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Recollection

** Introduction to Parity Conditions
**

Absolute & Relative Purchasing Power Parity

Real Exchange Rate

Fisher Effect (FE)

International Fisher Effect (IFE)

Unbiased Forward Rate (UFR)

Interest Rate Parity (IRP)

Covered Interest Arbitrage

Currency Forecasting => PROJECT

2

Introduction

Managers of multinational firms, international

investors, importers and exporters, and government

officials must deal with these fundamental issues:

Are changes in exchange rates predictable?

How are exchange rates related to interest rates?

What, at least theoretically, is the “proper”

exchange rate?

** To answer these questions we need to first understand
**

the economic fundamentals of international finance,

known as parity conditions.

3

Parity Conditions

Parity Conditions provide an intuitive explanation of the

movement of prices and interest rates in different

markets in relation to exchange rates.

The derivation of these conditions requires the

assumption of Perfect Capital Markets (PCM).

no transaction costs

no taxes

complete certainty

NOTE – Parity Conditions are expected to hold in the

long-run, but not always in the short term.

4

Otherwise. Purchasing Power Parity (PPP) PPP is based on the notion of arbitrage across goods markets and the basic building block of PPP is the Law of One Price (LOP). 5 . one could make profits by buying the good in the cheap market and reselling it in the expensive market. LOP states that the price of an identical good should be the same in all markets (assuming no transactions costs).

the exchange rate could be deduced from the relative local product prices: P$ S$ / £ P£ 6 . but the price of the product should remain the same. Comparison of prices would only require conversion from one currency to the other: P$ S$ £ P£ Conversely. The Law of One Price LOP states that a product’s price may be stated in different currency terms.

LOP Example Pwheat. The price of UK wheat will drop.70/£ *£2.5 = $4.5/bushel Spot rate (A$/£) = 1.70 wheat PAust S$ / £ PUK wheat A$ equivalent price of wheat in UK is A$1. 7 .25/bushel Implication: The demand for Australian wheat will increase forcing up its price. Aust = $4/bushel and Pwheat. UK = £2.

shtml 8 . First launched in 1986.com/products/bigmac/bigmac. see: http://www. updated ever since.oanda. For example. The Big Mac Index The most famous test is The Economist magazine’s Big Mac Hamburger standard.

9 .

They note several reasons why the Big Mac index may be flawed: It assumes that there are NO barriers to trade. but currencies can deviate from it for lengthy periods. labor) are also inputs that affect production costs. Prices are distorted by taxes. 10 . utilities. Research on the Big Mac Index Pakko and Pollard (1996) conclude that Big Mac PPP holds in the long-run. Profit margins may vary according to competition. Prices of non-traded goods (real estate.

71 14.14 12.00 44 Thailand 1.96 2.28 2.90 67 South Africa 1.80 20 Brazil 1.20 112 Canada 2.33 3.90 28 Czech Republic 1.70 5.38 1.48 2.00 65 Australia 1.32 2.80 16 Hong Kong 1.50 74 Turkey 2.47 7.90 17 Hungary 2.18 13.05 43 Peru 2.30 11 Malaysia 1.90 20 Euro area 2.96 2.84 1.10 66 11 .40 30 Singapore 1.98 9.60 30 China 1.20 44 Japan 2.70 50 Mexico 2.18 2. Working for a Big Mac Big Mac Net Hourly Minutes of work Big Mac Net Hourly Minutes of work Price (US $) Wage (US $) to buy a Big Mac Price (US $) Wage (US $) to buy a Big Mac Argentina 1.60 10 United States 2.80 14 New Zealand 2.21 9.60 10.22 6.85 3.10 26 Venezuela 2.80 42 Russia 1.60 17.09 14.30 15 Philippines 2.19 3.01 6.40 21 Colombia 2.40 49 South Korea 2.20 44 Chile 1.85 5.32 2.59 19 Switzerland 4.90 27 Denmark 4.86 7.20 2.62 2.70 49 Indonesia 1.13 1.20 62 Britain 3.40 17 Sweden 3.00 13 Taiwan 2.35 14 Poland 1.24 1.42 1.34 3.

A New Index – Starbucks Index 12 .

.t) is the domestic (foreign) price index (e.g. 13 .t (PIF. consumer price index) at time t.t Absolute PPP: S t D/ F PI F . The PPP exchange rate between the two countries should then be: PI D .t PID. Absolute PPP A less extreme form of the Law of One Price is ABSOLUTE PPP which says that the price of a basket of goods should be the same in each market.

Relative Purchasing Power Parity Relative PPP claims that exchange rate movements should exactly offset any inflation differential between two countries: Percentage 1 D change in SD/F Relative PPP: t 1 domestic prices D/F St 1 F SD/F S D/F D F t 1 t D/F St 1 F 1 D We can also write: S PPP t 1 S D/F 1 F t 14 .

