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Part 1Fundamentals of

International Finance

Lecture n°2Purchasing Power Parity & Interest Rate Parity

International Finance

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Part 1 - Contents

Part 1 : Fundamentals of International Finance (10 hrs) Echange rate determination

Purchasing power parity and interest parity relationsExchange rate determination

Exchange rate management and targets Monetary integration in the European Union The IMF and the provision of finance

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Purchasing Power Parity

Two basic concepts of exchange rate determination Purchasing Power Parity (PPP) Interest Rate Parity

Absolute Purchasing Power Parity - Definition P = S.P* : “law of one price” Domestic Prices = Exchange Rate . Foreign prices P and P* : general price indices Rearranging : S = P/P* The spot exchange rate between 2 currencies is equal to

the ratio of general price levels between the 2 countries.

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Purchasing Power Parity

Absolute Purchasing Power Parity - Definition R = S.P*/P = real exchange rate R = measure of a country’s competitiveness R is constant over time under the PPP model.

Relative Purchasing Power Parity - Definition S = b.P/P* Prices across countries might differ by a constant

factor “b”, accounting for transport costs and information costs.

Focuses on the movements in the exchange rate and the extent to which they reflect differential inflation:

dS/S = dP/P - dP*/P*

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Purchasing Power Parity

Absolute Purchasing Power Parity - Hypotheses Hypotheses

No transports costsPerfect information (on prices in both countries)Homogeneous goodsNo trade barriers

-> Equality brought by arbitrage

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Purchasing Power Parity

PPP absolute & relative - Interpretation ? No precision of causality : does the prices determine the

X rate, or the reverse? Goods included : traded & non traded? If yes, hypothesis

of perfect substitutability and similar productivity levels. If only traded goods included : PPP close to a tautology Short-run or long-run anchor? -> alternative : “cost parity theory”

(more seducing, but same nature of problems)

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Purchasing Power Parity

PPP absolute & relative - Theoretical criticisms (6) Information costs, transport costs, trade barriers : exist,

and could change over time. The direction of causality is unclear -> exchange rates

could determine prices. All disturbances are monetary, or more important than

real ones ->no account of productivity changes in one country.

No account of productivity differential between traded & non-traded goods sectors.

Ignores the role of income in determining exchange rates, and its consequences on a change in Demand.

No role of capital flows. Only focus on exchange of goods.

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Purchasing Power Parity

PPP absolute & relative - Empirical testing Tests of commodity arbitrage, of the absolute

version and on the relative version. Methods used:

RegressionsPlots of dataCointegration tests (for the long-term relationship)

-> Commodity arbitrage appear not to maintain the law of one price. Little empirical support.

Recent multivariate cointegration tests : some support (relative version) for some large currencies.

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Interest Rate Parity

Two basic concepts of exchange rate determination Purchasing Power Parity (PPP) Interest Rate Parity

Interest Rate Parity - Definition Covered interest rate parity (CIP) Uncovered interest rate parity (UIP) Real interest rate parity Unlike the PPP, CIP / UIP theories explicitly

involves the role of capital flows.

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Interest Rate Parity

Covered Interest Rate Parity - Definition CIP states that returns between assets in different

countries should be equalised. If they are not, equalisation is brought by arbitrage. It gives :

(1+it*) . Ft/St = (1+it)

Return of foreign invt = return of domestic invt where :

it* = foreign interest rate ; it = domestic interest rate

Ft = forward exchange rate

St = spot exchange rate

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Interest Rate Parity

Covered Interest Rate Parity - Hypotheses Assets : same risk, same maturity No transaction costs No information costs No control on capital flows

Plus, the transaction of in the forward market implies that there is no foreign exchange risk (risk that S changes while investing abroad).

Arbitrage : Ex. return greater abroad, we have : • (1+it*) . Ft/St > (1+it)

• -> Investors will buy spot rate and sell forward (to invest abroad), causing S to rise and F to fall, getting back to equality.

