Chapter 6: International Parity Conditions

International Parity Conditions

The economic theories that link exchange rates, price levels, and interest rates together

law of one price

If an identical product or service can be sold in two different markets and no restrictions exist on the sale or transportation of the product between markets, the price should be the same in both markets.

Why does the law of one price hold?

If the prices after exchange-rate adjustment were not equal, arbitrage for the goods worldwide ensures that eventually they will

Purchasing Power Parity (PPP)

A theory that the price of internationally traded commodities should be the same in every country, and hence the exchange rate between the two currencies should be the ratio of prices in the two countries.

Absolute Purchasing Power Parity

The theory that the exact rate of exchange between two currencies is found by equalizing the purchasing power of the two currencies.

Absolute PPP

Determining the "real" exchange rate that should exist by comparing the prices of identical products denominated in different currencies if markets were efficient is the absolute version of the PPP theory

Relative Purchasing Power Parity

A theory that if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate.

Relative PPP

The relative change in prices between two countries over a period of time determines the change in the exchange rate over that period.

In relative PPP theory, what causes changes in price levels?

Inflation

In the Relative PPP theory, what determines the exchange rate over that period?

relative changes in prices over a period of time

If PPP holds

- The differential inflation rates between countries are exactly offset by exchange rate changes

- Countries' competitive positions in world export market remains stable

- Changes in nominal exchange rate does not necessarily change the real exchange rateand the competitive positions of the countries

If PPP does not hold

- Changes in nominal exchange rates cause changes in real exchange rates

- Countries' competitive positions in world export market and trade balances change

- Changes in real exchange rate changes the competitive positions of the countries and leads to real exchange gains and losses

If exchange rates adjust to inflation differential...

PPP states that real exchange rates stay the same.

Exchange Rate Pass-Through

The degree to which the prices of imported and exported goods change as a result of exchange rate changes.

How much pass-through will happen in the face of an exchange rate change?

Depends on price elasticity of demand - how demand changes for any good as the prices of it change

price elasticity of demand formula

% change in quantity demanded / % change in price

|ep| < 1.0

price inelastic; → higher degree of pass-through

|ep| > 1.0

price elastic; → lower degree of pass-through

What happens when you have a higher degree of pass through?

- FX revenue increases (as increased prices are charged to align the exchange rate)

- the domestic revenue remains the same.

What happens when you have a lower degree of pass through?

- FX revenue remains stable (as foreign prices are stable but quantities decline)

- the domestic revenue decline.

How is pass through effecting emergent markets?

These countries are experiencing changing exchange rates, exchange rate pass through is a growing source of inflationary pressure and price instability.

Fisher Effect

Nominal interest rates (i) are a function of the real interest rate(r) and a premium (ᴨ) for inflation expectations

Real rates of interest should be equal everywhere through arbitrage
(T or F)

True

Without government intervention, how are differences in nominal rates explained?

By the inflation differential

Currencies with high rates of inflation should have _________ interest rates than currencies with lower rates of inflation

Higher

International Fisher Effect (IFE)

the spot exchange rate should change by an amount equal to the difference in interest rates between two countries.

How would spot exchange rate change under the International Fisher Effect?

Spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries - investors must be rewarded or penalized to offset the expected changes in exchange rates

IFE predicts: with unrestricted capital flows...

the investor should be indifferent to the denomination of investment as arbitrage would ensure that similar opportunities would provide similar returnsS¥=$1.00

The forward rate for any maturity is calculated by:

adjusting the current spot exchange rate by the ratio of eurocurrency interest rates of the same maturity for the two subject currencies.

The currency with the _________ interest rate will sell forward at a discount

Higher

the currency with the __________ interest rate will sell forward at a premium

Lower

Forward premium in foreign currency terms

($, home currency is unit; ¥ is price currency )

Forward premium in home currency terms

($, home currency is unit; ¥ is price currency )

Interest Rate Parity (IRP)

A theory that the differences in national interest rates for securities of similar risk and maturity should be equal to but opposite in sign (positive or negative) to the forward exchange rate discount or premium for the foreign currency (except for transaction costs).

What does IRP do?

Links foreign exchange markets with the international money markets

Why does disequilibrium between interest rates and exchange rates occur?

They can occur because of transaction costs and political risk

covered interest arbitrage

The spot and forward exchange markets are not constantly in the state of equilibrium described by IRP

- When the market is not in equilibrium, the potential for arbitrage profit exists - the arbitrager will move to take advantage of the disequilibrium by investing in which ever currency offers the higher return on a covered basis

How does Covered Interest Arbitrage Work?

The process whereby an investor earns a risk-free profit by (1) borrowing funds in one currency, (2) exchanging those funds in the spot market for a foreign currency, (3) investing the foreign currency at interest rates in a foreign country, (4) selling forward, at the time of original investment, the investment proceeds to be received at maturity, (5) using the proceeds of the forward sale to repay the original loan, and (6) sustaining a remaining profit balance.

Locating Arbitrage: If the difference in interest rates is greater than the forward premium (or expected change in the spot rate),

invest in the higher interest-yielding currency.

Locating Arbitrage: If the difference in interest rates is less than the forward premium (or expected change in the spot rate)

invest in the lower interest yielding currency.

Covered interest arbitrage opportunities continue until...

interest rate parity is reestablished as the arbitragers are able to earn risk-free profits by repeating the cycle as often as possible.

What do the Actions of Arbitragers do?

Their actions, nudge the foreign exchange and money markets back toward equilibrium

Uncovered Interest Arbitrage (UIA)

Investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates

The transaction is "uncovered" - the investor does not sell the higher yielding currency proceeds forward, choose to remain uncovered and accept the foreign exchange risk at the end of the period

Interest Rate Parity and Equilibrium

The disequilibrium situation,
depicted by point U is unstable,
because all investors have an
incentive to execute the same
covered interest arbitrage

Arbitragers' actions will ensure fund
flows to narrow the gap in interest
rates and/or decrease the premium
on the forward yen

unbiased forward rates (UFR) - Forward rate as an unbiased predictor of future spot rate:

Forward rate reflectsthe expected future spot rate of equal maturity

Unbiased prediction means

that the forward rate will, on average, overestimate and under estimate the actual future spot rate in equal frequency and degree

UFR assumes that the foreign exchange market is reasonably efficient. other assumptions:

- All relevant information is quickly reflected in both the spot and forward exchange markets
- Transaction costs are low
- Instruments denominated in different currencies are perfect substitutes for one another

What is forecast error?

The difference between the future actual spot rate and the forward rate

"unbiased predictor of the future spot rate," means

the errors are normally distributed around the mean future spot rate (the sum of the errors equals zero).

In equilibrium, the spot and forward currency markets are aligned with

interest differentials and differentials in expected inflation

Real exchange rate: If exchange rates adjust to inflation differential, real exchange rates _________ and competitive position of firms/countries ____________

Stay the same; remain unchanged