International Parity Conditions - PowerPoint PPT Presentation

1 / 40
About This Presentation
Title:

International Parity Conditions

Description:

Parity Conditions provide an intuitive explanation of the movement of prices and ... NOTE Parity Conditions are expected to hold in the long-run, but not always in ... – PowerPoint PPT presentation

Number of Views:302
Avg rating:3.0/5.0
Slides: 41
Provided by: vani5
Category:

less

Transcript and Presenter's Notes

Title: International Parity Conditions


1
International Parity Conditions
  • Reading Chapter 4

2
Class Outline
  • Introduction to Parity Conditions
  • Absolute Relative Purchasing Power Parity
  • Real Exchange Rate
  • Fisher Effect (FE)
  • International Fisher Effect (IFE)
  • Unbiased Forward Rate (UFR)
  • Interest Rate Parity (IRP)
  • Covered Interest Arbitrage
  • Currency Forecasting gt PROJECT

3
Introduction
  • Managers of multinational firms, international
    investors, importers and exporters, and
    government officials must deal with these
    fundamental issues
  • Are changes in exchange rates predictable?
  • How are exchange rates related to interest rates?
  • What, at least theoretically, is the proper
    exchange rate?
  • To answer these questions we need to first
    understand the economic fundamentals of
    international finance, known as parity conditions.

4
Parity Conditions
  • Parity Conditions provide an intuitive
    explanation of the movement of prices and
    interest rates in different markets in relation
    to exchange rates.
  • The derivation of these conditions requires the
    assumption of Perfect Capital Markets (PCM).
  • no transaction costs
  • no taxes
  • complete certainty
  • NOTE Parity Conditions are expected to hold in
    the long-run, but not always in the short term.

5
Purchasing Power Parity (PPP)
  • PPP is based on the notion of arbitrage across
    goods markets and the basic building block of PPP
    is the Law of One Price (LOP).
  • LOP states that the price of an identical good
    should be the same in all markets (assuming no
    transactions costs).
  • Otherwise, one could make profits by buying the
    good in the cheap market and reselling it in the
    expensive market.

6
The Law of One Price
  • LOP states that a products price may be stated
    in different currency terms, but the price of the
    product should remain the same.
  • Comparison of prices would only require
    conversion from one currency to the other
  • Conversely, the exchange rate could be deduced
    from the relative local product prices

7
LOP Example
  • Pwheat, Aust 4/bushel and Pwheat, UK
    2.5/bushel
  • Spot rate (A/) 1.70
  • A equivalent price of wheat in UK is A1.70/
    2.5
  • 4.25/bushel
  • Implication The demand for Australian wheat
    will increase forcing up its price. The price of
    UK wheat will drop.

8
The Big Mac Index
  • The most famous test is The Economist magazines
    Big Mac Hamburger standard.
  • First launched in 1986, updated ever since.
  • For example, see
  • http//www.oanda.com/products/bigmac/bigmac.shtml

9
(No Transcript)
10
Research on the Big Mac Index
  • Pakko and Pollard (1996) conclude that Big Mac
    PPP holds in the long-run, but currencies can
    deviate from it for lengthy periods. They note
    several reasons why the Big Mac index may be
    flawed
  • It assumes that there are NO barriers to trade.
  • Prices are distorted by taxes.
  • Profit margins may vary according to competition.
  • Prices of non-traded goods (real estate,
    utilities, labor) are also inputs that affect
    production costs.

11
Working for a Big Mac
12
A New Index Starbucks Index
13
Absolute PPP
  • A less extreme form of the Law of One Price is
    ABSOLUTE PPP which says that the price of a
    basket of goods should be the same in each
    market.
  • The PPP exchange rate between the two countries
    should then be

Absolute PPP
PID,t (PIF,t) is the domestic (foreign) price
index (e.g., consumer price index) at time t.
14
Relative Purchasing Power Parity
  • Relative PPP claims that exchange rate movements
    should exactly offset any inflation differential
    between two countries

Percentage change in domestic prices
Relative PPP
  • We can also write

15
Relative PPP
  • Relative PPP implies that the change in the
    exchange rate will offset the difference between
    the relative inflation of two countries.
  • The previous formula can be approximated as
  • where, pD and pF refers to the percentage change
    in domestic and foreign price levels respectively
    and ?s to the percentage change in the exchange
    rate.
  • If domestic inflation gt (lt) foreign inflation,
    PPP predicts the domestic currency should
    depreciate (appreciate).

