Uncovered Interest Arbitrage

As per uncovered interest parity (UIP) conditions, the difference between the interest rate of two countries equals the expected change of exchange rate between the currencies of the two countries. This means a country with higher interest rate with respect to another country is expected to depreciate in future. Absence of UIP would give birth to carry trade. Investors will borrow money from the country with lower interest rate and will invest in countries with higher interest rate due to the possibility of arbitrage. In carry trade money is borrowed in currency with low interest rate, converted to currency with high interest rate, invested in an asset with maturity date of the borrowing period, after maturity is converted back to the borrowed currency and debt is repaid. Due to the difference in exchange rate in borrowed money and invested money, the investor enjoys a surplus. Since, there is a foreign exchange risk associated with carry trade, the surplus (deficit) is considered as the risk premium. Thus, the return from arbitrage in absence of UIP has three components: a) the interest rate differential, b) spot rate change over investment period can add to or subtract from returns and c) gain or loss in funding currency has to be brought back into base currency

UIP is based on the premise of risk- neutrality and rationality. Hence, under UIP the interest rate differential is an unbiased predictor of future exchange rate. The expected future exchange ensures that the gain from interest rate difference is neutralized from the exchange rate differential.

Literature Review

Empirically, the UIP theory is usually rejected, and explanations for this rejection include that expectations are irrational whereas UIP is based on rational expectation. In 1984 Fama tested for UIP at distant horizons and found that interest rate differentials tend to be negatively, rather than positively, correlated with future currency movements, thereby wrongly predicting their direction[1]. Some of the widely accepted literature that prove absence of UIP are the publications of Frankel and Froot, Mark and Wu, Domowotz and Hakkio, Nieuwland, Bekaert and Hodrick, Baillie and Bollerslev etc. Other than irrational expectations the other reported reasons for absence of UIP are time-dependent risk premia, policy behaviour and structural parameters. McCallum has argued that monetary-policy behavior can be responsible for the apparent empirical failure of uncovered interest parity (UIP)[2]. Peter Ankel has investigated whether optimizing policy behaviour can account for the observed regime-dependence of UIP evidence[3]. In some of the literature at higher frequency doubtful statistical interference is considered as the cause of deviation from UIP. Some of the literatures have revealed that UIP holds in long horizon than short horizon (Chin and Medith-2005). Flood and Rose (2001) in their study found considerable heterogeneity across countries. Their findings detected signs that UIP at the short horizon holds better in crisis countries where exchange as well as interest rates display high volatility[4]. In the short run, a disequilibrium in the foreign exchange market leads to arbitraging opportunities. Without instantaneous adjustment a market in short-run remains in disequilibrium. Traders exploit the short run market inefficiency to generate arbitrage profits.

Studies of Cochrane (1999), Alexius (2001), Chinn (2006) and Zhang (2006) also reveal that UIP tends to hold for financial instruments of longer maturities. Lothian and Wu (2005) studied the validity of uncovered interest-rate parity (UIP) by constructing ultra long time series that span two centuries[5]. They found that The forward-premium regressions yield positive slope estimates over their whole sample period and become negative only when the sample was dominated by the period of 1980s. They also found that large interest-rate differentials have significantly stronger forecasting powers for currency movements than small interest-rate differentials. Their results indicate that uncovered interest-rate parity holds over the very long haul but can be deviated from for a long period of time due to slow adjustment of expectations to actual regime changes or to anticipations for extended periods of regime changes or other big events that never materialize.

The broadly followed specification (i.e. the approximate UIP) is usually written in the following approximate form of linear regression:

∆S_t+k= α+ β (i-i^*)+ error_t+k

Here,

· ∆S_t+k is the first difference of nominal exchange rate expressed in terms of domestic currency per unit of foreign currency,

· (i-i^*) is the interest rate differentials between the domestic interest rate i and the foreign interest rate i^*.

Null hypothesis: α=0 and β =1. The same hypothesis will be used in this study.

Testing of the approximate UIP hypothesis using this specification generally proceeds with a theoretical value of unity for the slope coefficient β in the above regression.

Froot and Thaler (1990) have reported that the average value of β across 75 published studies is−0.88. Numerous other studies have also confirmed that the relationship between the nominal exchange rate changes and interest rate differentials (or forward premium) is negative rather than positive as expected from the hypothesis of UIP.

Objective of the analysis here is to examine the empirical validity of the UIP hypothesis for 3 different countries- India, UK, and Canada. In the analysis US has been considered as the home country. The sample range covers more than 6o data points in term of month, emerging economies in this period witnessed increasing financial liberalization. Here the validity of the UIP hypothesis is tested by using the commonly used form of the UIP equation in a panel estimation of combination of emerging and developed nations.

