parity conditions in international finance and currency forecasting
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Parity Conditions in International Finance and Currency Forecasting. Chapter 8. PART I. ARBITRAGE AND THE LAW OF ONE PRICE. I.THE LAW OF ONE PRICE A.Law states: Identical goods sell for the same price worldwide. B.Theoretical basis: If the price after exchange-rate - PowerPoint PPT PresentationTRANSCRIPT
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Parity Conditions in International Finance and
Currency Forecasting
Chapter 8
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PART I.ARBITRAGE AND THE LAW OF
ONE PRICEI. THE LAW OF ONE PRICE
A. Law states:Identical goods sell for the same price worldwide.B. Theoretical basis:If the price after exchange-rate adjustment were not equal, arbitrage in the goods worldwide ensures eventually it will.
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ARBITRAGE AND THE LAW OF ONE PRICE
C. Five Parity Conditions Result From
These Arbitrage Activities
1. Purchasing Power Parity (PPP)
2. The Fisher Effect (FE)3. The International Fisher
Effect(IFE)
4. Interest Rate Parity (IRP)5. Unbiased Forward Rate
(UFR)
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ARBITRAGE AND THE LAW OF ONE PRICE
D. Five Parity Conditions Linked by
1. The adjustment of variousrates and prices to inflation.
2. The notion that money should
have no effect on real variables (since they have
beenadjusted for price changes).
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ARBITRAGE AND THE LAW OF ONE PRICE
E. Inflation and home currency depreciation are:
jointly determined by the growth of domestic money
supply relative to the growth of
domestic money demand.
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PART II.PURCHASING POWER PARITY
I. THE THEORY OF PURCHASINGPOWER PARITY is based on law of one price, and the no-arbitrage condition(internationally)
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PURCHASING POWER PARITY
II. ABSOLUTE PURCHASING POWER PARITYA. Price levels (adjusted for
exchange rates) should beequal between countries
B. One unit of currency has same
purchasing power globally.
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PURCHASING POWER PARITY
III. RELATIVE PURCHASING POWER PARITY
A. states that the exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries.
B. Real exchange rate stays thesame.
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PURCHASING 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
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PURCHASING POWER PARITY
2. If purchasing power parity is expected to hold, then the bestprediction for the one-periodspot rate should be
e1 = e0(1 + ih)1
(1 + if)1
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PURCHASING POWER PARITY
3. A more simplified but less precise
relationship is
e1 - e0 = ih - if
e0
that is, the percentage change should be approximately
equal tothe inflation rate differential.
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PURCHASING POWER PARITY
4. PPP says the currency with the higher
inflation rate is expected to depreciate relative to the currency with the lower rate of inflation.
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PURCHASING POWER PARITY
B. Real Exchange Rates:the quoted or nominal rate
adjustedfor it’s country’s inflation rate
e’t = et (1 + if)t = e0
(1 + ih)t
*real exchange rate remains constant
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PURCHASING POWER PARITY
C. Real exchange rates1. If exchange rate adjust to
inflation differential, PPP states that real exchange
rates stay the same.2. Competitive positions of
domestic and foreign firmsare unaffected.
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PART III.THE FISHER EFFECT
I. THE FISHER EFFECTstates that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations.
R = a + i
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THE FISHER EFFECT
B. Real Rates of Interest1. Should tend toward equality everywhere through arbitrage.2. With no government interference nominal rates vary by inflation differential or
rh - rf = ih - if
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THE FISHER EFFECT
C. According to the Fisher Effect,countries with higher inflation rates have higher interest
rates.D. Due to capital market
integration globally, interest rate differentials are eroding.
E. Real interest rate differences can exists due to currency
risk and country risk.
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PART IV.THE INTERNATIONAL FISHER
EFFECTI. IFE STATES:
A. the spot rate adjusts to the interest rate differential between two
countries.B. PPP & FE ---> IFE
et = (1 + rh)t
e0 (1 + rf)t
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THE INTERNATIONAL FISHER EFFECT
B. Fisher postulated1. The nominal interest rate
differential should reflect the inflation rate differential.
2. Expected rates of return are equal in the absence of government intervention.
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THE INTERNATIONAL FISHER EFFECT
C. Simplified IFE equation:
rh - rf = e1 - e0
e0
interest rate differential is equal to change in the exchange rate
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THE INTERNATIONAL FISHER EFFECT
D. Implications if IFE1. Currency with the lower
interest rate expected to appreciate relative to
onewith a higher rate.
2. Financial market arbitrageinsures interest rate differentialis an unbiased predictor of
change in future spot rate.3. Holds if the IR differential is
due to differences in expectedinflation.
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PART V.INTEREST RATE PARITY
THEORY
I. INTRODUCTIONA. The Theory states:
the forward rate (F) differs from the spot rate (S) at equilibrium
by an amount equal to the interest rate differential (rh - rf) between two countries.
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INTEREST RATE PARITY THEORY
2. The forward premium ordiscount equals the
interestrate differential. F - S/S = (rh - rf)
where rh = the home rate
rf = the foreign rate
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INTEREST RATE PARITY THEORY
3. In equilibrium, returns oncurrencies will be the samei. e. No profit will be realized
and interest rate parity exits which can be
written
(1 + rh) = F
(1 + rf) S
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INTEREST RATE PARITY THEORY
Interest rate parity is assured by the no-arbitrage condition.
B. Covered Interest Arbitrage1. Conditions required:
interest rate differential doesnot equal the forward premiumor discount.
2. Funds will move to a countrywith a more attractive rate.
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INTEREST RATE PARITY THEORY
3. Market pressures develop:
a. As one currency is moredemanded spot and soldforward.
b. Inflow of funds depressesinterest rates.
c. Parity eventually reached.
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INTEREST RATE PARITY THEORY
C. Interest Rate Parity states:1. Higher interest rates on a
currency offset by forwarddiscounts.
2. Lower interest rates are offset
by forward premiums.Deviations from IRP are small
and short-lived.Deviations may be caused by
taxes, transaction costs, capital controls.
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PART VI.THE RELATIONSHIP BETWEEN THE FORWARD AND THE FUTURE SPOT
RATEI. THE UNBIASED FORWARD RATE
A. States that if the forward rate isunbiased, then it should reflect
the expected future spot rate.
B. Stated asf0(t) = et
C. Usually holds, at least in terms of the direction (not necessarily the
magnitude).
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PART VII.CURRENCY FORECASTINGI. FORECASTING MODELS
A. have been created to forecast exchange rates in addition to parity conditions.B. Two types of forecast:
1. Market-based 2. Model-based
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CURRENCY 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
predict exchange rates beyond one year.
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CURRENCY FORECASTING
2. MODEL-BASED FORECASTSEmploy 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 data2. Charting and trend analysis