ppt (parity conditions).pdf

8/19/2019 PPT (Parity Conditions).pdf

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International Finance

Parity Conditions in International Finance


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Parity Conditions

Parity conditions in international financeprovides a framework to understand theinter-relationships between and among

exchange rates, interest rates andinflation rates.


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Parity Conditions

Terms utilized:

spot exchange rate ( )

forward exchange rate ( )

interest rates ( )

inflation rate ( )

home/domestic country (H or D)

foreign country (F)


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Law of One Price

This theory states that the price of a good orfinancial asset (using a common currency) will

be the same in different real or financialmarkets.

The Law of One Price serves as the

foundation for all the parity conditions to beconsidered.


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Law of One Price

The Law of One Price exists due to arbitrageopportunities. Arbitrage will cause prices to

converge across markets, the difference willonly be as a result of transaction andtransportation costs


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Five Parity Conditions

1) Purchasing Power Parity (PPP)

Relationship between spot rates and inflationrates

2) Fisher Effect (FE)

Relationship between interest rates andexpected inflation rates


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3) International Fisher Effect (IFE)

Relationship between domestic and foreigninterest rates and exchange rates

4) Interest Rate Parity (IRP)

Relationship between spot and forwardexchange rates and interest rates


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5) Forward Rates as Unbiased Predictor of

Future Spot Rates (UFR)

Relationship between forward exchange andexpected spot exchange rates


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Purchasing Power Parity

Absolute PPP States that price levels should equalize

worldwide when expressed in a common

currency

Such relationship is more applicable to tradedgoods with no trade restrictions


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Sample Problem:

The US and UK both produce the sametype of wheat. Price of wheat in the US

is $3.25 per bushel and the price ofwheat for the same unit in the UK is£1.35. The exchange rate should be

e = $3.25/ £1.35 = $2.4074/ £


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Relative PPP

States that exchange rate movements areoffset by inflation differentials between twocountries


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Relative PPP

Accurate version

=

Approximate version

=


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Relative PPP

Insights from approximate version of relative PPP

The exchange rate change would equal theinflation rate differential

Currencies affected by high rates of inflationshould devalue or depreciate relative tocurrencies enjoying lower rates of inflation


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Relative PPP

Exchange rate movements should justcancel out the difference in the foreign pricelevel relative to the domestic price level

Offsetting movements in price levels andexchange rates should have no effect onthe relative competitiveness of domestic

firms’ products vis-à-vis foreign products


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Relative PPP

Sample Problem 1

If the US and EU are running annual inflation

rates of 5% and 3%, respectively, and thecurrent spot rate is €1 = $1.07. What wouldbe the spot rate in a year’s time? (US = home)


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Relative PPP

Sample Problem 2

From the base level of 100 in the year 2000,

Japanese and US price levels in 2003 stood at102 and 106, respectively. If the 2000 $/¥exchange rate is $0.007692, what should theexchange rate be in 2003? (US = home)


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Relative PPP

Sample Problem 3

Suppose the EU is the domestic country and

the US is the foreign country. The spotexchange rate quote is $1.25 per euro.Suppose further that the expected annual USinflation rate is 8.91% and the expected EU

annual inflation rate is 12.87%. Calculate theexpected spot rate one year away.


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Relative PPP

Relative PPP generally does not hold for thefollowing reasons:

Goods prices are sticky

Differently constructed price indices Inclusion of non-traded goods and services in

the basket of goods used for determining theCPI


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Real Exchange Rate

The Real Exchange Rate

Offsetting movements in currencies andinflation rates should not affect the relative

competitive positions of countries. Currencychanges that affect relative competitiveness isbest reflected in the real exchange rate


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Fisher Effect

The Fisher Effect states that the nominal rate

of return is comprised of The real required rate of return ( )

An inflation premium ( ) or the inflation rate


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Fisher Effect

The relationship approximately being

The exact version of the relationship is


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Fisher Effect

The exact version of the Fisher Effect canfurther be reduced to

This would mean that financial assets in highinflation countries would bear higher rates of

nominal returns than those in countries with lowerrates of inflation.


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Fisher Effect

Sample Problem 1

If the expected inflation is 100% and the

real required return is 5%, what should thenominal interest rate be according to theFisher Effect?


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Fisher Effect

Sample Problem 2

In early 1996, the short term interest rate in

France was 3.7% and forecast inflation was1.8%. At the same time, short-term Germaninterest rate was 2.6% and forecast Germaninflation was 1.6%. What were the real

interest rates in France and Germany? What accounts for the difference in real

rates between France and Germany?


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International Fisher Effect

IFE states a relationship that links relativeinterest rates to changes in the exchange rate

Exact version:

Approximate version:


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The approximate version states thatfinancial assets with low rates of nominalreturns are expected to experience an

appreciation in its currency value relativeto those countries whose financialassets have higher nominal rates ofreturns.


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Sample Problem 1

The one year interest rate is 12% on Britishpound and 9% on the US dollar

If the current exchange rate is $1.63/£, what isthe expected future exchange rate in one year?

Suppose a change in expectations regardingfuture US inflation (rates) causes the expectedfuture spot rate to decline to $1.52/£, what shouldhappen to the US interest rate?


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Sample Problem 2

Suppose the three-year deposit rates onEurodollars and Eurofrancs (Swiss francs) are

12% and 7%, respectively. If the current spotrate for the Swiss franc is $0.3985/SF, what isthe spot rate implied by these interest rates forthe Swiss franc three years from now?


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International Parity Theory

Interest Parity Theory (IRP)

In countries where there are forward markets,expectations about the forward rate ( ) at

period t is that

IRP establishes a relationship between theforward discount or premium and the interestdifferential between two countries.


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Exact Version:

Approximate Version:

Financial assets with high nominal rates ofreturns are offset by forward discounts and vice

versa.


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Sample Problem

Assume interest rate is 16% on pound sterlingand 7% on euros. At the same time, inflation

is running at an annual rate of 3% in Germanyand 9% in England.

If the euro is selling at a one-year forwardpremium of 10% against the pound, is there anarbitrage opportunity?

What is the real interest rate in Germany? InEngland?


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Forward Rate

The Forward Rate as an Unbiased Predictorof the Future Spot Rate

If markets are efficient and all prices reflect all

forms of information (past, present and future),the forward rate should equal the future spotrate, such that

and that


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Forward Rate

Additional Problems:

Suppose that in Japan the interest rate is 8%and inflation is expected to be 3%. Meanwhile

the expected inflation rate in France is 12%and the English interest rate is 14%. To thenearest whole number, what is the bestestimate of the one-year forward exchange

premium (discount) at which the pound will beselling relative to the euro?


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Forward Rate

Additional Problems: Chase Econometrics has just published projected inflation

rates for the US and Germany for the next five years. USinflation is expected to be 10% per year and German

inflation is expected to be 4% per year. If the current exchange rate is $0.95/ €, forecast the

exchange rate for the next five years.

Suppose US inflation, over the next five years, turns outto average 3.2%, German inflation averages 1.5%, and

the exchange rate in five years is $0.99/ €. What hashappened to the real value of the euro over this five-yearperiod?

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