Further, to study the effect of Consumer Price Index (CPI) and Industrial Production on exchange range, these parameters were factored to the existing UIP equation. This study was carried out considered Canada as the foreign country and US as the domestic country.

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[1] Fama, E.F., 1984, ‘Forward and spot exchange rates,’ Journal of Monetary Economics, vol.14 (3) November: 319-38.

[2] McCallum, B.T., 1994b. Monetary policy and the term structure of interest rates. NBER Working Paper

No. 4938

[3] Peter Ankel, Uncovered interest parity, monetary policy and time-varying risk premia, Journal of International Money and Finance, 18 (1999), 835–851

[4] Kenneth Froot and Richard Thaler (1990), Foreign Exchange, Journal of Economic Perspectives, 4(3): 179-92

[5] Lothian and Wu, Uncovered Interest-Rate Parity over the Past Two Centuries, Frank J. Petrilli Center for Research in International Finance CRIF Working Paper series

Effective Supply Chain Management through Alignment, Agility and Adaptiveness

Unfortunately the understanding and implementation of supply chain management concepts are at a crude state. Many firms view supply chain a way to achieve high speed and low cost. But supply chain is a broader concept and covers multiple business dynamics beyond high speed and low cost. Firms that focus only on speed and efficiency may lose out due to piling inventory. On the other hand companies like Amazon, Dell and Wal-Mart have cracked the codes of SCM.

Only speed and efficiency are not sufficient to provide firms competitive edge. Effective SCM also requires Alignment, Agility and Adaptability[1].

Alignment

Alignment within the supply chain requires the firms to establish incentives for the supply chain partners to improve performance of the entire chain. The roles and domains of activity of each partner have to be clarified. This will avoid conflict. The risk and rewards in the chain should be shared proportionately in the chain. Information sharing and collaborative planning and forecasting provides scopes to align the supply chain for a common goal.

Agility

Agility refers to the ability to respond to short term changes in demand dynamics quickly and effectively. It requires timely sharing of information amongst supply chain members. Agility in supply chain is agility of all the members of the chain. Collaboration with customers, supply chain partners, academicians to improve the agility of the chain provides an edge over the rivals. Precise information on customer preference is prerequisite for effective SCM. But when customer demand changes in short term, the chain should be able to achieve to deliver the customer expectations. Producing finished product only when customer preference is accurate and reliable saves obsolence cost. The response time for unpredictable change in customer demand could be minimized by keeping a balanced inventory of basic components.

Adaptability

Adaptability of a supply chain is its ability to track market changes and to adjust with the evolving market dynamics. Supply chain has to undergo a continuous organizational mutation to be adaptive. Tracking economic changes, technological breakthroughs, sensing the social-political-cultural morphism of the market helps in the process of adaptation. Supply chains need to identify their resource base, ability to use the same resource base in future needs are crucial.

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[1] Hau L Lee, The Triple A Supply Chain, Havard Business Review, Oct 2004

India's Competitiveness

India ranks 49 out of the 133 nations in the Global Competitiveness Index.

India performs abysmally poor in Health and Primary Education with a rank of 101. Alarming sanitary situation, insufficient quality and quantity of education drags India down in competitiveness. Energy and transport infrastructure ranked at 76^th needs improvement. Corruption and Securities issues remain to be addressed.

India has better position when it comes to efficiency indicators. India’s financial system ranks 16^th indicating development in this system. India has a strong banking system ranked at 25^th. Due to huge population and growing purchasing power of consumers, India ranks 4^th in market size. Presence of a number of competitors makes India’s market efficiency reasonably good (rank: 48th). India still needs to work on lowering the entry barriers in certain markets. Rigid hiring and firing policy earns a low rank in labour market efficiency (rank: 83). Low penetration rate of internet and communication technology has resulted in poor rank (83) in technological readiness. Despite a strong and reliable higher education system, the rank of India in Higher education is 66 due to the lack of sufficient accessibility to all.

It is remarkable to notice India’s rank in innovation drivers. India ranks 27^th in business sophistication and 30^th in innovation.

When compared to other nations India lacks behind in several parameters. China is ahead of India in 10 out of the 12 pillars of competitiveness. India enjoys competitive advantage in financial market sophistication, market size, business sophistication and innovation.

India’s performance could be analyzed on the basis of each of the 12 pillars of competitiveness.

1 Institutions

India stands out much ahead of the countries of same income group and region when it comes to institutions. Business communities perceive India positively when it comes to institutions.

