International Parity Conditions . By : Madam Zakiah Hassan 9 February 2010. Introduction Exchange rates are influenced by interest rates and inflation rates and together, they influence markets for exchange rates in the future, known as forward rates.
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International Parity Conditions
By : Madam Zakiah Hassan
9 February 2010
Exchange rates are influenced by interest rates and inflation rates and together, they influence markets for exchange rates in the future, known as forward rates.
Means that, the main determinants of exchange rates are relative inflation rate, interest rates, national income and political stability.
The linkages among these variables are called ‘parity conditions’
Parity conditions are key relationship used to predict movements in exchange rates.
Since arbitrage plays a critical role in this discussion, we should define it upfront.
Learn how to predict foreign exchange rates using arbitrage arguments.
What is arbitrage
Business operation involving the purchase of foreign exchange gold, financial securities or commodities in one market and their almost simultaneous sale in another market, in order to profit from price differentials existing between the markets.
Arbitrage generally tends to eliminate price differentials between markets.
the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain profit.
Purchasing power parity (PPP) and Law of one price (LOP)
International Fisher Effect (IFE)
Fisher Effect (FE)
Interest Rate Parity (IRP)
Forward rates as unbiased predictors of future spot rates (UFR)
Exchange Rate Forecasts
Purchasing Power Parity
Differences in Interest Rates
The four parity conditions are all inter linked.
A change in price level ( inflation rate ) in the commodity market will affect the market interest rate.
A change in the market interest rate will then, in turn, affect the future spot rate (IFE) and the forward market through IRP.
The four main theoretical relationship among the S, F, P (inf), and I are shown in previous graph.
PPP is based on law of one price (LOP) and the no arbitrage condition.
LOP states : identical goods sell for the same price worldwide
Stated that in the absence of transportation cost, taxes and other restrictions, meanwhile the price of a product stated in a common currency such as USD should be the same in every country.
This means ‘ same product, same price’’ in one common currency.
Since the product is sold in different countries, the product’s price must be stated in different currency terms, but the price of the product should still be the same when expressed in one common currency.
So, PPP states : the exchange rate between two countries’ currencies should be equal to the ratio of their price levels.
PPP is a manifestation of the LOP applied internationally to a standard commodity basket.
(1) Absolute PPP
Goods and services should cost the same regardless of the country
This simply requires replacing a single product with a price index.
Example : if the price index in USD is the price of basket of goods in the US and a price index in AUD is the price of a similar basket of goods in Australia, then :
Price index USD = Price index AUD ( spot USD/AUD)
Problem : difficult of getting similar basket goods for both countries, because due to each country’s different consumption patterns.
(2) Relative PPP
The exchange rate is expected to adjust in order to reflect expected relative differences in purchasing power.
-----the exchange between HC and any FC will adjust of reflect changes in the price levels ( inflation) of two countries.
1.In mathematical terms:
where et = future spot rate
e0= spot rate
ih= home inflation
if = foreign inflation
t= the time period
2.If purchasing power parity is
expected to hold, then the best
prediction for the one-period
spot rate should be
US inflation 4%
Australia inflation 8%
Current spot is USD 0.8034 per AUD
Spot rate = (1 + 0.04) / ( 1 + 0.08 ) * 0.8034
= USD 0.7736 per AUD
the spot rate adjusts to the interest rate differential between two countries.
IFE = PPP + FE
Assume that American has USD 1 M to invest either in the UK or USA given the following information:
Spot rate USD 1.68/GBP
Forward rate USD 1.6066/GBP
UK interest rate 13 % p.a
USA interest rate 8.0625% p.a
Two alternative :
Alternative 1 : invest in USA & get USD 1,080,625 after one year ( 1M X 1.080625)
Alternative 2 :
Take advantage of the higher interest rate by investing in UK
USD 1 Million / 1.68 = GBP 595,238.
GBP 595,238 X 1.13 = GBP 672,619
Sell immediately one year forward at forward rate to get back USD
GBP 672,619 X 1.6066 = USD 1,080,630.
Arbitrage profit = USD 1 M – USD 1,080,630 = USD 80,630
Why doing covered interest rate because to protect against risk that pound will depreciate in one year.
Suppose that the current one year interest rate in the US is 9.4% and the UK interest rate is 11%. The spot rate is USD1.5 per GBP.
In this chapter, we learned about five parity conditions or relationship apply to spot rates, inflation rates and interest rates in different currencies: PPP, FE, IFE,IRP and forward rates as an unbiased forecast of the future spot rate or UFR.
International trade or exchange of goods and services across borders gives rise to international settlement with payments being made in different currencies.
Discrepancies may arise as a consequences when the settlement is executed in one currency as against the other currency. Moreover, economic conditions and changes in economic conditions in different countries may take effect on the value of goods measured in different currencies and the relative values and opportunity costs of these currencies.
International parities are important since they establish relative currency values and their evolution in terms of economic circumstances and cross broader arbitrage may be possible when they are violated.