see fig.2.)
3
Workings in bibliography
4
Workings in bibliography
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Fig. 2
No material consistency with the magnitude of changes in the exchange rate exists relative to
the interest rate movement. “Point 1” on fig. 1 shows a 750 basis point move and there is
relatively small increase in the exchange rate compared with some of the other positive
correlation movements. Also the two green connectors circa March 2010 and September
2010 should large not inconsiderable movements in the in the RID with results of minimal
movement in the exchange rate. This could be due to a number of external factors outside the
scope of the model. Market sentiment and activities play a huge part in shaping investors
decisions on capital movements. Also liquidation timing and contract limitations on funds
may restrict the movement of capital into Swiss francs and take advantage of the RID change.
The green circa arrow the last quarter of 2010 connects what appears to be a depreciation of
the currency following the decrease in the RID. However based on my knowledge of the
financial events of the last number years I believe this is a false representation by the RID
theory. (Discussed later)
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Fig 2.
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0.6
Thursday, December 15, 2011
Tuesday, November 15, 2011
Saturday, October 15, 2011
Thursday, September 15, 2011
1
Monday, August 15, 2011
Friday, July 15, 2011
Wednesday, June 15, 2011
Friday, April 15, 2011
Sunday, May 15, 2011
Tuesday, February 15, 2011
Tuesday, March 15, 2011
Saturday, January 15, 2011
Wednesday, December 15,…
Monday, November 15, 2010
Friday, October 15, 2010
Wednesday, September 15,…
Sunday, August 15, 2010
Thursday, July 15, 2010
Tuesday, June 15, 2010
Saturday, May 15, 2010
Thursday, April 15, 2010
Monday, February 15, 2010
Monday, March 15, 2010
Friday, January 15, 2010
Tuesday, December 15, 2009
Sunday, November 15, 2009
Thursday, October 15, 2009
Tuesday, September 15, 2009
Saturday, August 15, 2009
Wednesday, July 15, 2009
Monday, June 15, 2009
Friday, May 15, 2009
Wednesday, April 15, 2009
Sunday, February 15, 2009
Sunday, March 15, 2009
Thursday, January 15, 2009
Monday, December 15, 2008
SHORT-TERM NOMINAL INTER-BANK LENDING RATES
Nominal Interest Rate Differential with 12 month inter-bank lending rates
Swiss - German
(%)
0
-0.5
-1
-1.5
-2
2
-2.5
CHF/Euro
1
0.95
0.85
0.9
0.8
0.75
0.7
0.65
We examine the 12month inter-bank lending rates of Switzerland and Germany. These being
the Swiss Libor and the Euribor respectively. These are nominal rates which include inflation
to represent the effects of the economies on the exchange rate in study. With this interest
differential paradigm as with the RID model previously we expect to see a positive
correlation between the nominal inter-bank interest rate differential and the exchange rate.
The two red arrows shows a positive correlation with increasing currency demands on the
Swiss franc following the rise in interest rate differential on the inter-bank lending rates from
the Swiss perspective between April 2009 and May 2010. Similar as to the RID we encounter
the time lag in investors moving funds in response to the swell in interest rates. The purple
indicator highlights the positive correlation in the opposite direction with the nominal interest
rate differential decreasing with regard to the interest rate differential.
As with the long term RID study there is not a pure correlation. The short term correlation is
proving to be considerably weaker to the long-term, which was expected on comments in the
“Theory” section above. This is in conjunction with past studies of interest rate differential
and exchange rate determination. The green connectors point out deviations from the
expected result. The 1st green connector shows a negative correlation. With the decreasing
interest rate differential we would expect there to be some depreciation in the currency.
Moreover in August of 2010 the 2nd green connector points out the spike in the Swiss francEuro exchange rate following a decrease in the nominal inter-bank interest rate differential. If
the theory was to hold true we should have also seen an increase of the interest rate
differential in the months preceding August (reason discussed later).
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OVERALL ANALYSIS
It’s evident the interest differential model has had some decree when it is determining
exchange rates. This is more so evident in the long run with
real interest rates as opposed to the short term nominal rates as
expected. The models (both the RID and short-term nominal
interest rate differential) have not however been robust in
towards the end of 2011. While it could be easy to compel
ourselves to see positive correlations (which don’t exist/exist
for alternative reasons) in the period studied, the reality of
economic events in the same period must be accounted for when critiquing the models.
