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Parity Conditions

Parity Conditions. Eiteman and Stonehill Chapter 4. Big Mac index. The Big Mac, in real terms, should cost the same everywhere Prices increase with inflation prices of Big Macs in Canada increase by 1.9% prices of Big Macs in US increase by 2.3%

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Parity Conditions

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  1. Parity Conditions Eiteman and Stonehill Chapter 4 Parity Conditions

  2. Big Mac index • The Big Mac, in real terms, should cost the same everywhere • Prices increase with inflation • prices of Big Macs in Canada increase by 1.9% • prices of Big Macs in US increase by 2.3% • If nothing real changes, exchange rates should adjust for the difference • CD appreciates Parity Conditions

  3. The Law of one price • The Law of One Price does not hold - given an exchange rate of 1.1254 Parity Conditions

  4. Example - the Law of One Price • Price = 3.41 usd in January 2007 • Expected inflation 2.7% in 2007 • Price = 3.50 usd in January 2008 • Price = 3.80 cd in January 2007 • Inflation 1.7% in 2007 • Price = 3.86 cd in January 2008 • Implied exchange rate • 3.80 cd / 3.41usd = 1.1144 cd / 1 usd Jan 07 • 3.86cd / 3.50 usd = 1.1029 cd / 1 usd Jan 08 Parity Conditions

  5. Purchasing Power Parity (PPP) • Absolute PPP - the law of one price • the price of any good is the same after adjusting for exchange rate changes and relative inflation rates • Relative PPP • exchange rates adjust to take into account relative inflation rates Parity Conditions

  6. Purchasing Power Parity • Absolute parity • Relative parity Parity Conditions

  7. Purchasing Power Parity • The exchange rate changes to accommodate differential rates of inflation • If this is so, then relative PPP holds Parity Conditions

  8. Theory behind relative PPP • international competition in efficient goods markets will cause arbitrage of real prices of goods • relative inflation will cause internal prices to change • exchange rates will adjust for relative inflation so that real prices remain unchanged Parity Conditions

  9. PPP for forecasting • Known: forecasts of • Expected cd inflation, • Expected usd inflation • Known: the current exchange rate • Calculate the expected future spot • Compare to the quoted future spot Parity Conditions

  10. Relative Purchasing Power Parity % chg in spot x % chg in relative inflation Parity Conditions

  11. Empirical does PPP hold ? • international goods mkts not efficient short run • barriers to trade, transactions costs • measurement problems • indices measure changes in a market basket of goods, not traded goods • differences exist in tastes, level of development, income • approximately efficient in the long run Parity Conditions

  12. Exchange Rate pass through • exchange rate adjusts for relative inflation • relative inflation means • some prices increase faster than inflation • some slower • some prices decrease • relative real prices of goods may change internationally Parity Conditions

  13. Real exchange rates Parity Conditions

  14. Real effective exchange rates 100 Parity Conditions

  15. Differential Price movements • Calculate the expected price of buying US • Expected greater than actual price • if you are selling this product, you may face competitive pressures to lower price Parity Conditions

  16. Price elasticity of demand • How do the revenues of the firm react to changes in price • revenues decline if elasticity of own demand is less than 1 Parity Conditions

  17. Inelastic own demand P Decrease in revenue due to price decrease P0 PT Increase in revenue due to increased sales Q0 QT Q Parity Conditions

  18. Elastic own demand P Decrease in revenue due to price decrease P0 Increase in revenue due to increased sales PT Q0 QT Q Parity Conditions

  19. The Fisher Effect • The nominal interest rate • relative nominal interest rates are proportional to relative inflation rates Parity Conditions

  20. Empirical evidence • capital market integration • real returns are equal across economies • efficient capital markets will arbitrage differences • capital market segmentation • investor preferences may lead to real interest rate differentials • each economy is a separate market Parity Conditions

  21. International Fisher Effect • expected future spot should accommodate any interest rate differentials Parity Conditions

  22. Interest Rate parity • interest rate differentials are covered by the forward rate Parity Conditions

  23. Covered Interest Arbitrage • If US interest rates are higher than interest rate parity would forecast • Buy usd denominated bonds • 100,000 cd*0.8485 =84,846 usd • receive 84,846 * 1.0533 = 89,369 usd in one year • Forward contract at deliver of 104,195 cd in one year @ 1.1659 cd/usd in one year • Invest in Canada 100,000 cd * 1.0418 = 104,180 Parity Conditions

  24. Unbiased forward expectations • forward rate is the best predictor of the expected future spot • market determined • it is the best predictor? • it is not unbiased predictor? Parity Conditions

  25. Comparative statistics Parity Conditions

  26. Purchasing Power Parity Three months Six months One year Parity Conditions

  27. Fisher Effect Three months Six months One year Parity Conditions

  28. Interest rate parityInternational Fisher effect Three months Six months One year Parity Conditions

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