lessons iv and v: fx parity conditions · foreign exchange markets an overview of parity conditions...

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International Financial and Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered Interest Rate Parity The Fisher-open condition The Forward Rate Unbiased Focus on the Empirical Evidence Does the PPP Hold in Practice? Does the CIRP Hold in Practice? Does the UIRP Hold in Practice? Terminology To Put It into Practice Lessons IV and V: FX Parity Conditions Monday 30 th March, 2020

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Page 1: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Lessons IV and V: FX Parity Conditions

Monday 30th March, 2020

Page 2: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Table of Contents

An Overview of Parity ConditionsGetting StartedThe Law of One Price and the Purchasing Power ParityThe Uncovered Interest Rate ParityThe Fisher-open conditionThe Forward Rate Unbiased

Focus on the Empirical EvidenceDoes the PPP Hold in Practice?Does the CIRP Hold in Practice?Does the UIRP Hold in Practice?

Terminology

To Put It into Practice

Page 3: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Getting Started

Parity conditions should be thought of as break-evenvalues, where the decision-maker is indifferent between twoavailable strategies.Parity conditions rely heavily on the no free lunchprinciple⇒ violations of parities may give rise to arbitrageopportunities, that would be exploited and reabsorbed in avery short span of time.

Page 4: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

The LoP: an Overview

Ceteris paribus, the price of a product, when converted intoa common currency using the spot exchange rate, is thesame in every country:

PiD = SDF· PiF

with i=i th product

Page 5: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Ceteris Paribus...

There must be no frictions for the LOP to hold, meaningno legal restrictions on the movement of goods, notransportation costs and no tariffs.

Page 6: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

From the LoP to the PPP

If the LOP were to hold for a certain basket of goods andservices, we get the Purchasing Power Parity relation (inabsolute or static form):

PD = SDF· PF

with P= price index of the underlying basket ofgoods/servicesIn intuitive terms, the CIRP applies to financial markets:the PPP can be conceived as a parallel parity conditionreferring to the products market.

Page 7: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Rearranging the Terms...

SPPPDF

= PDPF

I Whenever SDF> SPPP ⇒ the domestic currency (D) is

undervalued or, equivalently, the foreign currency (F)is overvalued

I Whenever SDF< SPPP ⇒ the domestic currency (D) is

overvalued or, equivalently, the foreign currency (F) isundervalued

Page 8: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

From Theory to Practice

In practice, however, it is difficult to test the validity of PPPin absolute form: different baskets of goods are used indifferent countries to compute price indexes, given thattastes and needs differ on an international scale, affectingwhat people buy.Price levels could be substituted with inflations rates⇒ PPPin relative or dynamic terms

Page 9: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

From Static to Dynamic PPP I

Suppose that at time t0:

PD = SDF· PF

In 1 year time it will be:

PD · (1 + ∆PD) = SDF· (1 + ∆SD

F) · PF · (1 + ∆PF )

Divide the latter by the former and get:

(1 + ∆PD) = (1 + ∆SDF

) · (1 + ∆PF )

Page 10: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

From Static to Dynamic PPP II

Rearranging the terms:

∆SDF

= (1+∆PD)(1+∆PF ) − 1

Or, equivalently:

∆SDF

= (∆PD−∆PF )(1+∆PF )

When inflation is relatively low, the above relationshipsimplifies to:

∆SDF' (∆PD −∆PF )

The exchange rate offsets inflation differentials betweencountries.

Page 11: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

From the CIRP to the URIP

Based on the CIRP (Lesson III)

(1 + rD)n =Fn DF

SDF

(1 + rF )n

Assuming risk neutrality and zero transaction costs, itshould be that

FnDF

= SEDF

Substituting:

(1 + rD)n =SE

n DF

SDF

(1 + rF )n

Uncovered Interest Rate Parity: the mathematicalexpression is almost analogous to the one used for CIRP,apart from the fact that foreign exchange exposure is notcovered with a forward exchange contract

Page 12: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Digging a Little Bit Deeper

By definition, it must be that:

SEDF

= SDF· (1 + ∆SE )n

Substituting

(1 + rD)n = (1 + ∆SE )n · (1 + rF )n

Taking the nth-root and multiplying yield

1 + rD = 1 + ∆SE + ∆SE · rF + rF

If we ignore interaction terms, we will get

∆SE = rD − rF

Higher-yield currencies are expected to depreciate

Page 13: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Combining the PPP and the UIRP

If we now combine

∆SE = rD − rF

and

∆SDF

= (∆PD −∆PF )

we get

rD −∆PD = rF −∆PF

Fisher-open condition: real interest rates are equal indifferent countries

Page 14: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Stated in simpler terms...