16
Relative PPP Example
  • Given inflation rates of 5 and 10 in Australia
    and the UK respectively, what is the prediction
    of PPP with regards to A/GBP exchange rate?
  • (0.05 0.10)/(1 0.10) - 0.045 - 4.5
  • The general implication of relative PPP is that
    countries with high rates of inflation will see
    their currencies depreciate against those with
    low rates of inflation.

Relative PPP
17
How well does PPP work?
  • We have seen that the strictest version of PPP
    that all goods and financial assets obey the law
    of one price is demonstrably false.
  • However, there is clearly a relationship between
    relative inflation rates and changes in exchange
    rates.
  • Currencies that have had the largest relative
    decline (gain) in purchasing power see the
    sharpest erosion (appreciation) in their foreign
    exchange values.

18
Relative Purchasing Power Parity
  • Applications of Relative PPP
  • Forecasting future spot exchange rates.
  • Calculating appreciation in real exchange
    rates. This will provide a measure of how
    expensive a countrys goods have become (relative
    to another countrys).

19
Forecasting Future Spot Rates
  • Suppose the spot exchange rate and expected
    inflation rates are
  • What is the expected / exchange rate if
    relative PPP holds?

20
Real Exchange Rate
  • By definition, the real exchange rate measures
    deviations from PPP.
  • That is, changes in the spot exchange rate that
    do not reflect differences in inflation rates
    between the two currencies in question.

Real Exchange Rate
21
Real Exchange Rate
  • Appreciation/depreciation in the real exchange
    rate measures deviations from PPP.
  • When E 1, the denominator currency is valued
    correctly. The competitiveness of this country
    is unaltered.
  • When E lt 1, the denominator currency is
    undervalued. Products from the other country seem
    expensive relative to the base year. That is,
    the competitiveness of the denominator country
    improves.
  • When E gt 1, the denominator currency is
    overvalued. Products from the other country seem
    cheap relative to the base year. That is, the
    competitiveness of the denominator country
    deteriorates.

22
The Fisher Effect
  • The international Fisher relation is inspired by
    the domestic relation postulated by Irving Fisher
    (1930).
  • The Fisher effect (also called Fisher-closed)
    states
  • This relation is often presented as a linear
    approximation stating that the nominal interest
    rate is equal to a real interest rate plus
    expected inflation

23
The Fisher Effect
  • Applied to two different countries, like
    Australia and Japan, The Fisher Effect would be
    stated as
  • It should be noted that this requires a forecast
    of the future rate of inflation, not what
    inflation has been in the past.

24
The International Fisher Effect
  • The International Fisher Effect (also called
    Fisher-open) states that the spot exchange rate
    should change to adjust for differences in
    interest rates between two countries

25
The International Fisher Effect
  • The Fisher effect applied to two different
    countries like Australia and Japan would be
  • (1i) (1r)(1?)
  • (1i) (1r)(1?)
  • Dividing (1) by (2), we get
  • (3)

1
26
The International Fisher Effect
  • If real interest rates are equalized across
    countries, then for equation (3) we get r r

(4)
(5)
E(St1)
27
Tests of the International Fisher Effect
  • Empirical tests lend some support to the
    relationship postulated by the international
    Fisher effect (currencies with high interest
    rates tend to depreciate and currencies with low
    interest rates tend to appreciate), although
    considerable short-run deviations occur.

28
Unbiased Forward Rate (UFR)
  • Some forecasters believe that for the major
    floating currencies, foreign exchange markets are
    efficient and forward exchange rates are
    unbiased predictors of future exchange rates.
  • The unbiased forward rate (UFR) concept states
    that the forward exchange rate, quoted at time t
    for delivery at time t1, is equal to the
    expected value of the spot exchange rate at time
    t1.

29
Unbiased Forward Rate (UFR)
  • UFR can be written as
  • An unbiased predictor, however, does not mean the
    future spot rate will actually be equal to what
    the forward rate predicts.
  • Unbiased prediction means that the forward rate
    will, on average, overestimate and underestimate
    the actual future spot rate in equal frequency
    and degree.

