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
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
