Chapter_6_-_International_Parity_Conditions2

Chapter Overview

• Title: International Parity Conditions

• Course: ECON/FINC 3240

Importance of International Parity Conditions

• Managers, investors, importers, exporters, and government officials frequently grapple with:

  • Determinants of exchange rates

  • Predictability of exchange rate changes

• The theories that interlink exchange rates, price levels, and interest rates form the basis of international parity conditions.

• These conditions are fundamental to international finance theory.

Theories Surrounding Exchange Rate Determination

• Key Questions:

  • Can changes in exchange rates be predicted?

  • Should undervalued currencies be bought while overvalued ones should be sold?

• Determinants of Exchange Rates:

  • Price levels

  • Interest rates

• Connection: Exchange rate movements are linked to variations in price levels and interest rates through international parity conditions.

Prices and Exchange Rates

Law of One Price

• If identical goods are sold in different markets:

  • No sales restrictions and equal transportation costs exist

  • Prices should equate across markets.

• Law of One Price principle highlights the importance of equal pricing in competitive markets.

Market Equilibration

• In competitive markets:

  • Prices will converge without frictions such as transportation costs.

• Price comparison will require currency conversion.

Purchasing Power Parity (PPP)

• Absolute PPP:

  • If the law of one price holds for all products, PPP exchange rates can be derived from any set of prices.

  • We can calculate the 'real' PPP exchange rate from comparative pricing of identical goods in different currencies.

• Big Mac Index:

  • An informal way to examine PPP between currencies, indexed annually by The Economist.

Relative Purchasing Power Parity

• Definition:

  • An extension of absolute PPP, considering relaxed assumptions.

• Principle:

  • Relative PPP explains changes in exchange rates over time based on inflation differentials rather than spot rates.

• Formula:

  • Change in exchange rate inversely proportional to inflation differentials:

  • ( S_2 = S_1 \times \frac{1 + \pi_A}{1 + \pi_B} ) where ( \pi ) represents inflation.

Empirical Testing of PPP

• Findings:

  • PPP holds well over the long run but struggles for prediction over short intervals.

  • More accurate for high-inflation countries and underdeveloped capital markets.

Exchange Rate Pass-Through

Overview

• Measure of how import and export prices respond to exchange rate changes.

• Types:

  • Complete Pass-Through

  • Partial Pass-Through

Complete Pass-Through

• If a good costs €10,000 and the exchange rate changes from $1.00/€ to $1.20/€, the final cost is affected completely reflecting the increased exchange rate.

  • Price rises from $10,000 to $12,000 with full adjustment to currency valuation shifts.

Partial Pass-Through

• Less than full price adjustment occurs as currency values fluctuate.

  • If an item's price adjusts from €10,000 to $11,000 instead of the expected $12,000, the difference relates to demand elasticity.

• Price Elasticity of Demand definition:

  • Quantity demanded changes proportionally to price changes.

Impact on Emerging Market Currencies

• Emerging markets have transitioned from fixed exchange rates to systems allowing capital flow and currency passage pressures, leading to varying levels of exchange rate pass-through

Interest Rates and Exchange Rates

Fisher Effect

• Definition: The theory posits nominal interest rates equal the sum of the real rate of return and expected inflation.

• Equation:

  • ( i = r + \pi + (r \times \pi) )

• Applicable primarily to short-term government securities.

Fisher Effect Example

• If real interest is 5.5% and inflation rate shifts from 2.5% to 3.5%:

  • Nominal interest changes from 8% to 9% indicating a 1% increase.

International Fisher Effect

• Explores the exchange rate's movement relative to interest rates across countries.

• Explains how expected changes in interest influence currency values and exchange rates.

• Formula:

  • ( \frac{S_1 - S_2}{S_2} = i_D - i_F )

Forward Rate

Overview

• Definition: Quoted exchange rate for future settlement, thus facilitating forward exchange agreements.

• Forward Rate Formula:

  • ( F_{90} = S_{FC} = S_{FC} \times \frac{1 + (i_{FC} \times \frac{90}{360})}{1 + (i_{USD} \times \frac{90}{360})} )

Example of Forward Rate Calculation

• With a current spot rate and given interest rates, compute the forward rates which indicate how disparities influence foreign investments.

Interest Rate Parity (IRP)

Theory

• Links FX markets to international money markets, suggesting interest differentials equate to currency premiums/discounts.

Example Application of IRP

• Demonstrates practical use of interest rate parity theory by calculating future currency values based on different investment options in currency and interest interactions.

Covered Interest Arbitrage (CIA)

Definition

• Describes exploiting currency discrepancies when markets misalign, allowing arbitrage for riskless profits.

CIA Example

• Discusses the process of converting and investing in multiple currencies to benefit from differential interest rates.

Uncovered Interest Arbitrage (UIA)

Overview

• Investors engage in borrowing at lower interest rates while placing them in higher yield investments without hedging currency risk.

UIA Example

• Details gaining higher returns by effectively leveraging low-interest rate loans.

Forward Rate as an Unbiased Predictor

Concept

• Forward rates are considered unbiased predictors of future spot rates, with prediction errors averaging around zero.