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Parity Conditions in International Finance

Parity Conditions in International Finance. International Fisher Effect. The Fisher Effect Nominal interest rate is made up of two components A real required rate of return An inflation premium equal to the expected amount of inflation (1 + r n ) = (1 + r r ) (1 + i)

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Parity Conditions in International Finance

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  1. Parity Conditions in International Finance

  2. International Fisher Effect • The Fisher Effect • Nominal interest rate is made up of two components • A real required rate of return • An inflation premium equal to the expected amount of inflation • (1 + rn ) = (1 + rr) (1 + i) • The generalized version of the Fisher effect says that real returns are equalized across countries through arbitrage

  3. If expected real returns are higher in one country than another, capital will flow from country with lower real returns to a country with higher real returns • This process will continue until returns are equalized across countries

  4. In equilibrium, with no government interference, nominal interest rate differential will approximately equal the the anticipated inflation differential • Thus, currencies with high inflation rates should bear higher interest rates than currencies with lower low inflation rates • This relationship between anticipated exchange rate movements and the nominal level of interest rates is called the International Fisher Effect.

  5. If domestic interest rates exceed foreign interest rates, then the foreign currency must appreciate enough (or domestic currency must depreciate enough) to offset any benefit of higher interest rates in home country for the foreigners • If domestic interest rates are less than foreign interest rates, then the foreign currency must depreciate enough to offset any benefit of higher interest rates in foreign country for the domestic investor

  6. Lessons of IFE • Anticipated exchange rate changes can be derived from inspecting differences in nominal interest rates • The actual return to investors who invest in money market securities in their home country is simply the interest rate offered on those securities in their home country • The actual return to investors who invest in foreign money market securities depends on not only the foreign interest rate, but also on the percentage change in the value of foreign currency.

  7. Lessons of IFE • Effective return on home investment should on an average be equal to the effective return on a foreign investment

  8. Why IFE may not hold?

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