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Gross Domestic Product [$, Billions, 2008 (CIA/PPP)]

Gross Domestic Product [$, Billions, 2008 (CIA/PPP)]. Gross Domestic Product [$, Billions, 2008 (CIA/PPP)]. Gross Domestic Product [$, Billions, 2008 (CIA/PPP)]. Shapiro: Chapter 4 – The Law of One Price. Chapter 4 Problems. Problem 4.7. The Law of One Price. “Exchange-adjusted prices …

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Gross Domestic Product [$, Billions, 2008 (CIA/PPP)]

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  1. Gross Domestic Product[$, Billions, 2008 (CIA/PPP)]

  2. Gross Domestic Product[$, Billions, 2008 (CIA/PPP)]

  3. Gross Domestic Product[$, Billions, 2008 (CIA/PPP)]

  4. Shapiro: Chapter 4 –The Law of One Price

  5. Chapter 4 Problems • Problem 4.7

  6. The Law of One Price • “Exchange-adjusted prices … • of identical, tradable goods and financial assets … • must be within transaction costs of equality worldwide.”

  7. The Law of One Price • Enforced by arbitrageurs - ??? • Enforced by arbitrageurs - buy in one market and sell in another

  8. “Students Find $100 Textbooks Cost $50, Purchased Overseas”New York Times, 10-21-03

  9. The Law of One Price • Enforced by arbitrageurs - buy in one market and sell in another • Risk-adjusted expected returns on financial assets in different markets should be equal

  10. 5 Key Economic Relationships • Purchasing Power Parity (PPP) • Fisher Effect (FE) • International Fisher Effect (IFE) • Interest Rate Parity (IRP) • Forward Rates as unbiased predictors of future spot rates (UFR)

  11. Exhibit 4.1 Five Key Theoretical Relationships Among Spot Rates, Forward Rates, Inflation Rates, and Interest Rates

  12. Purchasing Power Parity (PPP) • “The ratio between domestic and foreign price levels should equal the equilibrium exchange rate between domestic and foreign currencies.” • $1 = loaf of bread • $1 = £0.6475 • £0.6475 = loaf of bread

  13. Purchasing Power Parity (PPP) • Relative Version: “Exchange rate between the home currency and any foreign currency will adjust to reflect changes in the price levels of the two countries.”

  14. Purchasing Power Parity (PPP) • Inflation = 5% (USA)Inflation = 3% (Switzerland)$ value of SFr must rise by 2% • et (1 + ih)t--- = ------------e0 (1 + if)t 2%

  15. Purchasing Power Parity (PPP) • Inflation = 5% (USA) • Inflation = 3% (Switzerland) • SFr 1 = $0.75 (spot) • What is e3?

  16. Purchasing Power Parity

  17. Purchasing Power Parity

  18. Purchasing Power Parity

  19. Purchasing Power Parity (PPP) • The exchange rate change during a period should equal the inflation differential for that same period. • “Currencies with high rates of inflation should devalue relative to currencies with lower rates of inflation.”

  20. Purchasing Power Parity (PPP) Shapiro: Exhibit 4.4

  21. Fisher Effect • Nominal interest rate (r) consists of: • real required rate of return, a • an inflation premium, i • 1 + r = (1 + a)(1 + i) • Real returns are equalized across countries through arbitrage.

  22. Fisher Effect • ah = af • rh - rf = ih - if • Currencies with high rates of inflation should bear higher interest rates than currencies with lower rates of inflation

  23. Exhibit 4.7 Fisher Effect: Empirical Data, May 2007

  24. International Fisher Effect • “Currencies with low interest rates are expected to appreciate relative to currencies with high interest rates.”

  25. International Fisher Effect

  26. International Fisher Effect • The expected home country (HC) returns from investing at home and abroad should be equal. • 1 + rh = (1 + rf)(e1/e0)

  27. Nominal vs. Real Rate of Interest[TheEconomist, 9-13-08]

  28. Interest Rate Parity (IRP)[Covered Interest Arbitrage] • “A condition where the interest rate differential is approximately equal to the forward differential between two currencies.”

  29. Interest Rate Parity (IRP)[Covered Interest Arbitrage] • Interest rate (London) = 12% • Interest rate (New York) = 7% • £ spot rate: £1 = $1.95 • 1-year forward rate: £1 = $1.88 • Forward differential: • ($1.88 - $1.95) / $1.95 = -3.6% • Rate differential: 12% - 4% = 8%

  30. Forward Rates as Unbiased Predictors of Future Spot Rates (UFR) • “The forward rate should reflect the expected future spot rate on the date of settlement.” • f1 = e1

  31. Forward Rates as Unbiased Predictors of Future Spot Rates (UFR) • Example: • 90-day forward rate: SFr1 = $0.75 • future spot rate: SFr1 = $0.75 • Empirical evidence: • forward rate appears biased • bias caused by risk premium • premium appears to average out

  32. Currency Forecasting • Forecasting requirements: • superior models • superior, consistent information • small, temporary deviations • predict government intervention

  33. Currency Forecasting • Market-based forecasts: • forward rates • interest rate differentials • Model-based forecasts • fundamental analysis • technical analysis

  34. Shapiro: Problem 4-7a • iUSA = 10% • iGDR = 4% • 1€ = $0.95 • Exchange rates for next five years? • €t = $0.95(1.10/1.04)t

  35. Shapiro: Problem 4-7a

  36. Shapiro: Problem 4-7b • iUSA = 3.2% • iGDR = 1.5% • e5 = $0.99/€ • Real value of the €? • €5 = .95(1.032/1.015)5 = 1.0323 • (.99 – 1.0323) / 1.0323 = -4.1%

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