Price levels adjusted for exchange rates should be equal between countries purchasing power globally... states that the exchange rate of adjust to reflect changes in the price levels o
Trang 1Parity Conditions in
International Finance and
Currency Forecasting
Chapter 8
Trang 3ARBITRAGE AND THE LAW OF
ONE PRICE
C Five Parity Conditions Result From
These Arbitrage Activities
2 The Fisher Effect (FE)
3 The International Fisher Effect
(IFE)
4 Interest Rate Parity (IRP)
Trang 4ARBITRAGE AND THE LAW OF
ONE PRICE
D Five Parity Conditions Linked by
rates and prices to inflation.
have no effect on real variables (since they have been
adjusted for price changes).
Trang 5ARBITRAGE AND THE LAW OF
ONE PRICE
E Inflation and home currency depreciation are:
growth of
domestic money demand.
Trang 6PART II.
PURCHASING POWER PARITY
I THE THEORY OF PURCHASING
POWER PARITY
is based on law of one price, and the no-arbitrage condition (internationally)
Trang 7PURCHASING POWER PARITY
II ABSOLUTE PURCHASING
POWER PARITY
A Price levels (adjusted for
exchange rates) should be equal between countries
purchasing power globally.
Trang 8PURCHASING POWER PARITY
PARITY
A states that the exchange rate of
adjust to reflect changes in the price levels of the
B Real exchange rate stays the
same.
Trang 9PURCHASING POWER PARITY
1 In mathematical terms:
et = (1 + ih)t e0 (1 + if)t where et = future spot rate
e0 = spot rate
ih = home inflation
if = foreign inflation
t = time period
Trang 10PURCHASING POWER PARITY
2 If purchasing power parity is
expected to hold, then the best prediction for the one-period spot rate should be
e1 = e0(1 + ih)1
(1 + if)1
Trang 11PURCHASING POWER PARITY
3 A more simplified but less precise
relationship is
e1 - e0 = ih - if e0
approximately equal to
the inflation rate differential.
Trang 12PURCHASING POWER PARITY
4 PPP says
Trang 13PURCHASING POWER PARITY
B Real Exchange Rates:
the quoted or nominal rate adjusted for it’s country’s inflation rate
e’t = et (1 + if)t = e0
(1 + ih)t
*real exchange rate remains constant
Trang 14PURCHASING POWER PARITY
C Real exchange rates
1 If exchange rate adjust to
domestic and foreign firms are unaffected.
Trang 15PART III.
THE FISHER EFFECT
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
Trang 16THE 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
Trang 17THE FISHER EFFECT
C According to the Fisher Effect,
countries with higher inflation rates have higher interest rates.
differentials are eroding.
E Real interest rate differences
Trang 18PART IV.
THE INTERNATIONAL FISHER
EFFECT
I IFE STATES:
A the spot rate adjusts to the interest
rate differential between two
countries.
B PPP & FE -> IFE
Trang 19THE INTERNATIONAL FISHER
EFFECT
B Fisher postulated
1 The nominal interest rate
rate differential.
2 Expected rates of return are equal in the absence of
government intervention.
Trang 20THE INTERNATIONAL FISHER
Trang 21THE INTERNATIONAL FISHER
EFFECT
D Implications if IFE
interest rate expected to appreciate relative to one
with a higher rate
insures interest rate differential
is an unbiased predictor of change in future spot rate.
3 Holds if the IR differential is
due to differences in expected
Trang 22PART V.
INTEREST RATE PARITY
THEORY
I INTRODUCTION
A The Theory states:
the forward rate (F) differs from
Trang 23INTEREST RATE PARITY
THEORY
discount equals the interest rate differential.
F - S/S = (rh - rf) where rh = the home rate
rf = the foreign rate
Trang 24INTEREST RATE PARITY
THEORY
3 In equilibrium, returns on
currencies will be the same
i e No profit will be realized
and interest rate parity exits which can be written (1 + rh) = F
(1 + rf) S
Trang 25INTEREST RATE PARITY
Trang 26INTEREST RATE PARITY
THEORY
3 Market pressures develop:
demanded spot and sold forward.
b Inflow of funds depresses
interest rates.
c Parity eventually reached.
Trang 27INTEREST RATE PARITY
THEORY
C Interest Rate Parity states:
1 Higher interest rates on a
currency offset by forward discounts.
2 Lower interest rates are offset
Trang 28PART 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
f0(t) = et
C Usually holds, at least in terms of the direction (not
Trang 30CURRENCY FORECASTING
1 MARKET-BASED FORECASTS
Derived from market indicators.
A the current forward rate contains implicit
information about exchange rate changes for one year.
B Interest rate differentials may be used to
Trang 31CURRENCY FORECASTING
2 MODEL-BASED FORECASTS
Employ fundamental and technical analysis.
A Fundamental relies on key
macroeconomic variables and policies which
most like affect exchange rates.
B Technical relies on use of
1 Historical volume and price data
2 Charting and trend analysis