Chapter 04. International Parity Conditions. International Parity Conditions . Foreign exchange rate quotations Measuring a change in spot rates Prices and exchange rates Law of one price Absolute Purchasing Power Parity (PPP) Relative Purchasing Power Parity
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International Parity Conditions
Home inflation rate is higher, but home currency does not depreciate as much (direct quote goes up). Foreign goods become relatively cheaper to US consumers.
π$ – πFC
Increased purchasing power of foreign goods. Cheaper to buy foreign goods.
Decreased purchasing power of foreign goods. Cheaper to buy domestic goods.
Home interest rate is higher, but home currency does not depreciate (direct quote goes up) as much. It is better to invest in the US. Foreigners will do the same.
i$ – iFC
Lower returns from investing in foreign deposits. Invest in the US.
Higher returns from investing in foreign deposits. Invest abroad.
(2.00 % per 90 days)
Dollar money market
S = SF 1.4800/$
F90 = SF 1.4655/$
Swiss franc money market
i SF = 4.00 % per annum
(1.00 % per 90 days)Interest Rate Parity (IRP)
Note that the Swiss franc investment yields $1,019,993, $7 less on a $1 million investment.
¥ 10,040,000 Repay
¥ 10,500,000 Earn
¥ 460,000 Profit
Japanese yen money market
S = ¥ 120.00/$
S360 = ¥ 120.00/$
US dollar money market
Invest dollars at 5.00% per annumUncovered Interest Arbitrage (UIA): The Yen Carry Trade
the yen proceeds
for US dollars,
investing in US
Note that the final outcome is determined by future spot rate. It is likely to test some nerves!!!
¥appreciates to below ¥114.74/$ you face losses.
t 4Forward Rates as an Unbiased Predictor
The forward rate available today (Ft,t+1), time t, for delivery at future time t+1, is used as a “predictor” of the
spot rate that will exist at that day in the future. Therefore, the forecast spot rate for time St2 is F1; the actual spot rate turns out to be S2. The vertical distance between the prediction and the actual spot rate is the forecast error. When the forward rate is termed an “unbiased predictor,” it means that the forward rate over or underestimates the future spot rate with relatively equal frequency and amount, therefore it misses the mark in a regular and orderly manner. The sum of the errors equals zero.