International Parity Conditions

International Finance and Investment Topic 4 Ali Emami Department of Finance Lundquist College of Business University of Oregon
University of Oregon, Ali Emami 1

International Parity Conditions
‡ Definition: The parity conditions are equilibrium conditions that establish linkage between financial prices (P, i, S, F) in the absence of arbitrage. ‡ Implications: Provide guidelines for financial strategic decisions suggested by each side of parity condition. The parity conditions define international financial ´break-evenµ points encompassing alternative strategies yielding identical financial outcomes suggested by each side (RHS and LHS) of parity condition.
University of Oregon, Ali Emami 2

Implications«Continued
‡ From private investors point of view, parity conditions help to make optimal (beneficial) financial decisions regarding the choice of currency for borrowing, location of plants in different countries, measuring currency risk exposure, etc. ‡ From public policy makers point of view, parity conditions help to evaluate the strength of national currencies, the efficiency of national capital markets, and the effectiveness of fiscal and monetary policies towards achieving macroeconomic policies.

University of Oregon, Ali Emami

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etc.. it implies that its almost impossible to make profit from arbitrage in goods. services. University of Oregon. ‡ When parity conditions do not hold. capital. ‡ When parity conditions hold.Continued ‡ The empirical evidence and tests on validity (invalidity) of parity conditions provide useful signals regarding the opportunity for making profits for private enterprise. Ali Emami 4 .Implications«««. it often implies the possibility of making profits doing arbitrage in goods. etc. capital.

University of Oregon. profit-maximizing enterprise will act to capitalize on arbitrage opportunities in trade of goods and services between countries.Parity Conditions in Perfect Capital Markets ‡ Perfect Capital Markets Assumptions:  No transaction costs (´priceµ differentials only provokes arbitrage)  No taxes. tariff or trade barriers  Complete certainty (no risk) Given these assumption. Ali Emami 5 . between spot and forward exchange rates. and between real and financial assets to the extent that eliminates any further arbitrage activity.

Ali Emami 6 .Purchasing Power Parity (PPP) Doctrine ‡ Purchasing power party doctrine was introduced by the Swedish economist Gustav Cassel in 1918 (Gustav Cassel. December 1918. ‡ He proposed the PPP doctrine after WWI as a new method for measuring exchange rates among countries. pp.µ Economic Journal. University of Oregon.413-415). ´Abnormal Deviations in International Exchanges.

PPP Definition ‡ Definition: Purchasing power parity focuses on the parity condition at a specific time that links the price of a specific product in a country in terms of its currency (P$) to: a) the price of the same product in another country denominated in its currency (P½ ). ¨$¸ P$ ! S © ¹ v P¼ (1) ª¼º University of Oregon. Ali Emami 7 . and b) the spot exchange rate between the two currencies (S($/¼)) .

Ali Emami 8 . University of Oregon. a) the relative PPP (RPPP).Types of PPP ‡ The PPP doctrine has two forms: a) The absolute PPP (APPP) and.

there are no opportunities for arbitrage based on the prices of a similar (homogenous) good in two countries. ‡ Hence. ¨$¸ P$ ! S © ¹ P¼ (1) ª¼º University of Oregon. prices of the same good in two trading partner countries will become identical (after adjustments in the exchange rate). ‡ The Law of One Price states that under PCM assumptions. Ali Emami 9 . Thus.Absolute PPP (APPP) ‡ The APPP relies on perfect capital market (PCM) assumptions and the Law of One Price (LOOP).

t P¼. Ali Emami .t (2) 10 University of Oregon. yields a measurement for exchange rate between Dollar and Euro currencies: ¨$¸ St © ¹ ª¼º $.APPP Continued ‡ APPP and Exchange Rate Substituting general price levels (a weighted price for all products) for each country in equation (1).

According to APPP. Ali Emami 11 .K.247 University of Oregon.67 while in U. one ounce of gold was priced at £4.APPP & Exchange rate: Example ‡ Exchange Rate Gold Standard (18761913): One ounce of gold in the United States was priced at $20.67 $4. what would be the S($/£)? ¨ $ ¸ P$ $20.86695 S© ¹ ! ! ! £ ª £ º P£ £4.247..

S Big Mac APPP ¨P © ªP Big Mac FC Big Mac $ ¸ ¹ º 12 University of Oregon. a MacDonald·s Big Mac. Ali Emami .The Big Mac Index ‡ Definition: The APPP measure of the ´true equilibrium valueµ of a currency based on one product.