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Interest Rate Parity

Covered Interest Rate Parity - Empirical tests Methods

Plot the different interest rates separately and compareTest if deviations are significantly different from zeroRegressing the forward premium on (i*-i) : by

• fp = a + b(i*-i); if b=1, a = 0, CIP holds (i*- fp=i)

Deviations not uncommon, supposedly due to :transaction costs (to what extent?)the existence of capital controls (Gibson (1989) : CIP

holds when controls on capital are removed)the existence of political risks : risks of capital controls

or taxes before funds are repatriated.

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Interest Rate Parity

Uncovered Interest Rate Parity - Definition UIP = CIP + foreign exchange risk States that returns between assets in different

countries should be equalised, plus a deviation accounting for exchange risk. It gives :

i* + Se = i where :

i* = foreign interest rate ; i = domestic interest rate Se = expected change in the spot exchange rate

This relation holds if the path of the exchange rate is known with certainty, or if arbitrageurs are risk neutral.

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Interest Rate Parity

i* + Se = i States that if the foreign interest rate is higher

than the domestic rate, then the domestic currency must be expected to appreciate, to maintain this relationship (otherwise : arbitrage).

Uncovered Interest Rate Parity - Hypotheses Rational expectations, i.e., forward market is

efficient Risk neutrality of arbitrageurs If risk aversion of arbitrageurs : introduction of a

risk premium : i* + Se - i =

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Interest Rate Parity

Uncovered Interest Rate Parity - Empirical evidence Difficulties :

Assess expectations on S; Joint test of rational behavior of investors and of

market efficiency (ex. no bubble phenomenon) General result : UIP does not hold

very little empirical support(possibly due to the existence of a risk premium)

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Forward Market

The forward market for foreign exchange Next to arbitrageurs, another important group on

the forex markets : speculators. They deliberately expose themselves to exchange rate risk.

Speculators will trade on the basis of the difference between f (forward) and se (spot expected) at a given time horizon.

Trade until f = se

Hypotheses underlying this relation:Speculators are risk neutralNot prevented from operating on the forward marketNo transaction costs

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Forward Market

We rational behavior hypothesis, we havest = st

e + ut , ut being a random walk (mean : zero)with the arbitrage relation : se= fwe have : st = ft-1 + ut (1)

meaning : ft-1 = non biaised estimator of St

(1) is the efficient market condition relating the actual spot exchange rate to the forward rate.

Tests over market efficiency of forward rates :Difficulty : joint test, both on market efficiency and

on fundamentals of the model supposed to derive se

Methods using regressions and serial autocorrelation tests

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Forward Market

Some results of the econometrical tests : Empirical support of existence of a risk premium (time-

varying), but no clear model of formationThe lagged spot rate (st-1) outperforms the forward rate

at predicting the spot rate -> abnormal profits could have been made, trading on the basis of the difference between the current spot rate and the forward rate at a given time.

Survey data about expectations formation of agents :Expected change in spot rates is not an unbiased

predictor of actual change in the spot rateAgents bias their estimation of spot rates, based on

extrapolation of recent trend -> destabilising expectations on exchange rates.

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Real Interest Rate Parity

Real Interest Rate Parity - Definition Question whether capital flows ensure that real

interest rates are equalised across countries. Important question for government, seeking to

adjust real interest rates to influence behaviour of individual agents.

Real interest rate parity needs PPP and UIP to hold.

Therefore, very few empirical support for RIP for US, UK and European countries, based on regression analysis and graphical evidence.

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Conclusion

Main results of the chapter : Serious theoretical questions on PPP theory and

few empirical support. CIP theory includes the role of capital mobility and

arbitrage. More empirical support of CIP while UIP does not hold empirically.

Relationship between spot and forward rates suggest the existence of a time-varying risk premium and some irrationality of market participants while forming expectations of exchange rates.

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Conclusion

Important policy implications : If agents form their expectations extrapolatively then

a policy of “leaning against the wind” may be beneficial.

That is, a forex market intervention attempting to break a trend in the market.

The existence of a risk premium that assets domestic and abroad are not perfect substitutes, and that interest rates in any country may not be identical to those abroad, even with no particular expectations of spot rate changes.

It also implies that sterilised intervention may work.