30
Empirical Tests of UFR
  • A consensus is developing that rejects the
    efficient market hypothesis.
  • It appears that the forward rate is not an
    unbiased predictor of the future spot rate and
    that it does pay to use resources in an attempt
    to forecast exchange rates.
  • The existence and success of foreign exchange
    forecasting services suggest that managers are
    willing to pay a price for forecast information
    even though they can use the forward rate to
    forecast at no cost.

31
Interest Rate Parity
  • Interest rate parity (IRP) is an arbitrage
    condition that provides the linkage between the
    foreign exchange markets and the international
    money markets.

Interest Rate Parity (IRP)
where, Ft and St are the forward and spot rates
and id and if are domestic and foreign interest
rates respectively.
32
Interest Rate Parity
  • The approximate form of IRP says that the
    forward premium equals the difference in interest
    rates.

Approximation of IRP
  • In general, the currency trading at a forward
    premium (discount) is the one from the country
    with the lower (higher) interest rate.

33
Interest Rate Parity An Example
  • Basic idea Two alternative ways to invest funds
    over same time period should earn the same
    return.
  • Suppose the 3-month money market rate is 8 p.a.
    (2 for 3-months) in the U.S. and 4 p.a. (1 for
    3-months) in Switzerland, and the spot exchange
    rate is SFr1.48/.
  • The 3-month forward rate must be SFr1.4655/ to
    prevent arbitrage opportunities (i.e., interest
    rate parity must hold).

34
The Example Continued
90 days
Rounding error.
35
Interest Rate Parity Why It Holds
  • This must hold by arbitrage. Otherwise riskless
    profits could be made. This is known as covered
    interest arbitrage (CIA) and occurs whenever IRP
    does not hold. CIA can involve the following
    steps
  • Borrow the domestic currency
  • Exchange the domestic currency for the foreign
    currency in the spot market
  • Invest the foreign currency in an
    interest-bearing instrument and then
  • Sign a forward contract to lock in a future
    exchange rate at which to convert the foreign
    currency proceeds back to the domestic currency.

36
Covered Interest Arbitrage Example
  • The annual interest rate in the AUS and UK are 5
    and 8 respectively. The current spot rate is
    1.50/ and the 1 year forward rate is 1.48/.
    Can arbitrage profits be made?
  • Borrow 1m (at 5)
  • Purchase 666,667 using 1m
  • Invest at 8 (will receive 720,000 in one
    years time)
  • Simultaneously sell 720,000 forward (1,065,600)
  • Repay loan interest of 1,050,000
  • ARBITRAGE PROFIT 15,600

1.05 ? 1.0656
37
The Example Continued
lt1,050,000gt
1,065,600
Profit 15,600
720,000
666,667
38
Covered Interest Arbitrage
  • Covered interest arbitrage should continue until
    interest rate parity is re-established, because
    the arbitrageurs are able to earn risk-free
    profits by repeating the cycle.
  • But their actions nudge the foreign exchange and
    money markets back toward equilibrium
  • Purchase of Pounds in the spot market and sale of
    in the forward market narrow the premium on
    forward pounds.
  • The demand for pound-denominated securities
    causes pound interest rates to fall, while the
    higher level of borrowing in Australia causes
    dollar interest rates to rise.

39
Uncovered Interest Arbitrage
0
  • A deviation from covered interest arbitrage is
    uncovered interest arbitrage (UIA).
  • In this case, investors borrow in countries and
    currencies exhibiting relatively low interest
    rates and convert the proceed into currencies
    that offer much higher interest rates.
  • The transaction is uncovered because the
    investor does no sell the higher yielding
    currency proceeds forward, choosing to remain
    uncovered and accept the currency risk of
    exchanging the higher yield currency into the
    lower yielding currency at the end of the period.

40
Currency Forecasting
  • What have we learnt about currency forecasting
    this week?
  • Unbiased forward rate
  • Long-term equilibrium relationships (RPPP and
    IFE)
  • More methodologies next week.
Write a Comment
User Comments (0)
About PowerShow.com