1977.9 5. April 12.70 Overvaluation(+) Or Undervaluation(-) Of local currency . 71.33 2.The Big Mac Index: Example Country United States Brazil China Germany Japan Mexico Switzerland Big Mac Prices (Local Currency) 2.99 117 8.79 8. 75.11 106 9. 4/25/00 1.90 Implied PPP 1. p.52 -6 +10 .18 3. p. April 29.90 4.11 + 38 Source: ³Big Mac Currencies´ The Economist.51 2.41 1. 2000. Ali Emami 13 .28 2.34% .´ The Economist. University of Oregon. ³Big Mac Currencies.35 Actual Spot Rate.99 294 20.95 9.94 1.

That is RPPP estimates percentage changes in the exchange rates over a given time period.t 1 ¼. ‡ Rewriting equation (2) for time period P (t+1) yields: S ¨ $ ¸ ! P (3) © ¹ ¼º ª ‡ Dividing (3) by (2) gives the dynamics behavior of exchange rate: t 1 $.Relative Purchasing Power Parity (RPPP) Doctrine ‡ Relative purchasing power parity (RPPP) is concerned with the changes in spot rate over time. Ali Emami 14 .t+1 & & P$  P¼ & S! & 1+ P¼ University of Oregon.

Implications of RPPP ‡ 1 & & P$  P¼ &¼ &¼ & & S .

$ !   S .

1 ¸ St © ¹ ! S 0 © ¹ © &¹ ª¼º ª ¼ º ª 1  P¼. Ali Emami t 15 . $ ! P$  P¼ & 1  P¼ ‡ 2 & ¨$¸ ¨ $ ¸ ¨ 1  P$.1 º University of Oregon.

0 104.3 117.) 40.6 Exchange Rate $0.006971 University of Oregon.S.S.003762/¥ $0.2 CPI (Japan) 44.Example: Consider the following information on U. and Japanese CPIs. Ali Emami 16 . What was the PPP implied exchange rate between the ¥ and the $ in 1989? Was the ¥ overvalued or under valued against the $? By how much? Year 1973 1989 CPI (U.

Answer: Dividing equation (3) by equation (2) yields: University of Oregon. Ali Emami 17 .

and the current spot rate is $1. Calculate the PPP rate for euro in four years.06 $1.S. ‡ Answer: 10.Example: Assume that inflation rate in U. and euro region are expected to be 6% and 4% respectively each year for the next four years.2812 per euro.285454 $1.04 ¼ University of Oregon.2812 S2008 ! ! ¼ 10. Ali Emami 18 .

.

5v ! £ £º 115 ª University of Oregon. Calculate the PPP exchange rate in 2004.S. ‡ Answer: 102 $1.330435 ¨ $¸ S2004 © ¹ ! $1.Example: Suppose the base period is year 1990. Ali Emami 19 .5 in 1990. Assume that currently (in 2004). The exchange rate was $1. CPI is 102 and the United Kingdom·s CPI is at 115 relative to 1990 base period. the U.

4 92 145. what would have been the S(DM/$) rate in 1998? S(DM/$) 1979 1998 DM2.98 © ª $ ¸ N CPI 79.50/$ CPIDM 92. DM ¹ ! S79 CPI º 98.3 Answer: CPI 98. if PPP hold over 1979-1998.4/$ DM2.Example: Given the following information.5 CPI$ 79.5 ! DM 2. DM ¨ DM S PPP. Ali Emami 20 .3 79.2 University of Oregon.2 145.$ CPI 79.0 120.$ 120.

t º ¹ market ( N ) © ª St © ¨ CPI ¸¹ ¥. Ali Emami .t  n ¹ ©© ¹ © © CPI ¥.t  n ¸ ¸ ©© © CPI ¹ ¹ ¹ $.t ‡ The Real Exchange Rate Based on Relative Purchasing Power Parity ¨$¸ © ¹! ª¥º market ( N ) ¨ $ ¸ St © ¹ ª¥º CPI$ CPI ¥ ¨$¸ R S RPPP .Real Purchasing Power Parity Exchange Rates ‡ The Real Bilateral Exchange Rate Based on Absolute PPP S RPPP.t  n © ¹ ! ª¥º Stmarket ( N ) n ¨ ¨ CPI $.t ¹ ¹ ºº ªª 21 University of Oregon.

Ali Emami 22 .Real Exchange Rate Based on the Market Exchange Rate ‡ Formula: ¨ FC ¸ S © ¹ $ º ¨ FC ¸ ª ! Streal © ¹ ¨ PFC ¸ ª $ º © ¹ P$ º ª nominal t S real t ¨ P$ ¸ ¨ FC ¸ nominal ¨ FC ¸ ¹ © ¹ ! St © ¹v© ª $ º ª $ º ª PFC º University of Oregon.

