Parity conditions in International Finance

1
Parity conditions in International Finance

• A summary

2
Predicting Exchange Rates

• International Parity Approach use arbitrage
  arguments.
• Fundamental Approach use macro models
• Technical Approach use time series

3
Objective

• Learn how to predict foreign exchange rates using
  arbitrage arguments

4
Outline

• On arbitrage and speculation
• Purchasing Power Parity (PPP)
• The International Fisher Effect (IFE)
• Interest Rate Parity (IRP)

5
ArbitrageENCYCLOPÆDIA BRITANNICA

• Business operation involving the purchase of
  foreign exchange, gold, financial securities, or
  commodities in one market and their almost
  simultaneous sale in another market, in order to
  profit from price differentials existing between
  the markets.
• Arbitrage generally tends to eliminate price
  differentials between markets.

6
Mind the distinction

• Arbitrage attempt at exploiting short-term
  market inconsistencies in order to extract
  risk-free profits
• Speculation betting that the market will go up
  or down in the short-term. Speculators take on
  tremendous risks.
• Whenever there is high risk involved, arbitrage
  becomes speculation

7
Arbitrage in the foreign exchange market

• Uncovered (Speculation)
• Covered (True arbitrage)

8
Example of uncovered arbitrage

• i(us) 5
• i(uk) 8
• s 1.5
• Borrow in at 5
• Buy pounds and lend at 8
• At maturity exchange back pounds for
• Hope that youll have enough to repay the loan
  and make an arbitrage profit

9
Example of covered arbitrage

• i(us) 5
• i(uk) 8
• s 1.5
• f 1.48
• Borrow in at 5
• Buy pounds and lend at 8
• At maturity exchange back pounds for
• Repay the loan and make an arbitrage profit

10
Purchasing Power Parity

• Absolute PPP
• Goods and services should cost the same
  regardless of the country
• Relative PPP
• The exchange rate is expected to adjust in order
  to reflect expected relative differences in
  purchasing power.

11
PPP Background

• The basis for PPP is the "law of one price".
• Competitive markets will equalize the price of an
  identical good in two countries (expressed in the
  same currency).

12
Exemplification

• A particular DVD player sells for
• C 700 in Sherbrooke
• US 500 in Burlington
• Exchange rate US 1.50/C.
• Consequences
• Consumers in Burlington would prefer buying it in
  Sherbrooke.
• Result
• The DVD player price in Sherbrooke should
  increase to C750

13
Caveats

• (1) Transportation costs, barriers to trade, and
  other can make a difference.
• (2) There must be competitive markets for the
  goods and services in question in both countries.
  
• (3) The law of one price only applies to tradable
  goods.

14
PPP Implications

• When a country's domestic price level is
  increasing (inflation), the exchange rate must
  depreciated in order to return to PPP.

15
Relative PPP Calculation

• E(st)/s0 (1inflationh)t/(1inflationf)t
• when t1
• E(s1)/s0 (1inflationh)/(1inflationf)

16
(No Transcript)
17
(No Transcript)
18
(No Transcript)
19
The Big Mac Index
20
Food for thoughtJan 7th 1999From The Economist
print edition

• For more than a decade, The Economists Big Mac
  index has offered a light-hearted guide to
  whether currencies are at their correct level.
• It is based on the theory of purchasing-power
  parity (PPP)the notion that a basket of goods
  and services should cost the same in all
  countries.
• Thus if the price of a Big Mac is lower in one
  country than in America, this suggests that its
  currency is undervalued relative to the dollar
  and vice versa.
• The price of a Big Mac varies in the euro area,
  from euro3.36 in Finland to a bargain euro2.19 in
  Portugal. The weighted average price in the 11
  countries is euro2.53, or 2.98 at current
  exchange rates.
• In America a Big Mac costs only 2.63 (taking the
  average of three cities).
• So the Euro is 13 overvalued against the dollar.

21
Big MacCurrenciesApr 27th 2000From The
Economist print edition

• Some people read tea leaves to predict the
  future. We prefer hamburgers
• Some readers beef that our Big Mac index does not
  cut the mustard. They are right that hamburgers
  are a flawed measure of PPP, because local prices
  may be distorted by trade barriers on beef, sales
  taxes or big differences in the cost of
  non-traded inputs such as rents. Thus, whereas
  Big Mac PPPs can be a handy guide to the cost of
  living in countries, they may not be a reliable
  guide to future exchange-rate movements. Yet,
  curiously, several academic studies have
  concluded that the Big Mac index is surprisingly
  accurate in tracking exchange rates over the
  longer term.
• Indeed, the Big Mac has had several forecasting
  successes. When the euro was launched at the
  start of 1999, most forecasters predicted that it
  would rise. But the euro has instead
  tumbledexactly as the Big Mac index had
  signaled. At the start of 1999, euro burgers were
  much dearer than American ones. Burgernomics is
  far from perfect, but our mouths are where our
  money is.

22
(No Transcript)
23
The Fisher Effect

• The Simple Fisher Effect
• The International Fisher Effect

24
The Fisher Effect

• Simple Fisher Effect
• Nominal interest rates equal real interest rates
  plus inflation premium
• (1ni) (1 ri)(1inflation)
• ni ri inflation (ri)(inflation),
• When (ri)(inflation) is a very small number
• ni ri inflation

25
International Fisher Effect (IFE)

• The exchange is expected to change in order to
  reflect expected relative differences in nominal
  interest rates.
• IFE assumes differences in nominal interest rates
  are driven by expected relative differences in
  inflation.
• E(st)/s0 (1nih)t/(1nif)t
• E(s1)/s0 (1nih)/(1nif), when t1

26
Interest Rate Parity (IRP)

• The forward exchange rate reflects expected
  relative differences in nominal interest rates.
• IRP also assumes differences in nominal interest
  rates are driven by expected relative differences
  in inflation.
• ft/s0 (1nih)t/(1nif)t
• f1/s0 (1nih)/(1nif), when t1

27
What is the relationship between forward and
future expected exchange rates?

• Some believe f E(s)
• Some believe f E(s) risk premium

28
Summary

• The Law of One Price - the arbitrage argument -
  says that goods and services should be worth the
  same when compared across borders
• An increase in inflation and the resulting
  increase in the nominal interest rate should
  cause the domestic currency to depreciate.
• And vice-versa.