High-yield currencies carry more inflation risk and tend todepreciate over time

Page 15: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

The Fwd Rate Unbiased

If we assume that

FnDF

= SE DF

we could infer that

Fn DF−SD

Fn·SD

F

=SEDF

−SDF

n·SDF

Fwd Rate Unbiased: Today’s fwd premium/discountequals the expected percentage change in the spot rate

Page 16: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Does PPP hold in practice?

Testing the validity of PPP may be troublesome as aconsequence of:

I Different baskets of goods underlying the price index

I Non tradable goods

I Transaction costs (quotas, tariffs, duties)

I Different consumers’ preferences = Different priceindexes’ weighting schemes

I Oligopolistic markets

Page 17: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Emerging Empirical Evidence

The emerging empirical evidence suggests that:

I PPP performs poorly in the short run

I Prices seem to revert to their PPP levels in the longrun⇒mean reverting processes

I The speed of adjustment towards the PPP level is apositive function of the size of the deviation

I PPP deviations may be permanent if a permanent realshock affects one country but not the other

Page 18: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Persistent Deviations from the PPP

High productivity gains⇓

Higher real income growth⇓

Appreciating (non constant) real exchange rates⇓

Deviations from PPP

Page 19: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

The Balassa-Samuelson Effect I

The Balassa-Samuelson effect focuses on the relationshipamong

Page 20: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

The Balassa-Samuelson Effect II

Would you be able to explain why productivity gainsgenerally go hand in hand with RER appreciations?Can you explain why richer countries tend to exhibitrelatively higher price levels?

Page 21: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Does the CIRP Hold in Practice?

Very closely, but not exactly as a consequence of:

I Execution risk

I Transaction costs (Is it really so? Step back to LessonIII...)

I Political risk

I Tax advantages

I Liquidity risk

Page 22: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

CIRP and Execution Risk

There might be time lags during execution, thus implyingsome extra risk⇒ placing orders takes time and marketprices may change.This tends to create a band around the CIRP line.

Page 23: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

CIRP and TC

Transaction costs do not always contribute to deviationsfrom IRP: Round-trip arbitrages tend to create a bandaround the CIRP line, whilst one-way arbitrages do not(Lesson III)

Page 24: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

CIRP and Political Risk

Political risk involves the uncertainty that while funds areinvested in a foreign country, they may be frozen (theycannot be repatriated), confiscated or even madeinconvertible into other currencies.Investors typically require a risk premium from foreigninvestments versus domestic investments: Political riskcreates a band around the CIRP line.Watch out: The band does not have to be of equal widthon the two sides of the CIRP line, if one country is seen asriskier than the other.

Page 25: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

CIRP and Taxation

As long as tax rates depend on the country in which fundsare borrowed/invested, the interest parity condition will beaffected.

I Withholding taxes

I Differences between the tax rate on income (τI ) andthe tax rate on capital gains (τK )

Page 26: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Withholding tax

Withholding tax: tax applied to foreigners at the source oftheir earnings.Withholding taxes are unlikely to create any band aroundthe parity line if the rate of withholding ≤ the tax rate thatwould be applied to the earnings at home, since domesticwithholding tax credits (purposely designed to avoid doubletaxation) will offset the tax withheld.

Page 27: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Income vs K gains taxation I

rD − rF = 1−τK1−τI

· n ·F 1

nDF−SD

FSD

F

As long as τK < τI ,

1−τK1−τI

> 1

Investors (borrowers) with favourable capital gains treatmentwill prefer investments denominated in currencies trading ata forward premium (discount).

Page 28: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Income vs K gains taxation II

If τK 6= τI , the slope of the CIRP line may be affected.After taxes, if capital gains taxes are paid on foreignexchange earnings, even when hedged, the investor willreceive only (1− τI ) of the interest and (1− τK ) of the gainfrom the forward premium (considered as a K gain).

