CHAPTER 8 – THE PORTFOLIO BALANCE MODEL
8.1 INTRODUCTION
• International investors may regard domestic and foreign bonds differently → having
different characteristics
o Some might be riskier – requires higher expected return
• 3 operations used to influence the exchange rate
o 1. Open market operations (OMO)
o exchange of domestic money for domestic bonds or vice versa
• 2. Foreign exchange operation
o Exchange of domestic money for foreign bonds or vice versa
o Affects the domestic money supply – termed as non-sterilized intervention in
foreign exchange market
• 3. Sterilized foreign exchange operation
o Exchange of domestic for foreign bonds and vice versa
o Domestic base remains unchanged
o Represents the difference between OMOs and FXOs
8.2 THE CONCEPT OF RISK PREMIUM
• Domestic and foreign bonds are no longer perfect substitutes → UIP condition no
longer holds
• More risky bonds → higher return
• 3 conditions for risk premium to exist
o 1. There must be perceived differences in risks
▪ Risky → its expected return is uncertain
▪ If equally risky → substitutes
o 2. There has to be risk aversion
o 3. There must be a difference between risk minimising portfolio and the
actual portfolio
• If all 3 conditions are satisfied → UIP condition does not hold → existence of risk
premium
o 𝑟 − 𝑟 ∗= 𝐸𝑠 + 𝑅𝑃
▪ r – domestic interest rate
▪ r* - foreign interest rate
▪ Es – expected rate of depreciation of domestic currency (domestic
currency units per unit of foreign currency)
▪ RP – risk premium required on domestic bonds (positive/negative)
o 1% positive risk premium on the domestic currency is a negative 1% risk
premium on the foreign currency
8.3 DIFFERENT TYPES OF RISK
• Investors are assumed to be rational → want to maximize their utility (positive
function of expected real returns and negative function of risk)
, • Risky asset → expected real return is uncertain
Currency risk
• Inflation risk
o Occurs when the inflation rates in domestic and foreign economies is
uncertain
o If PPP holds continuously
▪ Real rate of return on domestic bond = nominal interest rate –
expected domestic inflation rate
o Greater variance of expected inflation raises the relative riskiness
• Exchange risk
o If PPP holds continuously → inflation risk would be the only risk
▪ Not the case
o The expected rate of return from holding foreign bonds → foreign interest
rate less the expected rate of inflation plus expected deviation of the
exchange rate from PPP
o Fluctuations of the exchange rate around PPP that constitute exchange rate
risk
Country risks
• Exchange control risk
o Investors face uncertain real rates of return
o Due to risk of the imposition of a tax on interest element during holding
period
• Default risk
o Government refuses to pay interest (sometimes principal) on bonds issues by
them denominated in foreign currency
▪ It can always print money
• Political risk
o covers broad range of scenarios
o Danger investors face because of political scenarios
• What matter is the difference in risk between domestic and foreign bonds
• If they are equally risky → then perfect substitutes
8.4 A PORTFOLIO BALANCE MODEL
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller natyprycova. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $6.95. You're not tied to anything after your purchase.