CHAPTER 4

PARITY CONDITIONS AND CURRENCY FORECASTING

CHAPTER OVERVIEW
I. II. III. IV. ARBITRAGE AND THE LAW OF ONE PRICE PURCHASING POWER PARITY THE FISHER EFFECT THE INTERNATIONAL FISHER EFFECT THE RELATIONSHIP BETWEEN THE FORWARD AND FUTURE SPOT RATE CURRENCY FORECASTING

V.
VI.

FIVE KEY THEORETICAL RELATIONSHIPS

UFR D%e PPP IFE

forward discount or premium

interest rate differential

IRP

expected inflation differential

FE

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 prices after exchange-rate

adjustment were not equal,

arbitrage of the goods ensures eventually they will worldwide.

ARBITRAGE AND THE LAW OF ONE PRICE

C. Five Parity Conditions Result From These Arbitrage Activities
1. 2. 3. Purchasing Power Parity (PPP) The Fisher Effect (FE) The International Fisher Effect (IFE) Interest Rate Parity (IRP) Unbiased Forward Rate (UFR)

4. 5.

ARBITRAGE AND THE LAW OF ONE PRICE

D. Five Parity Conditions Linked by 1. The adjustment of various rates and prices to inflation.

ARBITRAGE AND THE LAW OF ONE PRICE

2. The notion that money should have no effect on real variables (since they have been adjusted for price changes).

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.

ARBITRAGE AND THE LAW OF ONE PRICE

F. THE LAW OF ONE PRICE - enforced by international arbitrage.

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.

PURCHASING POWER PARITY

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

PURCHASING POWER PARITY

II. ABSOLUTE PURCHASING POWER PARITY same purchasing power
globally.

B. One unit of currency has

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.

PURCHASING POWER PARITY

1.In mathematical terms: ih et 1 e0 1 i f

t t

where

et e0 ih if t

= = = = =

future spot rate spot rate home inflation foreign inflation the time period

PURCHASING POWER PARITY

2. If purchasing power parity is expected to hold, then the best prediction for the one-period spot rate should be
et e0

i 1
f

ih 1

t t

PURCHASING POWER PARITY

3. A more simplified but less precise relationship is et ih i f e0
that is, the percentage change should be approximately equal to the inflation rate differential.

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.

PURCHASING POWER PARITY

B. Real Exchange Rates: the quoted or nominal rate adjusted for a countrys inflation rate is
e et
' t

(1 i f ) (1 ih )

PURCHASING POWER PARITY

C. Real exchange rates 1. If exchange rates adjust to inflation differential, PPP states that real exchange rates stay the same.

PURCHASING POWER PARITY

C. Real exchange rates
2. Competitive positions: domestic and foreign firms are unaffected.

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

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

THE FISHER EFFECT

C. According to the Fisher Effect, countries with higher inflation rates have higher interest rates.

THE FISHER EFFECT

D. Due to capital market
integration globally, interest

rate differentials are eroding.

THE FISHER EFFECT

D. Capital market integration has homogenized markets around the world

CAPITAL MARKET SEGMENTATION

Real interest rates aus arw DU.S. SU.S. Drw

Srw

credit

CAPITAL MARKET INTEGRATION

DU.S. + Drw = DW Real interest rates aw SU.S. + Srw = SW

credit

PART IV. THE INTERNATIONAL FISHER EFFECT (IFE)

I. IFE STATES: A. the spot rate adjusts to the interest rate differential between two countries.

THE INTERNATIONAL FISHER EFFECT

IFE = PPP + FE
et (1 rh ) t t e0 (1 rf )

THE INTERNATIONAL FISHER EFFECT

B. Fisher postulated 1. The nominal interest rate differential should reflect the inflation rate differential.

THE INTERNATIONAL FISHER EFFECT

B. Fisher postulated
2. Expected rates of return are equal in the absence of government intervention.

THE INTERNATIONAL FISHER EFFECT

C. Simplified IFE equation:
(if rf is relatively small)

rh - rf = e1 - e0 e0

THE INTERNATIONAL FISHER EFFECT

D. Implications of IFE 1. Currency with the lower interest rate expected to appreciate relative to one with a higher rate.

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.

PART V. 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 = e t

PART VI. CURRENCY FORECASTING

I. FORECASTING MODELS A. have been created to forecast exchange rates in addition to parity conditions. B. Two types of forecast: 1. Market-based 2. Model-based

CURRENCY FORECASTING
MARKET-BASED FORECASTS: derived from market indicators. A. The current forward rate contains implicit information about exchange rate changes for one year. B. Interest rate differentials may be used to predict exchange rates beyond one year.

CURRENCY FORECASTING
MODEL-BASED FORECASTS: include fundamental and technical analysis. A. Fundamental relies on key macroeconomic variables and policies which most like affect exchange rates. B. Technical relies on use of 1. Historical volume and price data 2. Charting and trend analysis