Government: Government efficiency and ability to nurture a business-conducive environment is evaluated encouraging by entrepreneurs.

Judiciary System: The independent and well functioning judiciary system provides India a sound scope to implement rule of the law.

Intellectual Property Rights: India is also ranked low in Intellectual Property Rights (IPR) related issues. Considering the importance role played by IT and communication technology it is imperative to strengthen the IPR related laws in India.

Corruption: Business communities rank India poor on trust on politicians and administrative/bureaucratic corruption. Transparency International has ranked India 85 out of 180 nations in Corruption Perception Index. India is still considered as a nation where business is affected by bureaucratic red tape. May be a second round of reforms to eliminate the red tape is demand of the time now.

Terrorism: Threat of terrorism has been always associated with India. The serial bomb blasts in various cities of the nation followed by the Mumbai terrorist attack stains negative colours on the business environment of India.

Crimes: On a positive note India ranks much better when it comes to other forms of crimes scoring well above its comparative nations of same income group and region.

Private Institution: India’s rank in private institutions is at a reasonable number of 51. Unfortunately the rank has shown a negative movement which might be assigned to Satyam episode. India needs to improve its accounting and corporate governance practices in order to unmask such scams.

2 Infrastructure

Indian competitiveness is adversely affected by the poor state of infrastructure and lack of it. Shortage of power, water and transportation facility etc. hold back India. The country ranks 76 in infrastructure. Some economists opine that lack of infrastructure prevents India’s transition from an agrarian economy to a manufacturing economy.

Electricity: Electrification is the biggest infrastructural challenge faced by India. Electricity production per unit of GDP has started falling after 2000. The electricity loss during distribution and transportation remain s a major problem to be tackled. High government regulation and dominance of public players have added to the wounds of power sector.

Road Transport: India ranks below Pakistan and China when it comes to road communication. 65% of freight and 85% of passenger traffic are carried by the road. Hence, Improvement of road connectivity is imperative. Road accidents are also high in India. This underscores the need of road safety.

Port Infrastructure: India’s port infrastructure suffers from low turnaround time, insufficient handling capacity, and frequent human intervention. Low productivity and bottlenecks make the situation worse. It is reported that India’s ports operate at more than 90% of their capacity. This emphasizes the need of upgrading the existing ports and building new ports to meet the business and trade requirements. Indian government’s attempt to encourage public-private partnership (PPP) is expected to bring reforms in port functioning. Government is also planning to provide more autonomy to major ports to increase their performance.

Air transport: India is out-forming many of its comparative countries in terms of air transportation. Government’s decision to end state monopoly in aviation sector has paid up. Competition among private and public players, emergence of low cost airlines has demonstrated the dynamism of India’s aviation sector. Governments initiative to modernize 35 airports are and privatization of Mumbai, Delhi, Hyderabad, Cochin and Bangalore airports are expected to increase the efficiency and performance of aviation sector.

Railroad: With 14 million passengers daily, India’s rail is the largest rail of the world. Indian ranks an impressive 20^th position in rail infrastructure. However, the high density road corridors face capacity constraints.

It is widely accepted that India’s infrastructure development would be possible through investment. Lack of sufficient public funds emphasized public private partnership (PPP) in this sector. Allocation of more than 40% of budgetary outlay to infrastructure development in the 2010-2011 budgets is positive signal at long-term orientation for competitiveness building.

3 Macroeconomic Stability

Indian ranks 96 in macroeconomic pillar. Fiscal deficit is the primary reason for this low rank. However, the 2010-2011 budget aiming at reducing the deficit from more than 6% to 5.5% over might increase India’s rank in this parameter in future. The Fiscal Responsibility and Budget Management Act (FRBMA) 2003 have helped India to achieve some fiscal discipline. Balance budget is still a distant dream.

Government borrowing: The high government debt of around 75% of the GDP is detrimental to the state of economy. It is estimated that Indian government borrows 34% of the money it spends. Regulations forcing the commercial banks to invest in government bonds divert the money from the more productive sector of the economy.

Inflation: India is facing severe challenges to curtail the increasing inflation rate. Particularly the food inflation rate is a matter of concern. With the increase in oil and petroleum prices as an outcome of 2010-2011 budget it is expected that the price of commodity products will continue to increase as more inflationary pressures.

India has been exploring the options of coming out populist budgets to cut back subsidy and to for reforms in tax structure. Withdrawal of subsidy in some sectors like IT corroborates the fact that government is giving priority to reduce fiscal deficit.

4 Health And Primary Education

India ranks 101 in health and primary education. The situation is linked to lack of government funds to invest in such sectors, lack of skill manpower and infrastructure.

