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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

International Finance Mojmir Mrak

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

CONTENTS AND PURPOSE1. 2. 3. 4. 5. The Purchasing Power Parity Theory The Interest Rate Parity Theory The Fisher Effect The International Fisher Effect Forward Rate as an Unbiased Predictor of the Future Spot Rate 6. Synthesis of the Parity Conditions Theories in International Finance get acquainted with the conceptual basis for the analysis of exchange rate changesInternational Finance Mojmir MrakCONTENTS END

" Purpose:

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

1. The Purchasing Power Parity Theory PPP Concept" Basic logic: the exchange rate between two currencies should ensure that the Law of One Price holds not only with respect to one good, but with respect to an identical basket of goods and services in the two countries

" Assumptions of the Law of One Price: zero transport costs, no barriers full information identical quality of goods and services, universal basket of goods and servicesInternational Finance Mojmir MrakCONTENTS END

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

Absolute Version of PPP" spot exchange rate is determined by the relative prices of similar baskets of goodss0 ! p$ p DEM

Relative Version of PPP and Mathematical Derivationst s 0 s0International Finance Mojmir MrakCONTENTS

e e T $ T DEM e 1 T DEM Page 4

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

Empirical Tests of PPP" interpretation problems: which prices should be used to calculate the price level? short run or long run?

" problems of the theory: unrealistic assumptions statistical problems (identical basket of goods?) ignores capital flows cause-and-effect relationship between the exchange rate and prices?

International Finance Mojmir Mrak

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

Empirical Tests of PPP

" Empirical tests results: long run traded goods and services sector countries that are geographically close to each other high rates of inflation in comparison to their trading partners

" Best usage: long-run target exchange rate to which the exchange rate between two currencies should move

International Finance Mojmir Mrak

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

2. The Interest Rate Parity Theory (IRP) IRP Concept" Basic logic: capital flows between two countries occur as a result of differences in their interest rates size of the difference is extremely important for the size of the difference between spot and forward exchange rates of the two currencies forward rate discount/premium is closely related to the difference in the national interest rates

" Investor can invest at home or abroad: exchange the domestic currency for a foreign currency in the spot market, invest the foreign currency in a foreign money market instrument, convert the resulting proceeds back to the domestic currency in the forward marketInternational Finance Mojmir MrakCONTENTS END

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

IRP and Covered Interest Arbitrage (CIA)" IRP ensures that investments of similar risk yield similar profits " if an investment in a home country and an investment abroad yield the same profit, then there is no possibility for CIA " CIA: no exchange rate risk, because sale/purchase of a foreign currency in the spot market occurs simultaneously with the sale/purchase of the same foreign currency in the forward market

International Finance Mojmir Mrak

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

Empirical Tests of IRP" Deviations from IRP: transaction costs international capital flows barriers political risk investors wish to spread their wealth to decrease risk

" Fairly convincing empirical support: especially euro-currency market transactions deviations from IRP are mainly the result of capital controls, taxes and other capital transfer tariffs and transaction costs

International Finance Mojmir Mrak

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

3. The Fisher Effect FE Concept" Basic logic: arbitrage causes the equalization of the real rates of return, the real interest rates

" balance will be reached when the difference in nominal interest rates will be equal to the difference in expected rates of inflation

International Finance Mojmir Mrak

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

Empirical Tests of FE" countries with higher rates of inflation have higher nominal interest rates " arbitrage that occurs with enormous international capital flows forces the real interest rates in the most important countries to converge to the same level " national capital markets segmentation: main explanation for empirically low correlation between nominal interest rates and expected rates of inflation

International Finance Mojmir Mrak

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

4. The International Fisher Effect IFE Concept" Basic logic: difference in real interest rates will initiate international capital flows

" Assumptions: perfect competition in the goods market and in the financial market all countries consume an identical basket of goods certainty and identical risk of domestic and foreign securities perfect international capital mobility

International Finance Mojmir Mrak

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

The International Fisher Effect and Uncovered Interest Arbitrage (UIP)" UIP: borrow domestic currency at a fixed interest rate and for a given period of time in financial center A exchange the borrowed domestic currency into a foreign currency in financial center B immediately, deposit at a fixed interest rate for the same period of time as the domestic currency was borrowed in financial center A domestic currency is bought at the end of the period at the spot exchange rate that is prevailing at that time risky transaction whose profit/loss depends on the difference in future and current spot exchange rateInternational Finance Mojmir Mrak Page 13

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

Empirical Tests of IFE" validity depends crucially on perfect exchangeability of domestic and foreign securities: perfect international capital mobility investors perception that investments at home and abroad are equally risky

" empirical tests support the idea that the countries with high rates of inflation and high nominal interest rates are usually also the countries whose currencies tend to depreciate " low support to the relationship between the differences in nominal interest rates and the expected movement of the spot exchange rateInternational Finance Mojmir MrakCONTENTS END

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

5. Forward Rate as an Unbiased Predictor of the Future Spot Rate FUS Concept" Assumptions: all relevant information is quickly reflected in both the spot and forward exchange markets low transaction costs perfect capital mobility and identical risk (financial instruments are perfect substitutes)

" spot and forward rate depend completely on the current expectations of economic agentsInternational Finance Mojmir Mrak Page 15

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

Mathematical Derivation and Explanation of FUSf 0 s 0 st s 0 ! s0 s0

" if there exists a forward premium on home currency with respect to the foreign currency, then the home currency is expected to appreciate with respect to the foreign currency

International Finance Mojmir Mrak

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

Empirical Tests of FUS" immediately after 1973: foreign exchange market quite efficient forward rate is the unbiased predictor of spot rate in the short run

" newer empirical tests: impossible to test the foreign exchange market efficiency, the foreign exchange market is not efficient forward discount currencies usually depreciate with respect to the forward premium currencies even if we assume that the forward rate is an unbiased predictor of the future spot rate in the long run, this is not true in every single momentInternational Finance Mojmir MrakCONTENTS END

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

6. Synthesis of the Parity Conditions Theories in International Finance" strong theoretical basis for the understanding and explanation of the international financial environment, especially the factors that influence changes in exchange rates

International Finance Mojmir Mrak

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UNIVERZA V LJUBLJANIFACULTY OF ECONOMICS

Ex ecte ercenta e c an e in ot exc an e rate o ome c rrenc relati ve to orei n c rrenc v o no na t jo val to Forward rate as an unbiased predictor of the future spot rate Purchasing power parity st s0 e !T$ T e s0

For ar

remi m/ i co nt on orei n c rrenc

International Fisher effect st s0 ! i$ i DEM s0

Di erence in ex ecte rate o in l ati on

Interest rate parity 0 s0 ! i$ i s0

Fisher effect e e i $ i DEM ! T $ T DEM

Di erence in intere t rate

International Finance Mojmir Mrak

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f 0 s 0 st s 0 ! s0 s0

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