ifinance - interest rate parity and purchasing power parity - capapham

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  • 1.Interest Rate Parity &Purchasing power parityPresented byDanish Hasan RamizJunaid Zamir

2. Interest Rate Parity (IRP) 3. Interest Rate Parity The Interest Rate Parity states that theinterest rate difference between twocountries is equal to the percentagedifference between the forwardexchange rate and the spot exchangerate. 4. It plays essential role in foreignexchange markets. The difference between the interestrates in any two countries is the sameas the difference between the forwardand the spot rates of their respectivecurrencies. 5. Interest rate parity A currency is worth what it can earn. The return on a currency is the interest rateon that currency plus the expected rate ofappreciation over a given period. When the returns on two currencies areequal, interest rate parity prevails. 6. ExplanationThe relationship can be seen when you follow thetwo methods an investor may take to convertforeign currency into U.S. dollars. Option A would be to invest the foreign currencylocally at the risk-free rate for a specific timeperiod. Then convert the proceeds from theinvestment into U.S. dollars at the maturity. Option B would be to invest the same dollars in the(U.S.) market for the same time period. When noarbitrageopportunities exist, the cash flows fromboth options are equal. 7. MathematicallyRate of return in local Rate of return in foreign= currency currency 8. In equilibrium, returns on currencies will be thesame i. e. No profit will be realized and interest rate parity exits which can be written(1 + rh) = F(1 + rf) S 9. Violation of IRPIf interest rate parity is violated, then an arbitrageopportunity exists. The simplest example of this is whatwould happen if the forward rate was the same as the spotrate but the interest rates were different, then investorswould: borrow in the currency with the lower rate convert the cash at spot rates enter into a forward contract to convert the cash plus theexpected interest at the same rate invest the money at the higher rate convert back through the forward contract repay the principal and the interest, knowing the latter will beless than the interest received. 10. Implications of IRP If domestic interest rates are less thanforeign interest rates, you will investin foreign country at higher interestrates. Domestic investors can benefit byinvesting in the foreign market 11. Implications of IRP If domestic interest rates are morethan foreign interest rates, you willinvest in domestic market at higherinterest rates Foreign investors can benefit byinvesting in the domestic market 12. Purchasing power parity (PPP) 13. Purchasing power parity (PPP)The purchasing power of a countryscurrency. The number of units ofcurrency required to purchase abasket of goods in Pakistan and thesame basket of goods and servicesthat a USD would buy in United states. 14. Need for PPP Because the exchange rates onlyreflects when goods are traded. Also,currencies are traded for purposesother than trade in goods andservices, e.g., to buy capital assets.Also, different interest rates,speculation or interventions by centralbanks can influence the foreign-exchange market. 15. Purpose Differences in living standardsbetween nations because PPP takesinto account the relative cost of livingand the inflation rates of thecountries, 16. Assumption In the absence of transportation andother transaction costs, competitivemarkets will equalize the price of anidentical good in two countries whenthe prices are expressed in the samecurrency. 17. Example For example, a TV set that sells for 750 CanadianDollars [CAD] in Vancouver should cost 500 USDollars [USD] in Seattle when the exchange ratebetween Canada and the US is 1.50 CAD/USD. Ifthe price of the TV in Vancouver was only 700 CAD,consumers in Seattle would prefer buying the TVset in Vancouver due to which the US consumersbuying Canadian goods will bid up the value of theCanadian Dollar, thus making Canadian goodsmore costly to them. This process continues untilthe goods have again the same price. 18. Fluctuations PPP rate fluctuations are mostly due todifferent rates of inflation in the twoeconomies which would result in thedifference in prices at home andabroad 19. Reasons for different measuresThe main reasons why different measuresdo not perfectly reflect standards of livingare: PPP numbers can vary with the specificbasket of goods used, making it a roughestimate. Differences in quality of goods are hard tomeasure and thereby reflect in PPP. 20. Range and quality of goods Local, non-tradable goods and services (likeelectric power) that are produced and solddomestically. Tradable goods such as non-perishablecommodities that can be sold on theinternational market 21. RankCountryGDP (PPP) $M1 United States14,264,6002 China7,916,4293 Japan4,354,3684 India3,288,3455 Germany2,910,4906 Russia 2,260,907 27 Pakistan 439,558List by the International Monetary Fund (2008) 22. Factors effectingIRP and PPP 23. Factors of PPP Technology Luxury goods Raw materials Energy prices 24. Factors for IRPFactors that influence the level of marketinterest rates include:- Expected levels of inflation- General economic conditions- Monetary policy- Foreign exchange market activity- Foreign investor- Levels of sovereign debt outstanding- Financial and political stability 25. FormulasFo = forward rate} IRPSo = current spot rateic = interest rate in country cib = interest rate in country bS1 = expected spot rate} PPPSo = current spot rateic = expected inflation rate in country cib = expected inflation rate in country b 26. QuestionIRPA Canadian company is expected to receiveKuwaiti dinars in 1 years time. The spot rateis CAD/Dinar 5.4670. The company couldborrow in dinars at 9% or in Canadiandollars at 14%. There is no forward rate forone years time. Predict what the exchangerate is likely to be in one year 27. SolutionSo = 5.4670ic = 14% or 0.14ib = 9% or 0.09F = 5.4670 x (1 + 0.14) (1 + 0.09) F = 5.7178 28. QuestionPPPThe spot exchange rate between UK sterlingand Danish kroner is 1 = 8 kroners.Assuming that there is now purchasingparity an amount of commodity costing110 in UK will cost 880 kroners inDenmark. Over the next year price inflationin denmark is expected to be 5% while in UKit is expected to be 8%. What is theexpected spot exchange rate at the end ofthe year? 29. SolutionSo = 8ic = 5% or 0.05ib = 8% or 0.08S1 = 8 x (1 + 0.05)(1 + 0.08) S = 7.781 30. UK price = 110 x 1.08= 118.80Danish price = 880 x 1.05= 924 Kroner= 924 = 7.78 118.80 31. Thank you

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