Relative PPP Relative PPP implies that the change in the exchange rate will offset the difference between the relative inflation of two countries. πD and πF refers to the percentage change in domestic and foreign price levels respectively and s to the percentage change in the exchange rate. If domestic inflation > (<) foreign inflation. The previous formula can be approximated as: s D F where. 15 . PPP predicts the domestic currency should depreciate (appreciate).

045 = .4. what is the prediction of PPP with regards to $A/GBP exchange rate? Relative PPP St St 1 D F St 1 1 F = (0.5% The general implication of relative PPP is that countries with high rates of inflation will see their currencies depreciate against those with low rates of inflation.10)/(1 + 0. 16 .0.05 – 0.10) = . Relative PPP Example Given inflation rates of 5% and 10% in Australia and the UK respectively.

However. 17 . Currencies that have had the largest relative decline (gain) in purchasing power see the sharpest erosion (appreciation) in their foreign exchange values. there is clearly a relationship between relative inflation rates and changes in exchange rates. How well does PPP work? We have seen that the strictest version of PPP – that all goods and financial assets obey the law of one price – is demonstrably false.

2. Calculating appreciation in “real” exchange rates. This will provide a measure of how expensive a country’s goods have become (relative to another country’s). Relative Purchasing Power Parity Applications of Relative PPP: 1. Forecasting future spot exchange rates. 18 .

t 0 PPP 1 $ 1.05 19 . 5%.02 90 ¥ / $ 87. Japan 2% What is the expected ¥/$ exchange rate if relative PPP holds? 1 ¥ S ¥ / $.S . U .43 ¥ / $ 1. Forecasting Future Spot Rates Suppose the spot exchange rate and expected inflation rates are: S¥/$.t0 90 ¥ / $. t1 S ¥ / S .

That is. Real Exchange Rate By definition. the real exchange rate measures deviations from PPP. S t 1 Real Exchange Rate: E PPP S t 1 20 . changes in the spot exchange rate that do not reflect differences in inflation rates between the two currencies in question.

Real Exchange Rate Appreciation/depreciation in the real exchange rate measures deviations from PPP. When E = 1. When E < 1. When E > 1. Products from the other country seem cheap relative to the base year. That is. Products from the other country seem expensive relative to the base year. the competitiveness of the denominator country deteriorates. the denominator currency is valued correctly. That is. the denominator currency is undervalued. the competitiveness of the denominator country improves. 21 . The competitiveness of this country is unaltered. the denominator currency is overvalued.

The Fisher effect (also called Fisher-closed) states: 1 i 1 r 1 i r r This relation is often presented as a linear approximation stating that the nominal interest rate is equal to a real interest rate plus expected inflation: i r 22 . The Fisher Effect The international Fisher relation is inspired by the domestic relation postulated by Irving Fisher (1930).

a rise in a country's expected inflation rate will eventually cause an equal rise in the interest rate (and vice versa). • Fisher Effect • This equation tells us that. all things being equal. 23 . Contd.

like Australia and Japan. The Fisher Effect Applied to two different countries. not what inflation has been in the past. 24 . The Fisher Effect would be stated as: i r $ $ $ i¥ r ¥ ¥ It should be noted that this requires a forecast of the future rate of inflation.

This increased amount of inflation should cause the currency in the country with the high interest rate to depreciate against a country with lower interest rates. country B's currency should appreciate roughly 5% compared to country A's currency. For example. 25 . The rational for the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate.IFE Mean? An economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries' nominal interest rates for that time. if country A's interest rate is 10% and country B's interest rate is 5%. What Does International Fisher Effect .

The International Fisher Effect The International Fisher Effect (also called Fisher-open) states that the spot exchange rate should change to adjust for differences in interest rates between two countries: StD1/ F 1 iD StD/ F 1 iF 26 .

we get: (3) 1 i$ 1 r$ 1 $ 1 i ¥ 1 r¥ 1 ¥ =1 27 . The International Fisher Effect The Fisher effect applied to two different countries like Australia and Japan would be: (1) (1+i$) = (1+r$)(1+$) (2) (1+i¥) = (1+r¥)(1+¥) Dividing (1) by (2).

then for equation (3) we get r$ = r¥: 1 i $ 1 $ International Fisher: (4) 1 i ¥ 1 ¥ S t 1 St iD iF i$ i¥ $ ¥ (5) St 1 iF 1 i¥ 1 ¥ Remember this? E(St+1) S t 1 S t D F St 1 F 28 . The International Fisher Effect If real interest rates are equalized across countries.

