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CHAPTER 4

CHAPTER 4. PARITY CONDITIONS AND CURRENCY FORECASTING. PART I. ARBITRAGE AND THE LAW OF ONE PRICE. I. THE LAW OF ONE PRICE A. Law states: Identical goods sell for the same price worldwide. ARBITRAGE AND THE LAW OF ONE PRICE. B. Theoretical basis: If the price after exchange-rate

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CHAPTER 4

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  1. CHAPTER 4 PARITY CONDITIONS AND CURRENCY FORECASTING

  2. PART I. ARBITRAGE AND THE LAW OF ONE PRICE • I. THE LAW OF ONE PRICE • A. Law states: • Identical goods sell for the same price worldwide.

  3. ARBITRAGE AND THE LAW OF ONE PRICE • B. Theoretical basis: • If the price after exchange-rate • adjustment were not equal, arbitrage in the goods worldwide ensures eventually it will.

  4. ARBITRAGE AND THE LAW OF ONE PRICE • C. Five Parity Conditions Result From These Arbitrage Activities • 1. Purchasing Power Parity (PPP) • 2. The Fisher Effect (FE) • 3. The International Fisher Effect • (IFE) • 4. Interest Rate Parity (IRP) • 5. Unbiased Forward Rate (UFR)

  5. ARBITRAGE AND THE LAW OF ONE PRICE • D. Five Parity Conditions Linked by • The adjustment of various • rates and prices to inflation.

  6. ARBITRAGE AND THE LAW OF ONE PRICE • E. Inflation and home currency depreciation: • 1. jointly determined by the growth of domestic money supply; • 2. Relative to the growth of • domestic money demand.

  7. ARBITRAGE AND THE LAW OF ONE PRICE • F. THE LAW OF ONE PRICE • - enforced by international • arbitrage.

  8. PART II. PURCHASING POWER PARITY • I. THE THEORY OF PURCHASING • POWER PARITY: • states that spot exchange rates between currencies will change to the differential in inflation rates between countries.

  9. PURCHASING POWER PARITY • II. ABSOLUTE PURCHASING • POWER PARITY • A. Price levels adjusted for • exchange rates should be • equal between countries

  10. PURCHASING POWER PARITY • II. ABSOLUTE PURCHASING • POWER PARITY • B. One unit of currency has same purchasing power globally.

  11. PURCHASING POWER PARITY • III. RELATIVE PURCHASING POWER PARITY • A. states that the exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries.

  12. PURCHASING POWER PARITY • 1. In mathematical terms: • where et = future spot rate • e0 = spot rate • ih = home inflation • if = foreign inflation • t = the time period

  13. PURCHASING POWER PARITY • 2. If purchasing power parity is • expected to hold, then the best • prediction for the one-period • spot rate should be

  14. PURCHASING POWER PARITY • 3. A more simplified but less precise relationship is • that is, the percentage change should be approximately equal to the inflation rate differential.

  15. PURCHASING POWER PARITY • 4. PPP says • the currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation.

  16. PURCHASING POWER PARITY • B. Real Exchange Rates: • the quoted or nominal rate adjusted for a country’s inflation rate is

  17. PURCHASING POWER PARITY • C. Real exchange rates • 1. If exchange rates adjust to inflation differential, PPP states that real exchange rates stay the same.

  18. PART III.THE FISHER EFFECT (FE) • I. THE FISHER EFFECT • states that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations. • R = a + i

  19. THE FISHER EFFECT • B. Real Rates of Interest • 1. Should tend toward equality • everywhere through arbitrage. • 2. With no government interference nominal rates vary by inflation differential or • rh - rf = ih - if

  20. PART IV. THE INTERNATIONAL FISHER EFFECT (IFE) • I. IFE STATES: • A. the spot rate adjusts to the interest rate differential between two countries.

  21. THE INTERNATIONAL FISHER EFFECT • IFE = PPP + FE

  22. THE INTERNATIONAL FISHER EFFECT • B. Fisher postulated • 1. The nominal interest rate differential should reflect the inflation rate differential.

  23. THE INTERNATIONAL FISHER EFFECT • B. Fisher also postulated that • 2. Expected rates of return are equal in the absence of government intervention.

  24. THE INTERNATIONAL FISHER EFFECT • C. Simplified IFE equation: • (if rf is relatively small)

  25. THE INTERNATIONAL FISHER EFFECT • D. Implications of IFE • 1. Currency with the lower interest rate is expected to appreciate relative to the one • with a higher rate.

  26. THE INTERNATIONAL FISHER EFFECT • D. Implications of IFE • 2. Financial market arbitrage: • insures interest rate differential is an unbiased predictor of change in future spot rate.

  27. PART VI. INTEREST RATE PARITY THEORY • I. INTRODUCTION • A. The Theory states: • the forward rate (F) differs from the spot rate (S) at equilibrium by an amount equal to the interest differential (rh - rf) between two countries.

  28. INTEREST RATE PARITY THEORY • 2. The forward premium or • discount equals the interest • rate differential. • (F - S)/S = (rh - rf) • where rh = the home rate • rf = the foreign rate

  29. INTEREST RATE PARITY THEORY • 3. In equilibrium, returns on • currencies will be the same • i. e. No profit will be realized • and interest parity exists • which can be written

  30. INTEREST RATE PARITY THEORY • B. Covered Interest Arbitrage • 1. Conditions required: • interest rate differential does • not equal the forward premium or discount. • 2. Funds will move to a country • with a more attractive rate.

  31. INTEREST RATE PARITY THEORY • 3. Market pressures develop: • a. As one currency is more demanded spot and sold forward. • b. Inflow of fund depresses interest rates. • c. Parity eventually reached.

  32. INTEREST RATE PARITY THEORY • C. Summary: • Interest Rate Parity states: • 1. Higher interest rates on a • currency offset by forward discounts. • 2. Lower interest rates are offset by forward premiums.

  33. PART VI. THE RELATIONSHIP BETWEEN THE FORWARD AND THE FUTURE SPOT RATE • I. THE UNBIASED FORWARD RATE • A. States that if the forward rate is unbiased, then it should reflect the expected future spot rate. • B. Stated as • ft = et

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