‡ The parity condition implied by this theory establishes the break-even condition where the return on a domestic currency investment is identical with the return on a foreign currency investment covered against exchange rate risk University of Oregon.Interest Rate Parity (IRP) Theory and the Fisher Parities ‡ Interest rate parity focuses on the parity condition that links the spot and forward (expected) exchange rates with international money and bond markets. Ali Emami 23 .

CIRP Relations ‡ Invest $1 at Home at the rate of i$ and after one year get: $ 1 .

1  i$ ‡ Invest $1 in euro at the rate of i ¼ and after one year get: ®¨ « » ¸ ±© ¬ ¼ ± $1 ¹ ¹ v .

1  i¼ ¼ v ¯ ¬© ¬ ¼ ±© S0 ¨ $ ¸ ¹ ¬© © ¼ ¹ ¹ ¼ ±ª ª º º ­ ½¼ ° ¾ ± $ ¸± 1 year ¨ 0 © ¹¿ ª ¼ º± ± À$ 24 University of Oregon. Ali Emami .

continued ‡ Where to invest (if you got the money)? ®¨ ¾ « » ¸ ¬ © $1 ¹ ¼ ¨$¸ ¬© ¼ v F01 year © ¹ ¿ ¹ v .CIRP Relations«««.

1  i¼ $1.

then invest in $. then invest in Euro. Ali Emami 25 .1  i$ ¦ ¯ ª¼º ¬© S ¨ $ ¸ ¹ ¼ ¬© 0 © ¼ ¹ ¹ ¼ ª ª ºº ­ ½¼ À$ ‡ If (LHS > RHS). ‡ If (LHS < RHS). ‡ If (LHS = RHS). University of Oregon. then indifferent.

continued ‡ Where to borrow and invest (if you don·t have money)? $ 1 .CIRP Relations«««.

1  i $ ¦ ®¨ « ±© ¬ $1 ± ¬© ¯ ¬ ±© S0 ¨ $ ¸ © ¹ ¬ª ±© ª ¼ º ­ ° ¸ ¹ ¹ v .

‡ If (LHS < RHS). Ali Emami 26 . University of Oregon. ‡ If (LHS = RHS). then borrow from $ and invest in Euro.1  i ¼ ¹ ¹ º » ¼ ¼ v ¼ ¼ ½¼ 1 year 0 ¾ ± ¨ $ ¸± © ¹¿ ª ¼ º± ± À$ ‡ If (LHS > RHS). then borrow from euro and invest in $. then indifferent.

Variations of Covered and Uncovered IRP Formula ‡ 1 ‡ 2 ‡ 3 ‡ 4 ¨$¸ ¨ $ ¸ .

1  i$ © ¹! S© ¹ ª¼º ª ¼ º .

1  i¼ ¨$¸ ¨ $ ¸ .

1  i$ ES © ¹ ! S © ¹ ª¼º ª ¼ º .

1  i¼ ¨ $ ¸ ¨ $ ¸ F © ¹ S© ¹ ª ¼ º ª ¼ º ! ¨ $ ¸ S© ¹ ª ¼ º .

i$  i¼ .

1  i ¼ ¨$¸ ¨$¸ F © ¹S© ¹ .

i$  i¼ ! ª ¼ º¨ $ ¸ ª ¼ º .

1  i¼ S© ¹ ª¼º University of Oregon. Ali Emami 27 .

Uncovered IRP: Relationship Between PPP and IRP: Fisher·s ´interest-open economyµ condition ‡ 1 & & P$  P¼ & S! & 1+ P¼ ! 4 6 4 44F7 ES 4 4 8 ¨ $ ¸« ¨ ¨$¸ & $ ¸» S t © ¹ ¬1  S © ¹ ¼  S © ¹ ª ¼ º­ ª ¼ º½ ª ¼ º .

i$  i¼ ! ¨$¸ .

1  i¼ S© ¹ ª¼º ‡ 2 ‡ 3 ‡ 4 &¨ $ ¸ ! .

i$  i ¼ S© ¹ .

1  i ¼ ª¼º & & P$  P¼ .

i$  i¼ ! & 1+ P¼ .

1  i¼ University of Oregon. Ali Emami 28 .

Fisher·s ´interest-open economyµ condition ‡ 1 & & P  P¼ ! .

i$  i¼ .

$ .

i$ 14 &  P$ 2 4 3 i $r e a l ‡ 2 ! .

i4¼ 1 &  P¼ 2 4 3 i real ¼ University of Oregon. Ali Emami 29 .

Market Forces and Covered Interest Parity University of Oregon. Ali Emami 30 .

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