Sanitation and diseases: Only 28% of India’s population has access to sanitation facilities. A sizeable portion of Indian population suffers from diseases like tuberculosis; malaria etc. 21% of Indian suffers from malnutrition.

Primary Education: India has achieved more than 90% of enrollment in primary education. Since many countries have achieved universal literacy at primary education level India still lags behind. Quality of primary education remains a problematic area. Poor spending is the primary reason for such abysmal performance. Indian has increased its planned allocation to schools from Rs 26,800 Crores to Rs 31,036 Crores in 2010-2011 budget.

5 Higher Education and Training

With a rank of 66 Indian has higher enrollment rate then its comparative countries, but has lower quality of education. Enrolment rate in secondary education is at 55% which is low. Quality is far better in higher education. On a positive note India performs better in quality of higher education and provision of on the job training. In the last few budgets India had the provisions to create more IIMs, IITs and NIFTs to give boost to the higher education sector.

6 Goods/services Market Efficiency

According to a World Bank report starting a business in India takes 30 days. Though the number has reduced, it needs further reduction. Costs associated with starting a new business are high in India.

Tax structure: World Bank estimates that on an average Indian firms pay 76% of their profits as tax. Widening tax base is an option that could be exercised by the government to lower tax rates.

Market Competition: Lowering barriers for foreign players will helps to improve market efficiency through more fierce competition.

Formal Sector: India needs to encourage its players to switch from unorganized informal sector to organized formal sectors. This will improve productivity and will help to handle the critical issues of tax base increase as many informal sectors are outside the tax structure.

7 Labour Market Efficiency

Labour market has been a problem for India’s competitiveness. India ranks 83 in these parameters.

Firing cost: In India it is difficult to dismiss employees. The cost of firing is also very high.

Employer and Employee Relation: Employee and employer relation is not considered as confrontational in India

Labour efficiency: Labour efficiency level of India is encouraging. Educational attainment gap has also prevented adequate participation of female workforce.

Brain drain: India faces lesser brain drain than the countries of similar growth rate. This is expected to increase India’s competitiveness as India is being able to retain and attract talent.

8 Financial Market Sophistication

Indian ranks 16^th in financial market sophistication. Despite financial crisis of recessions of 2008-09 India’s rank has improved on this parameter.

Equity market: India has an extremely dynamic equity market. A jump from $387 billion to $1811 billion in total market capitalization of the companies listed in equity market from 2005 to 2008 corroborates this fact. Obtaining funds from domestic markets of India has become easier.

Decreasing government regulation on matters of allocation of funds, simple policies for foreign capital investment etc. are some of the improvement areas in this sector.

9 Technological Readiness

India Ranks 83 in technological readiness. India’s compound annual growth rate in technology is around 65% from 1998 to 2008. Broadband access, use of computers etc. lags in India. However, when it comes to firms in adopting technology, Indian firms outperform many of its competitors in technology adoption. Greater diffusion and spread of ICT is a priority area for India.

10 Market size

Indian ranks fourth in market size. The US is the first followed by China and Japan. Consumption in Indian market still faces the problems of low income. Increasing annual disposable income has increasing the consumption capacity of Indian consumers over the year.

Sales Tax: Movement of goods and services within states of India is governed and sales tax imposed by state governments. As a result price of the same product varies in different states. In addition regulations like Essential Commodities Act restrict free movements of goods within the nation. Deregulation in these areas will give a boost to India’s competitiveness.

Export Market: India is world’s 26^th biggest exporter with just 1% share of total exports of the world. This underscores the room of growth in export market for India. Improvement in trade openness will increase exports.

11 Business Sophistication

India ranks 27^th in global sophistication parameter. Nation’s competence in Business Process Outsourcing, Information technology, telecommunication, consumer retailing, automobile sector, pharmaceutical and air transport could be the reasons for higher business sophistication.

There are seven Indian companies in fortune magazine’s global 500 lists of biggest companies by revenue. Financial Times list includes 5 Indian financial companies on the basis of their revenue.

12 Innovation

Spending in research and development is crucial to foster innovation. The provisions of budget 2010-2011 encouraged higher investments on R&D.

Academia: National Institutes of Technology, Indian Institutes of Technology and Indian Institute of Science etc. focuses on research and development activities.

Research organizations: research organizations like ISRO, ICAR, BARC, ICSR etc. have been instrumental in fostering innovation in India.

Private Spending: Private spending on research and development in India is low. This is a negative trend and needs attention.

IPR: Intellectual property rights in India are believed to be not par with other nations. In order to nurture innovation India needs increase the purview and enforceability of Intellectual Property Rights.