PARITY CONDITIONS AND CURRENCY FORECASTING

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CHAPTER 4

• PARITY CONDITIONS AND CURRENCY FORECASTING

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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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ARBITRAGE AND THE LAW OF ONE PRICE

• B. Theoretical basis
• If the price after exchange-rate
• adjustment were not equal, arbitrage in the
  goods worldwide ensures eventually it will.

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ARBITRAGE AND THE LAW OF ONE PRICE

• C. Five Parity Conditions Result From These
  Arbitrage Activities
• 1. Purchasing Power Parity (PPP)
• 2. The Fisher Effect (FE)
• 3. The International Fisher Effect
• (IFE)
• 4. Interest Rate Parity (IRP)
• 5. Unbiased Forward Rate (UFR)

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ARBITRAGE AND THE LAW OF ONE PRICE

• D. Five Parity Conditions Linked by
• The adjustment of various
• rates and prices to inflation.

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ARBITRAGE AND THE LAW OF ONE PRICE

• E. Inflation and home currency depreciation
• 1. jointly determined by the growth of
  domestic money supply
• 2. Relative to the growth of
• domestic money demand.

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ARBITRAGE AND THE LAW OF ONE PRICE

• F. THE LAW OF ONE PRICE
• - enforced by international
• arbitrage.

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PART II. PURCHASING POWER PARITY

• I. THE THEORY OF PURCHASING
• POWER PARITY
• states that spot exchange rates between
  currencies will change to the differential in
  inflation rates between countries.

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PURCHASING POWER PARITY

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

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PURCHASING POWER PARITY

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

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PURCHASING POWER PARITY

• III. 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.

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PURCHASING POWER PARITY

• 1. In mathematical terms
• where et future spot rate
• e0 spot rate
• ih home inflation
• if foreign inflation
• t the time period

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PURCHASING POWER PARITY

• 2. If purchasing power parity is
• expected to hold, then the best
• prediction for the one-period
• spot rate should be

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PURCHASING POWER PARITY

• 3. A more simplified but less precise
  relationship is
• that is, the percentage change should be
  approximately equal to the inflation rate
  differential.

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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.

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PURCHASING POWER PARITY

• B. Real Exchange Rates
• the quoted or nominal rate adjusted for a
  countrys inflation rate is

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PURCHASING POWER PARITY

• C. Real exchange rates
• 1. If exchange rates adjust to inflation
  differential, PPP states that real exchange
  rates stay the same.

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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.
• R a i

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THE FISHER EFFECT

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

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PART IV. THE INTERNATIONAL FISHER EFFECT (IFE)

• I. IFE STATES
• A. the spot rate adjusts to the interest rate
  differential between two countries.

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THE INTERNATIONAL FISHER EFFECT

• IFE PPP FE

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THE INTERNATIONAL FISHER EFFECT

• B. Fisher postulated
• 1. The nominal interest rate
  differential should reflect the
  inflation rate differential.

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THE INTERNATIONAL FISHER EFFECT

• B. Fisher also postulated that
• 2. Expected rates of return are equal in
  the absence of government intervention.

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THE INTERNATIONAL FISHER EFFECT

• C. Simplified IFE equation
• (if rf is relatively small)

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THE INTERNATIONAL FISHER EFFECT

• D. Implications of IFE
• 1. Currency with the lower interest rate
  is expected to appreciate relative to the one
• with a higher rate.

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THE INTERNATIONAL FISHER EFFECT

• D. Implications of IFE
• 2. Financial market arbitrage
• insures interest rate differential is an
  unbiased predictor of change in future spot
  rate.

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PART VI. INTEREST RATE PARITY THEORY

• I. 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 - rf) between two
  countries.

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INTEREST RATE PARITY THEORY

• 2. The forward premium or
• discount equals the interest
• rate differential.
• (F - S)/S (rh - rf)
• where rh the home rate
• rf the foreign rate

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INTEREST RATE PARITY THEORY

• 3. In equilibrium, returns on
• currencies will be the same
• i. e. No profit will be realized
• and interest parity exists
• which can be written

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INTEREST RATE PARITY THEORY

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

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INTEREST RATE PARITY THEORY

• 3. Market pressures develop
• a. As one currency is more demanded spot and
  sold forward.
• b. Inflow of fund depresses interest rates.
• c. Parity eventually reached.

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INTEREST RATE PARITY THEORY

• C. Summary
• Interest Rate Parity states
• 1. Higher interest rates on a
• currency offset by forward discounts.
• 2. Lower interest rates are offset by
  forward premiums.

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PART VI. THE RELATIONSHIP BETWEEN THE FORWARD
AND THE FUTURE SPOT RATE

• I. THE UNBIASED FORWARD RATE
• A. States that if the forward rate is unbiased,
  then it should reflect the expected future spot
  rate.
• B. Stated as
• ft et