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Chapter 4 The International Parity Conditions

International Parity Conditions: - Forward premium - Expected change in spot exchange rate to cross currency differentials in nominal interest rates - Inflation Real exchange rate: - A measure of currency s purchasing power relative to other currencies

4.1 The law of one price - an asset must have the same value regardless of the currency in which it is measured - if the Purchasing Power Parity (PPP) does not hold opportunity to make arbitrage profit
Arbitrage Profit - profitable position with o NO net investment o NO risk - Arbitrage opportunities are quickly exploited drives prices back to equilibrium - Pf: price of asset in foreign currency Pd: price of asset in domestic currency - Law of one price: o The value of an asset has to be the same whether value is measured in foreign or domestic currency o Spot rate of exchange = value in the foreign currency to the value in the domestic currency o Pd / Pf = S d/f o If this equality does not hold opportunity for riskless arbitrage profit in cross currency transactions - assume the transaction costs are relatively small - PPP always hold in liquid markets because the potential for arbitrage ensures that prices are in equilibrium - PPP does not always hold in illiquid markets as they involve high transaction costs / policies that prevent the law of one price to hold Transactions costs and the no arbitrage condition - NO arbitrage opportunities PPP must hold within the bounds of transaction costs for identical assets bought / sold simultaneously in two / more locations - Market frictions may restrain arbitrage from working o Barriers of cross border flow of capital o Trade barriers o Taxes o Financial market controls - Buying / selling asset involves a greater costs than trading a financial claim on the real asset o E.g.: transporting gold is more expensive than buying the ownership of gold o Currency all be stored conveniently in the Eurocurrency market at a competitive interest rate - Actively traded financial assets are more likely to conform to the law of one price than similar real asset

Chapter 4 The International Parity Conditions

4.2 Exchange rate equilibrium - Spot exchange and forward currency contracts are traded in liquid interbank markets with few governmental restrictions / market frictions
Bilateral rate Equilibrium and Locational arbitrage - Absence of market frictions NO arbitrage condition for trade in spot exchange rates between two banks X and Y This ensure bilateral exchange rate equilibrium Sd/f (Y) = S d/f (X) - if this relation does not hold within the bounds of transaction costs Locational arbitrage opportunities between banks - the larger the trade , the larger the profit - long position: o has ownership of an asset o benefit if the price goes up o long dollars = buy dollars - short position: o the holder of the position has sold the asset with the intention of buying it at a later time o Benefit if the price goes down o Short euros = sold euros - Banks try to minimise their net exposures currency balances must be netted out o E.g.: bought 100m euros, sold 120m euros net position = short 20m euros o Try to minimise this net exposures because currency dealers operating with large imbalances risk big gains / losses if new info arrived that cause the currency values to change unexpectedly Cross rates and Triangular arbitrage - Cross exchange rate = exchange rate that does not involve domestic currency - Triangular arbitrage ensure cross rates are in equilibrium - Sd/e Se/f Sf/d = 1 no arbitrage condition for triangular arbitrage (give the bilateral exchange rate) o if this condition does not hold the triangular arbitrage provides an opportunity for a riskless profit o the triangular arbitrage is worth doing as long as the transaction cost is < 1- Sd/e Se/f Sf/d of the transaction amount - example: P.65 - if <1: o at least one of these exchange rates are too low o Buy the currency in the denominator with the currencies in the numerator o Triangular arbitrage forces them to go back to the equilibrium - If > 1: o At least one of these exchange rates are too high o Sell the currencies in the denominator for the currencies in the numerators - No arbitrage condition ensures that currency cross rates are in equilibrium at all times

4.3 Interest Rate Parity and Covered Interest Arbitrage Ft d/f/S0d/f = [(1+id) / (1+if)]t - Forward premium / discount reflects the interest rates differential on the right hand side of the equation - No arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries - Because the nominal interest rate, spot rate and forward rate contracts are actively traded in the interbank market the IRP always hold within the bounds of transaction costs in these markets. -

