Parity Conditions

1
Parity Conditions

• Chapter 8

2
Parity Conditions

• There are three international parity conditions
• Interest rate parity (IRP- end of chapter 7)
• Purchasing power parity (PPP)
• International fisher effect (IFE)

3
Interest Rate Parity (IRP)

• IRP relates interest rate differentials to
  forward differentials.
• What does IRP say?

4
Interest Rate Parity

• How do I compute the forward premium/discount (p)
  that is consistent with IRP?
• where ih is the home interest rate and if is the
  foreign interest rate
• Thus, if ih is higher than if the foreign
  currency should exhibit a forward________
• Similarly, if ih is lower than if the foreign
  currency should exhibit a forward _________

5
Interest Rate Parity

• What is the implication of IRP for covered
  interest arbitrage (CIA)?
• Example
• Assume 6mth interest rate in Brazil 7
• 6mth interest rate in U.S. 6
• Spot rate 1Real 0.10
• Forward premium/discount that is consistent with
  IRP (1.06)/(1.07)-1 -0.0093 or -0.93
  discount

6
Interest Rate Parity

• We then use this to find the forward rate that is
  consistent with IRP
• 0.10(1 - 0.0093) 0.09907
• This implies that conducting CIA will result in a
  profit of ______

7
Interest Rate Parity

• PROOF
• Assume you have 10,000
• Buy Reals 10,000/0.10 100,000 Reals
• Invest _at_7 100,000(1.07) 107,000 Reals
• Convert to s 107,000(.09907) 10,600.49
• How much would you have made had you invested in
  the U.S.?
• Was CIA worthwhile?

8
Interest Rate Parity

• General points regarding IRP
• Empirical evidence generally confirms that IRP
  holds
• Transactions costs, currency restrictions and
  tax laws may eliminate potential profits
• Political risk considerations
• IRP does not imply that investors in 2 countries
  earn exactly the same return ?it implies that CIA
  cannot be used to earn higher returns than those
  available in home country

9
Purchasing Power Parity (PPP)

• PPP relates inflation differential to changes
  in the spot rate
• What does PPP say?
• Two versions
• Absolute
• Relative

10
Purchasing Power Parity

• where Ih inflation in the home country, If is
  inflation in the foreign country, and ef is the
  percentage change in the foreign currency
  predicted by PPP
• Thus, if Ih gt If the foreign currency is
  expected to _______
• If Ih lt If , the foreign currency is expected to
  ______

11
Purchasing Power Parity

• Example
• Assume exchange rates are in equilibrium
  initially and Ih 8, If 6. Calculate the
  percentage change in the foreign currency
  predicted by PPP.
• What if the numbers were reversed i.e.
• Ih 6 and If 8?

12
Purchasing Power Parity

• You can also approximate the percentage change
  using just the inflation differential as follows
• Ih-If approximate percentage change in the
  foreign currency predicted by PPP

13
Purchasing Power Parity

• What is the empirical evidence regarding PPP?
• Significant deviations from PPP are
• observed over time because
• Other factors affect exchange rates
• Substitute goods are not always available
• Exchange rate pass-through

14
International Fisher Effect (IFE)

• IFE relates interest rate differentials to
  changes in the spot rate
• What does IFE say?

15
International Fisher Effect (IFE)

• IFE is based on the following relationship
• Nominal interest rate real interest rate
  inflation premium
• IFE assumes that real interest rates are the
  same in all countries

16
International Fisher Effect

• Percentage change in the spot rate (ef)predicted
  by IFE
• where ih is the interest rate in the home country
  and if is the interest rate in the foreign
  country.
• So, if ih gt if foreign currency is expected to
  _____
• If ih lt if foreign currency is expected to
  _______

17
International Fisher Effect

• ef can also be approximated as (ih-if)
• Does IFE hold?
• Not consistently because
• Based on PPP which doesnt always hold
• Other factors affect exchange rates

18
Summary

• The parity conditions have implications market
  efficiency
• They can also be used to forecast exchange rates