Finance 319 Lecture 6 cont.

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Finance 319 Lecture 6 (cont.)

• Course Website
• http//www.citi.umich.edu/u/galka/319
• Galina Albert Schwartz
• Department of Finance
• University of Michigan
• Business School

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Practical Matters Investment History
Video

• The coming Wed., 01.31.2001
• 700pm, in room D1230
  (Davidson Hall)
• How The Really Smart Money Invests A Brief
  History of Investing

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Lecture Summary International Parity Conditions

• Perfect Capital Market Hypothesis holds ?
• International Parity Conditions hold
• Examples of PPP PCM violations
• why these violations are related

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Perfect Capital Markets (PCM) a reminder

• PCM implies
• 1. Zero transaction costs
• 2. Zero Taxes
• 3. No regulatory requirements
• 4. No uncertainty
• Does PCM hold?
• Yes, it holds (approximately)
• No, in real world, all conditions, 1 - 4 are
  violated

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Violations of PCM hypothesis

• 1. generalized transaction costs menu costs,
  real transport costs, brokerage fees other
  overhead expenses
• 2. Taxes, tariffs, quotas
• 3. Regulations banking, environmental, labor
• 4. Uncertainty (in demand supply)

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Why PPP could hold?

• Assume that PCM holds
• Then the costs of doing arbitrage are zero
• In this case PPP holds
• because any violation of PPP will be arbitraged
  away

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Violations of PPP hypothesis

• 1. generalized transaction costs menu costs,
  real transport costs, brokerage fees other
  overhead expenses
• 2. Taxes, tariffs, quotas
• 3. Regulations banking, environmental, labor
• 4. Uncertainty (in demand supply)

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Why are PPP PCM related?

• If PCM holds, arbitrage is FREE
• PCM ? arbitrage expenses 0
• 1. Zero transaction costs
• 2. Zero Taxes
• 3. No regulatory requirements
• 4. No uncertainty
• Does PPP hold? Yes No

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Next Lecture Interest Rate Parity

• Interest Rate Parity IRP
• To read Levich, Ch. 5
• Rogoff, Kenneth, (1996), The Purchasing Power
  Parity Puzzle, Journal of Economic Literature,
  Vol. 34, No. 2. , pp. 647-668. (S)

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Summary of Today

• PPP holds, but only approximately
• Violations of PPP and PCM are related
• Once we introduce a correction, which is
  calculate the expenses on doing arbitrage, PPP
  holds