Chapter 4 The International Parity Conditions

Covered Interest Arbitrage - Location arbitrage: take advantage of price discrepancy between two locations - Triangular arbitrage: take advantage of price discrepancy across 3 bilateral cross rates - Covered interest arbitrage: take advantage of interest rates differentials that are not fully reflects in the forward premium. o Covered interest rate parity forward contracts have been used to cover exchange rate risk o Ensure that the forward / spot ratio over each future period is determined by the differential between foreign and domestic interest rates over that period o Spot and forward rates are linked through interest rates differentials o Spot / forwards rates are volatile  If the interest rates do not move the forward premium will stay the same, it only changes when foreign / domestic interest rate change o Difference in interest rates allows arbitrage opportunities (P.67)  Borrow in one currency  Convert it into foreign currency at the spot rate  Invest the foreign currency in that country for n years  Sell the foreign currency / buy back the domestic currency at the forward rate  Repay the loan  Difference = arbitrage profit (where the condition does hold)  Cover the difference in the spot and forward currency markets - If LHS > RHS borrow at id and invest at if while covering your forward cash flows at the forward rate Fd/t o Borrow at id Think about the relationships in the equations! o Buy S0 o Invest at if o Sell Ft o Locks in arbitrage profit based on the difference between the two ratios - If LHS < RHS borrow in the foreign currency and invest in domestic currency o Borrow at if o Buy at Ft o Invest at id o Sell at S0 4.4 Less Reliable International Parity Conditions - Covered interest arbitrage is possible because each contract in the interest rate parity relation is actively traded in the interbank markets - Parity conditions are less reliable because they involve at least one non contractual future prices - Disequilibrium in non traded prices cannot be arbitraged and cab persist for long period of time Relative Purchasing Power Parity - The expected change in the spot exchange rate should reflect the relative inflationary expectations in the two currencies if the currencies are to retain their relative purchasing power E[St d/f ] / S0d/f = [(1+E[pd] / (1+E[pf])]t - Expected spot rate appreciation / depreciation is determined by the currencies expected inflation differential - Only holds on average as neither expected inflation nor future spot rates are traded contracts - Currency tend to increase against other currencies with high inflation

Chapter 4 The International Parity Conditions

Forward Rates as Predictors of Future Spot Rates - Forward Parity: forward exchange rates are unbiased predictors of future spot rates F td/f = E[St d/f] - If the forward parity holds forward premium should reflect the expected change in the spot exchange rate according to - F td/f / S0d/f= E[Std/f] / S0d/f - Forward rates are not good predictors of future spot rates over short forecasting horizons - The forward premium reflects the relative opportunity cost of capital in the two currencies through the interest rate parity relation The International Fisher Relation - If investors care about their real return (inflation adjusted return) set nominal returns to compensate them for their real required return and expected inflation (1 + nominal interest rate) = (1 + inflation rate)(1 + real interest rate) - International fisher relation [(1+id) / (1+if)]t = [(1+E[pd] / (1+E[pf])]t - Realized real rates are not equal across currencies during any single period because of unexpected inflation in each currency - Investors attracted to high real returns eventually drive prices upward in currencies with high expected real return o But therefore has driven promised yields downward o Pushes real rates back towards equilibrium o There are still cross currency differences in real interest rate o Inflation differentials have little power to explain interest rate differentials Uncovered Interest Parity

E[Std/f] /S0d/f = [(1+id) / (1+if)]t Nominal interest rates reflect expected changes in exchange rates (vice versa) Interest rate Parity Interest rate differential [(1 + id) / (1 + i f)]t Forward Premium Ftd/f / S0d/f

[(1+E[pd] / (1+E[pf])]t
Expected Inflation differential

= E[Std/f] /S0d/f
Expected change in spot rate

Relative PPP 4.5 The Real Exchange Rate - Identify the real changes in spot rates of exchange adjust nominal exchange rates for the effects of inflation in foreign and domestic currencies Real Changes in Purchasing Power - Use the RPPP to find out the expected future spot rate nominal exchange rate - Real exchange rate captures changes in the purchasing power of a currency relative to other currencies by backing out the effects of inflation from changes in nominal exchange rates - Refer to P.74 (figure 4.10) The Real Exchange Rate

Chapte 4

he nte national

arity Con ition

The re e change rate is the nominal e change rate adj sted for relative changes in domestic and foreign price levels The real e change rate as a % of the beginning spot rate


nflation adj stment: o whether this change in the nominal e change rate reflects the acc mulated inflation differential between the two currencies f change in the nominal spot rate of e change e actly offsets the mean inflation differential the real e change rate will remain at 100% of its base level The real e change rate provides a measure of the purchasing power of two currencies relative to a base period The change in real e change rate totally depends on the change in the o Nominal e change rate o Inflation rate differentials during the period ic a base period in which the purchasing power of the two currencies if close to e uilibrium If the answer is >1 it does not mean the currency is overvalued because as we can pic any year as the base period, the currency might have been undervalued in the base period and remains undervalued


Xtd/f / Xt-1d/f