International Parity Conditions

1 / 26

# International Parity Conditions - PowerPoint PPT Presentation

International Parity Conditions. (or chapter 4). Agenda. What is PPP &amp; law of one price? What is exchange rate pass-through? How do interest rates &amp; exchange rates link? Interest rate parity? What is covered interest arbitrage? What is uncovered interest arbitrage?. ¥. \$.

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.

## PowerPoint Slideshow about 'International Parity Conditions' - baldwin

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript

### International Parity Conditions

(or chapter 4)

Agenda
• What is PPP & law of one price?
• What is exchange rate pass-through?
• How do interest rates & exchange rates link?
• Interest rate parity?
• What is covered interest arbitrage?
• What is uncovered interest arbitrage?

¥

\$

Prices and Exchange Rates
• Law of one price:
• product’s price same in all markets

P\$ S = P¥

• where spot exchange rate is S, yen per dollar.
Purchasing Power Parity & Law of One Price

• spot exchange rate is determined by relative prices of similar basket of goods.

• Relative change in prices b/n countries determines change in forex rate.
Absolute PPP: Big Mac Index
• Economist’s Big Mac PPP:
• Big Mac in China costs Yuan 9.90.
• Big Mac in US costs \$2.71.
• Implied PPP exchange rate

Economist,

4/ 2003

4

P

PPP line

3

2

1

-6

-5

-4

-3

-2

-1

1

2

3

4

5

6

-1

-2

-3

-4

Relative PPP

% change spot rate foreign currency

US\$/ yen

InfJAPAN- InfUS

But:
• PPP is not very accurate predictor…
• Why?
• PPP holds well over very long term…
• PPP holds better for countries w/ high inflation & underdeveloped capital markets…
• Why?
Is forex under-/over- valued?
• Use forex indices: trade-weighted bilateral exchange rates b/n the home country & trading partners
• Nominal exchange rate index : use actual exchange rates.
• Real effective exchange rate index indicates how the weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period.
Q:
• Can you tell when a currency is overvalued?
• Why the real exchange rate deviates from 100?

Real Effective Exchange Rate Indices

United States & Japan (1995 = 100)

€/\$

Exchange Rate Pass-Through
• Pass-through: change in prices of imported/exported goods when exchange rate changes
• BMW made in Germany cost @ spot rate US\$ 35,000.
• where P\$ is the price in US\$, P€ is price in euros, S is spot rate
• Euro appreciates by 20%. But BMW is now only \$40,000.
• Pass-through:
• Degree of pass-through: 14.29 % / 20 % = 0.71 or 71 %
Interest Rates & Exchange Rates?
• What is a fair nominal interest rate?
• Fisher Effect:nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation.

i = r +  + r 

• iis nominal rate, r is real rate,  is expected rate of inflation.
• FE good for short maturity bonds, NOT long maturity ones.
• Why?

FC

International Fisher effect
• International Fisher effect (Fisher-open):

spot exchange rate change equals opposite of interest rate differential.

where S is indirect quote.

• Direct Quotes: US\$/ Foreign Currency.
• Indirect Quotes: Foreign Currency / US\$.
• Fisher-open not precise in short-term.
• Why?
• Should include forex risk premium.
Forward Rate
• Forward Rate
• A forward rate: exchange rate quoted today for settlement @ future date
Forward Rate
• Spot rate SF 1.48/\$
• 90-day euro Swiss franc deposit rate 4% p.a.
• 90-day euro-dollar deposit rate 8% p.a.
• Forward premium ordiscount : % difference b/n spot & forward rates in annual percentage terms.
• For indirect quotes (FC per home currency, FC/\$) then
• Swiss franc sells forward @ premium 3.96% p. a.

(takes 3.96% more US\$ to get franc at 90-day forward rate)

• For direct quotes (\$/FC), use (F-S)/S.

Interest

yield

Euro yield curve

6.0 %

5.0 %

low interest rate currrency

4.0 %

Eurodollar

yield curve

3.0 %

2.0 %

1.0 %

1

2

3

4

5

6

Months

Currency Yield Curve & Forwards
Interest Rate Parity (IRP)
• Interest rate parity:difference in national interest rates for securities of similar risk & maturity should be equal to opposite of forward rate discount/ premium for foreign currency.

or

Interest Rate Parity (IRP)

i \$ = 8 % per annum

(2 % 90 days)

Start

End

 1.02

\$1,000,000

\$1,020,000

\$1,019,993

Dollar money market

S = SF 1.4800/\$

F90 = SF 1.4655/\$

Swiss franc money market

 1.01

SF 1,480,000

SF 1,494,800

i SF = 4 % per annum

(1 % 90 days)

90 days

Covered Interest Arbitrage (CIA)
• Because spot & forward markets are not in equilibrium, arbitrage exists.
• Covered interest arbitrage (CIA): invests in currency that offers higher return on covered basis.

Eurodollar rate = 8.00 % per annum

Start

End

Arbitrage

Potential

 1.04

\$1,000,000

\$1,040,000

\$1,044,638

Dollar money market

S =¥ 106.00/\$

F180 = ¥ 103.50/\$

Yen money market

 1.02

¥ 106,000,000

¥ 108,120,000

Euroyen rate = 4.00 % per annum

Covered Interest Arbitrage (CIA)

180 days

Uncovered Interest Arbitrage (UIA)
• Uncovered interest arbitrage (UIA): investors borrow in currencies w/ low interest rates & convert proceeds into currencies w/ high interest rates.
• “Uncovered” because investor does not sell the currency forward.

Investors borrow yen at 0.40% per annum

Start

End

 1.004

¥ 10,000,000

¥ 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

 1.05

\$ 83,333,333

\$ 87,500,000

Invest dollars at 5.00% per annum

Uncovered Interest Arbitrage (UIA): The Yen Carry Trade

Then exchanges

the yen proceeds

for US dollars,

investing in US

dollar money

markets for

one year

360 days

Interest Rate Parity (IRP) & Equilibrium

4

3

foreign currency (¥)

2

1

4.83

-6

-5

-4

-3

-2

-1

1

2

3

4

5

6

-1

-2

-3

Percent difference between

foreign (¥) and domestic (\$)

interest rates

X

U

-4

Y

Z

Exchange rate

F2

S2

Error

Error

F3

F1

S3

Error

S4

Time

t 1

t 2

t 3

t 4

Forward Rate - Unbiased Predictor?

S1