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**Alan Shapiro 7th Edition J.Wiley & Sons
**

Power Points by Joseph F. Greco, Ph.D. California State University, Fullerton

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CHAPTER 4

PARITY CONDITIONS AND CURRENCY FORECASTING

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CHAPTER OVERVIEW

ARBITRAGE AND THE LAW OF ONE PRICE II. PURCHASING POWER PARITY III. THE FISHER EFFECT IV. THE INTERNATIONAL FISHER EFFECT V. INTEREST RATE PARITY THEORY VI. THE RELATIONSHIP BETWEEN THE FORWARD AND FUTURE SPOT RATE VII. CURRENCY FORECASTING

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I.

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.

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

5. 3.ARBITRAGE AND THE LAW OF ONE PRICE C. Purchasing Power Parity (PPP) The Fisher Effect (FE) The International Fisher Effect (IFE) Interest Rate Parity (IRP) Unbiased Forward Rate (UFR) 6 . 4. Five Parity Conditions Result From These Arbitrage Activities 1. 2.

Five Parity Conditions Linked by 1.ARBITRAGE AND THE LAW OF ONE PRICE D. The adjustment of various rates and prices to inflation. 7 .

The notion that money should have no effect on real variables (since they have been adjusted for price changes). 8 .ARBITRAGE AND THE LAW OF ONE PRICE 2.

jointly determined by the growth of domestic money supply. 9 . 2. Relative to the growth of domestic money demand. Inflation and home currency depreciation: 1.ARBITRAGE AND THE LAW OF ONE PRICE E.

10 .ARBITRAGE AND THE LAW OF ONE PRICE F.enforced by international arbitrage. THE LAW OF ONE PRICE .

PART II.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 I. 11 .

PURCHASING POWER PARITY II. ABSOLUTE PURCHASING POWER PARITY A. Price levels adjusted for exchange rates should be equal between countries 12 .

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

PURCHASING POWER PARITY III. 14 . 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.

In mathematical terms: e e where t 0 ! et e0 ih if t = = = = = .PURCHASING POWER PARITY 1.

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1 i i h f t t future spot rate spot rate home inflation foreign inflation the time period 15 .

then the best prediction for the one-period spot rate should be e t ! e 0 i . If purchasing power parity is expected to hold.PURCHASING POWER PARITY 2.

1 i .

1 h f t t 16 .

A more simplified but less precise relationship is et e0 ! ih i f that is. the percentage change should be approximately equal to the inflation rate differential.PURCHASING POWER PARITY 3. 17 .

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. 18 .

Real Exchange Rates: the quoted or nominal rate adjusted for a country s inflation rate is e ' t ! e (1 i t f ) t t (1 i h ) 19 .PURCHASING POWER PARITY B.

PURCHASING POWER PARITY C. 20 . Real exchange rates 1. PPP states that real exchange rates stay the same. If exchange rates adjust to inflation differential.

21 . Competitive positions: domestic and foreign firms are unaffected.PURCHASING POWER PARITY C. Real exchange rates 2.

R = a + i 22 .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.

Real Rates of Interest 1.if 23 .THE FISHER EFFECT B. With no government interference nominal rates vary by inflation differential or rh . 2.rf = ih . Should tend toward equality everywhere through arbitrage.

countries with higher inflation rates have higher interest rates.THE FISHER EFFECT C. 24 . According to the Fisher Effect.

interest rate differentials are eroding.THE FISHER EFFECT D. 25 . Due to capital market integration globally.

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

THE INTERNATIONAL FISHER EFFECT IFE = PPP + FE et (1 r h ) ! e0 (1 r f ) t t 27 .

THE INTERNATIONAL FISHER EFFECT B. 28 . Fisher postulated 1. The nominal interest rate differential should reflect the inflation rate differential.

THE INTERNATIONAL FISHER EFFECT B. 29 . Expected rates of return are equal in the absence of government intervention. Fisher postulated 2.

THE INTERNATIONAL FISHER EFFECT C. Simplified IFE equation: (if rf is relatively small) rh r f e1 e 0 ! e0 30 .

Currency with the lower interest rate expected to appreciate relative to one with a higher rate.THE INTERNATIONAL FISHER EFFECT D. Implications of IFE 1. 31 .

Implications of IFE 2.THE INTERNATIONAL FISHER EFFECT D. 32 . Financial market arbitrage: insures interest rate differential is an unbiased predictor of change in future spot rate.

rf) between two countries. 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 . INTEREST RATE PARITY THEORY I.PART VI. 33 .

INTEREST RATE PARITY THEORY 2.S)/S = (rh . The forward premium or discount equals the interest rate differential. (F .rf) where rh = the home rate rf = the foreign rate 34 .

returns on currencies will be the same i.INTEREST RATE PARITY THEORY 3. e. In equilibrium. No profit will be realized and interest parity exists which can be written (1 + rh) = F (1 + rf) S 35 .

2.INTEREST RATE PARITY THEORY B. 36 1. Conditions required: . Covered Interest Arbitrage interest rate differential does not equal the forward premium or discount. Funds will move to a country with a more attractive rate.

c.INTEREST RATE PARITY THEORY 3. As one currency is more demanded spot and sold forward. Parity eventually reached. 37 . Market pressures develop: a. Inflow of fund depresses interest rates. b.

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

States that if the forward rate is unbiased. then it should reflect the expected future spot rate.PART VI. Stated as ft = et 39 . B. THE RELATIONSHIP BETWEEN THE FORWARD AND THE FUTURE SPOT RATE I.THE UNBIASED FORWARD RATE A.

B.PART VI. Model-based 40 . Created to forecast exchange rates in addition to parity conditions. FORECASTING MODELS A. CURRENCYFORECASTING I. Market-based 2. Two types of forecast: 1.

The current forward rate contains implicit information about exchange rate changes for one year. 41 . A. Interest rate differentials may be used to predict exchange rates beyond one year. B.CURRENCY FORECASTING MARKET-BASED FORECASTS: derived from market indicators.

A. B. Technical relies on use of 1.CURRENCY FORECASTING MODEL-BASED FORECASTS: include fundamental and technical analysis. Charting and trend analysis 42 . Fundamental relies on key macroeconomic variables and policies which most like affect exchange rates. Historical volume and price data 2.

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