29 . Tests of the International Fisher Effect Empirical tests lend some support to the relationship postulated by the international Fisher effect (currencies with high interest rates tend to depreciate and currencies with low interest rates tend to appreciate). although considerable short-run deviations occur.

is equal to the expected value of the spot exchange rate at time t+1. The unbiased forward rate (UFR) concept states that the forward exchange rate. quoted at time t for delivery at time t+1. Unbiased Forward Rate (UFR) Some forecasters believe that for the major floating currencies. 30 . foreign exchange markets are “efficient” and forward exchange rates are unbiased predictors of future exchange rates.

overestimate and underestimate the actual future spot rate in equal frequency and degree. Unbiased prediction means that the forward rate will. 31 . does not mean the future spot rate will actually be equal to what the forward rate predicts. Unbiased Forward Rate (UFR) UFR can be written as: Ft t+1 = Et[St+1] An unbiased predictor. however. on average.

Empirical Tests of UFR A consensus is developing that rejects the efficient market hypothesis. It appears that the forward rate is not an unbiased predictor of the future spot rate and that it does pay to use resources in an attempt to forecast exchange rates. 32 . The existence and success of foreign exchange forecasting services suggest that managers are willing to pay a price for forecast information even though they can use the forward rate to forecast at no cost.

Ft and St are the forward and spot rates and id and if are domestic and foreign interest rates respectively. 33 . Interest Rate Parity Interest rate parity (IRP) is an arbitrage condition that provides the linkage between the foreign exchange markets and the international money markets. Interest Rate Parity (IRP) Ft . t 1 1 id St 1 if where.

Interest Rate Parity The approximate form of IRP says that the % forward premium equals the difference in interest rates.t 1 Ft . the currency trading at a forward premium (discount) is the one from the country with the lower (higher) interest rate. 34 . Approximation of IRP Ft .t 1 St 1 id i f id i f St St In general.

The 3-month forward rate must be SFr1. (1% for 3- months) in Switzerland. interest rate parity must hold).a. Suppose the 3-month money market rate is 8% p. (2% for 3-months) in the U.S.a. and 4% p. Interest Rate Parity – An Example Basic idea: Two alternative ways to invest funds over same time period should earn the same return. 35 .4655/$ to prevent arbitrage opportunities (i..48/$. and the spot exchange rate is SFr1.e.

000 1.993* S = SF 1.00 % per annum (2.000 1.4800/$ 90 days F90 = SF 1.00 % per annum (1.02 $1.000.480.494. The Example Continued i $ = 8.01 SF 1.4655/$ Swiss franc money market SF 1.00 % per 90 days) * Rounding error.00 % per 90 days) Start End $1.019.000 Dollar money market $1.800 i SF = 4.020. 36 .

Otherwise riskless profits could be made. and then • Sign a forward contract to “lock in” a future exchange rate at which to convert the foreign currency proceeds back to the domestic currency. Interest Rate Parity: Why It Holds This must hold by arbitrage. • Invest the foreign currency in an interest- bearing instrument. This is known as covered interest arbitrage (CIA) and occurs whenever IRP does not hold. 37 . • Exchange the domestic currency for the foreign currency in the spot market. CIA can involve the following steps: • Borrow the domestic currency.

50 1.000 in one year’s time) 4. Purchase £666. Can arbitrage profits be made? Ft .08) ?? St 1.000 forward ($1.50/£ and the 1 year forward rate is $1.05 ≠ 1. Simultaneously sell £720. The current spot rate is $1. Borrow $1m (at 5%) 2. Invest £ at 8% (will receive £720.600) 5.667 using $1m 3.600 38 . Repay loan + interest of $1.t 1 1. Covered Interest Arbitrage: Example The annual interest rate in the AUS and UK are 5% and 8% respectively.48 1 id (1 i f ) 1.48/£.05 (1.050.065. ARBITRAGE PROFIT = $15.0656 1.000 6.

065.667 £720.600 2 Convert Profit = $15.050.50/£ at $1.600 Cover Spot Forward 4 at $1.000. The Example Continued 1 Borrow for 1 year $1.48/£ 3 Invest for 1 year £666.000 <$1.000> at i$ = 5% $1.000 at i£ = 8% 39 .

But their actions nudge the foreign exchange and money markets back toward equilibrium: 1. because the arbitrageurs are able to earn risk-free profits by repeating the cycle. 2. 40 . while the higher level of borrowing in Australia causes dollar interest rates to rise. The demand for pound-denominated securities causes pound interest rates to fall. Covered Interest Arbitrage Covered interest arbitrage should continue until interest rate parity is re-established. Purchase of Pounds in the spot market and sale of £ in the forward market narrow the premium on forward pounds.

investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceed into currencies that offer much higher interest rates. choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period. In this case. The transaction is “uncovered” because the investor does no sell the higher yielding currency proceeds forward. Uncovered Interest Arbitrage A deviation from covered interest arbitrage is uncovered interest arbitrage (UIA). 41 .

Currency Forecasting What have we learnt about currency forecasting this week? Unbiased forward rate Long-term equilibrium relationships (RPPP and IFE) More methodologies next week. 42 .

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