Toward the latter end of 2011 we see a spike in the Swiss-franc Euro exchange rate. This was
due to the ongoing Euro debt crisis inducing panic in international investor due to speculation
on the collapse of the Euro single currency. Investors in turn wanted a safe haven for their
funds and the Swiss-franc was a popular choice by many. The Swiss-franc operating as a
floating currency appreciated as demand for the Swiss coinage soared. This over-valuation of
the Swiss-franc posed a threat to the Swiss economy particularly tourism and exporters.
Consequently in September of 2011 the highest point of the Swiss-franc appreciation the
Swiss National Bank (SNB) announced it would peg its currency against the euro at
1.2CHF/Euro, willing to enforce it by buying foreign currency at unlimited quantities. This is
why we see the sharp rise in demand and following drop of the Swiss-franc Euro exchange
rate and not necessarily due to the interest rate movements.
The future of this exchange rate is somewhat more predictable due to the announcement by
the SNB. This in itself is interesting as the Swiss-franc becomes a useful vehicle for the carry
trade for investors investing in euro areas. Investors know the Swiss-franc should not
appreciate further against the Euro based on the SNB announcement and auxiliary
depreciation will make repaying their borrowings less expensive in terms of Euro.
Moreover actions the SNB take to implement this new policy may require some form of
Quantitative Easing. These actions could result in a further manipulation of interest rates if
the SNB move to sterilize the inflows. Inflation could also be adversely affected putting
further pressure on the RID model as a tool in exchange rate determination. How the SNB
manage the exchange rate with the Euro and the inflationary affect are sure to have
implications on the Swiss economy and exchange rate going forward.
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CONCLUSION
To conclude there appears to be some merit to the RID model to exchange rate determination
and to a lesser extent the nominal interest rate differential on the inter-bank 12 month rate.
Nevertheless the models have not held up in 2011. They in essence rely too heavily on
assumptions such as economic growth and stable economic activity to be used as a significant
exchange rate determination utensil in his period where market sentiment and volatility
played a more prevailing role. Despite this with the correct acceptance of the short comings
of the RID model it can be used to good effect in the determination of exchange rates.
Word Count excluding references and bibliography: 2319-300=2019
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BIBLIOGRAPHY
Department of economics University College Dublin: Interest Rate Linkages in the Exchange
Rate Mechanism Rodney Thom.
Foreign Exchange Markets – Richard J. Sweeney (Book)
The economist online
RTE News online
ADVFN Financial News online
Prof Dr. Simon Evenett “Can the Swiss national Bank tame the Strong Swiss Franc”
Global Financial Journal: Structural Breaks in the Real Exchange Rate and Real Interest Rate
Relationship
Institute for Empirical Research in Economics, University of Zurich: Real Exchange Rates &
Real Interest Rate Differentials: a Present Value interpretation.
Deutsche Bank Bundesbank: Monthly Report July 2005
Department of Economics National Chung Cheng University Taiwan: Working Papers
∑ % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑜𝑓 𝑢𝑝 𝑡𝑖𝑐𝑘 𝑚𝑜𝑣𝑒𝑚𝑒𝑛𝑡𝑠 𝑜𝑓 𝑅𝐼𝐷 𝑜𝑣𝑒𝑟 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑/375
Calculation on reference 4: ∑ % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑓𝑟𝑜𝑚 𝑐𝑜𝑟𝑟𝑒𝑠𝑝𝑜𝑛𝑑𝑖𝑛𝑔 𝑐ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒/375
∑ % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑜𝑓 𝑑𝑜𝑤𝑛 𝑡𝑖𝑐𝑘 𝑚𝑜𝑣𝑒𝑚𝑒𝑛𝑡𝑠 𝑜𝑓 𝑅𝐼𝐷 𝑜𝑣𝑒𝑟 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑/382
Calculation on reference 5: ∑ % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑓𝑟𝑜𝑚 𝑐𝑜𝑟𝑟𝑒𝑠𝑝𝑜𝑛𝑑𝑖𝑛𝑔 𝑐ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒/382
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