Page 29: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

CIRP and Liquidity Preferences

Liquidity: refers to how easily, quickly and cheaply anasset can be converted into cash.Suppose the funds put in a covered foreign investment areneeded earlier ⇒ The investor might incur in potentiallosses when monetizing the original investment⇒ Liquiditypreference is likely to create a band around the coveredinterest-parity line.The potential width of the band due to liquiditypreference depends on the likelihood that the funds willbe needed earlier

Page 30: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Empirical Evidence

Empirically, the CIRP seems to hold:

I in the eurocurrency market

I for short term lending/borrowing

Page 31: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Emerging Empirical Evidence

The empirical evidence reveals that the UIRP holds poorlyin the short run.

I Whenever short term interest rates are high, currenciestend to appreciate

I Carry trade strategies are profitable in the short run

I Basket carry trade strategies perform even better

Page 32: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Carry Trade in practice (Q2-2012) I

Intensifying worries about PIIGS⇒ IncreasingGovernment bond yields

Page 33: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Carry Trade in practice (Q2-2012) II

Growing unemployment rates

Page 34: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Carry Trade in practice (Q2-2012) III

Explosive growth in DEBT/GDP ratios

Page 35: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Carry Trade in practice (Q2-2012) IV

Page 36: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Carry Trade in practice (Q2-2012) V

Speculative bet against the EuroWithin our mandate, the ECB is ready to do whatever ittakes to preserve the Euro. And believe me, it will beenough - July 26, 2012

Page 37: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Real Exchange Rate

Real Exchange Rate: broad summary measure of the pricesof one country’s goods and services relative to the prices ofanother’s⇒ useful to asses the purchasing power of acurrency in a foreign country

qDF

=SD

F·PF

PD

Watch out: If PPP holds, the real exchange rate isperfectly constant.

Page 38: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Risk Neutrality

Risk Neutrality: investor attitude according to which thevalue of a sure chance of gain or loss is considered to beequal to an unsure chance of the same amount of gain orloss (Source: The Business Dictionary)

Page 39: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

Carry Trade

Carry Trade: Trading strategy consisting in selling arelatively low interest rate currency and using the fundsto purchase another yielding a higher interest rate

Page 40: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

To Put It into Practice I

5.1: You have been given the following information:

rUSD rGBP SUSDGBP

Fn USDGBP

0.05 0.06 1.5 1.4895

where

I rUSD= annual interest rate on USD short term paper

I rGBP= annual interest on GBP short term paper

On the basis of the foregoing data:

I In which paper would you invest?

I In which currency would you borrow?

I What is the profit from interest arbitrage?

Page 41: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

To Put It into Practice II

5.2: Focus on the table below

Page 42: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

To Put It into Practice III

I Which is the most overvalued currency? Why?

I Which is the most undervalued currency? Why?

Page 43: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

To Put It into Practice IV

5.3: Assume that the inflation rate in Brazil is expected toincrease substantially. How will this affect Brazil’s nominalinterest rates and the value of its currency? If the IFE holds,how will the nominal return to U.S. investors who invest inBrazil be affected by the higher inflation in Brazil? Justifyyour claims.

Page 44: Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered

InternationalFinancial and

Foreign ExchangeMarkets

An Overview ofParity Conditions

Getting Started

The Law of One Priceand the PurchasingPower Parity

The UncoveredInterest Rate Parity

The Fisher-opencondition

The Forward RateUnbiased

Focus on theEmpirical Evidence

Does the PPP Hold inPractice?

Does the CIRP Holdin Practice?

Does the UIRP Holdin Practice?

Terminology

To Put It intoPractice

To Put It into Practice V

5.4: Assume the following information is available for USand Europe:

Nominal rUSD 0.04Nominal rEUR 0.06

Expected InflationUSD 0.02Expected InflationEUR 0.05

SUSDEUR

1.13

F1USDEUR

1.13

I Does the CIRP hold?

I According to the PPP, what is the expected change inthe spot rate of the Euro in one year?

I According to the UIRP, what is the expected change inthe spot rate of the Euro in one year?