International Parity Conditions

1
International Parity Conditions

• (or chapter 4)

2
Agenda

• What is PPP law of one price?
• What is exchange rate pass-through?
• How do interest rates exchange rates link?
• Interest rate parity?
• What is covered interest arbitrage?
• What is uncovered interest arbitrage?

3
Prices and Exchange Rates

• Law of one price
• products price same in all markets

P ? S P

• where spot exchange rate is S, yen per dollar.

4
Purchasing Power Parity Law of One Price

• Absolute purchasing power parity
• spot exchange rate is determined by relative
  prices of similar basket of goods.
• Relative purchasing power parity
• Relative change in prices b/n countries
  determines change in forex rate.

5
Absolute PPP Big Mac Index

• Economists Big Mac PPP
• Big Mac in China costs Yuan 9.90.
• Big Mac in US costs 2.71.
• Implied PPP exchange rate

6
Economist, 4/ 2003
7
Relative PPP
change spot rate foreign currency US/ yen
InfJAPAN- InfUS
8
But

• PPP is not very accurate predictor
• Why?
• PPP holds well over very long term
• PPP holds better for countries w/ high inflation
  underdeveloped capital markets
• Why?

9
Is forex under-/over- valued?

• Use forex indices trade-weighted bilateral
  exchange rates b/n the home country trading
  partners
• Nominal exchange rate index use actual exchange
  rates.
• Real effective exchange rate index indicates how
  the weighted average purchasing power of the
  currency has changed relative to some arbitrarily
  selected base period.

10
Q

• Can you tell when a currency is overvalued?
• Why the real exchange rate deviates from 100?

11
Real Effective Exchange Rate Indices
United States Japan (1995 100)
12
Exchange Rate Pass-Through

• Pass-through change in prices of
  imported/exported goods when exchange rate
  changes
• BMW made in Germany cost _at_ spot rate US 35,000.
• where P is the price in US, P is price in
  euros, S is spot rate
• Euro appreciates by 20. But BMW is now only
  40,000.
• Pass-through
• Degree of pass-through 14.29 / 20 0.71
  or 71

13
Interest Rates Exchange Rates?

• What is a fair nominal interest rate?
• Well, can ask a banker or read Irvin Fisher
• Fisher Effect nominal interest rates in each
  country are equal to the required real rate of
  return plus compensation for expected inflation.

i r ? r ?

• i is nominal rate, r is real rate, ? is expected
  rate of inflation.
• FE good for short maturity bonds, NOT long
  maturity ones.
• Why?

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International Fisher effect

• International Fisher effect (Fisher-open)
• spot exchange rate change equals opposite of
  interest rate differential.
• where S is indirect quote.
• Direct Quotes US/ Foreign Currency.
• Indirect Quotes Foreign Currency / US.
• Fisher-open not precise in short-term.
• Why?
• Should include forex risk premium.

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Forward Rate

• Forward Rate
• A forward rate exchange rate quoted today for
  settlement _at_ future date

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Forward Rate

• Spot rate SF 1.48/
• 90-day euro Swiss franc deposit rate 4 p.a.
• 90-day euro-dollar deposit rate 8 p.a.

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Premium or discount?

• Forward premium or discount difference b/n
  spot forward rates in annual percentage terms.
• For indirect quotes (FC per home currency, FC/)
  then
• Swiss franc sells forward _at_ premium 3.96 p. a.
• (takes 3.96 more US to get franc at 90-day
  forward rate)
• For direct quotes (/FC), use (F-S)/S.

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Currency Yield Curve Forwards
19
Interest Rate Parity (IRP)

• Interest rate paritydifference in national
  interest rates for securities of similar risk
  maturity should be equal to opposite of forward
  rate discount/ premium for foreign currency.
• or

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Interest Rate Parity (IRP)
90 days
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Covered Interest Arbitrage (CIA)

• Because spot forward markets are not in
  equilibrium, arbitrage exists.
• Covered interest arbitrage (CIA) invests in
  currency that offers higher return on covered
  basis.

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Covered Interest Arbitrage (CIA)
180 days
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Uncovered Interest Arbitrage (UIA)

• Uncovered interest arbitrage (UIA) investors
  borrow in currencies w/ low interest rates
  convert proceeds into currencies w/ high interest
  rates.
• Uncovered because investor does not sell the
  currency forward.

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Uncovered Interest Arbitrage (UIA) The Yen
Carry Trade
Then exchanges the yen proceeds for US
dollars, investing in US dollar money markets
for one year
360 days
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Interest Rate Parity (IRP) Equilibrium
4
3
Percentage premium on foreign currency ()
2
1
4.83
-5
-3
-1
-4
-2
2
4
1
3
5
-6
6
-1
-2
-3
Percent difference between foreign () and
domestic () interest rates
X
U
-4
Y
Z
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Forward Rate - Unbiased Predictor?
S1