Transcript Slide 1

CHAPTER 4
PARITY CONDITIONS
AND
CURRENCY
FORECASTING
1
PART I. ARBITRAGE AND THE LAW
OF ONE PRICE
I.
THE LAW OF ONE PRICE
A. Law states:
Identical goods sell for the same price
worldwide.
ARBITRAGE AND THE LAW OF ONE
PRICE
B.
Theoretical basis:
If the prices after exchange-rate
adjustment were not equal,
arbitrage in the goods worldwide ensures
eventually it will.
ARBITRAGE AND THE LAW OF ONE
PRICE
C. Five Parity Conditions Result
From These Arbitrage Activities
1.
2.
3.
4.
5.
Purchasing Power Parity (PPP)
The Fisher Effect (FE)
The International Fisher Effect
(IFE)
Interest Rate Parity (IRP)
Unbiased Forward Rate (UFR)
ARBITRAGE AND THE LAW OF ONE
PRICE
D. Five Parity Conditions Linked
by
1. The adjustment of various
rates and prices to inflation.
2. The notion that money should have no
effect on real variables (since they
have been adjusted for price changes).
ARBITRAGE AND THE LAW OF ONE
PRICE
E.
Inflation and home currency
depreciation:
1. jointly determined by the
growth of domestic money
supply;
2. Relative to the growth of
domestic money demand.
ARBITRAGE AND THE LAW OF ONE
PRICE
F. THE LAW OF ONE PRICE
- enforced by international
arbitrage.
PART II. PURCHASING POWER
PARITY
I. THE THEORY OF PURCHASING
POWER PARITY:
states that spot exchange rates between
currencies will change to the differential in
inflation rates between countries.
PURCHASING POWER PARITY
II. ABSOLUTE PURCHASING
POWER PARITY
A. Price levels adjusted for
exchange rates should be
equal between countries
PURCHASING POWER PARITY
II. ABSOLUTE PURCHASING
POWER PARITY
B. One unit of currency has same purchasing
power globally.
PURCHASING POWER PARITY
III. RELATIVE PURCHASING
POWER PARITY
A. states that the exchange rate of one
currency against another will adjust to
reflect changes in the price levels of the
two countries.
PURCHASING POWER PARITY
1.
In mathematical terms:
et
e0
where
1 
ih

1  i f
et
e0
ih
if
t
=
=
=
=
=
future spot rate
spot rate
home inflation
foreign inflation
the time period

t

t
PURCHASING POWER PARITY
2.
If purchasing power parity is
expected to hold, then the best
prediction for the one-period
spot rate should be
1  ih 
t
et  e0
1  i 
t
f
PURCHASING POWER PARITY
3. A more simplified but less precise
relationship is
et
 ih  i f
e0
that is, the percentage change should be
approximately equal to the inflation rate
differential.
PURCHASING POWER PARITY
4.
PPP says
the currency with the higher inflation rate
is expected to depreciate relative to the
currency with the lower rate of inflation.
PURCHASING POWER PARITY
B.
Real Exchange Rates:
the quoted or nominal rate adjusted for a
country’s inflation rate is
e  et
'
t
(1  i f )
(1  ih )
t
t
PURCHASING POWER PARITY
C. Real exchange rates
1. If exchange rates adjust to inflation
differential, PPP states that real exchange
rates stay the same.
PURCHASING POWER PARITY
C. Real exchange rates
2.
Competitive positions:
domestic and foreign firms
are unaffected.
PART III.
THE FISHER EFFECT (FE)
I. THE FISHER EFFECT
states that nominal interest rates (r) are a
function of the real interest rate (a) and a
premium (i) for inflation expectations.
R = a + i
THE FISHER EFFECT
B.
Real Rates of Interest
1. Should tend toward equality
everywhere through arbitrage.
2. With no government interference
nominal rates vary by inflation
differential or
rh - rf = i h - i f
THE FISHER EFFECT
C. According to the Fisher Effect,
countries with higher inflation rates have
higher interest rates.
THE FISHER EFFECT
D. Due to capital market
integration globally, interest
rate differentials are eroding.
PART IV. THE INTERNATIONAL
FISHER EFFECT (IFE)
I. IFE STATES:
A. the spot rate adjusts to the interest rate
differential between two countries.
THE INTERNATIONAL FISHER
EFFECT
IFE = PPP + FE
et
(1  rh )

t
e0
(1  rf )
t
THE INTERNATIONAL FISHER
EFFECT
B.
Fisher postulated
1. The nominal interest rate
differential should reflect
the inflation rate differential.
THE INTERNATIONAL FISHER
EFFECT
B.
Fisher also postulated that
2.
Expected rates of return are
equal in the absence of
government intervention.
THE INTERNATIONAL FISHER
EFFECT
C. Simplified IFE equation:
(if rf is relatively small)
e1  e0
rh  rf 
e0
THE INTERNATIONAL FISHER
EFFECT
D. Implications of IFE
1. Currency with the lower
interest rate is expected to
appreciate relative to the one
with a higher rate.
THE INTERNATIONAL FISHER
EFFECT
D. Implications of IFE
2.
Financial market arbitrage:
insures interest rate differential is an
unbiased predictor of change in
future spot rate.
PART VI. INTEREST RATE PARITY
THEORY
I. INTRODUCTION
A. The Theory states:
the forward rate (F) differs from the spot
rate (S) at equilibrium by an amount
equal to the interest differential (rh - rf)
between two countries.
INTEREST RATE PARITY THEORY
2.
The forward premium or
discount equals the interest
rate differential.
(F - S)/S = (rh - rf)
where
rh = the home rate
rf = the foreign rate
INTEREST RATE PARITY THEORY
3.
In equilibrium, returns on
currencies will be the same
i. e. No profit will be realized
and interest parity exists
which can be written
F 1  rh 

S 1  rf 
INTEREST RATE PARITY THEORY
B.
Covered Interest Arbitrage
1. Conditions required:
interest rate differential does
not equal the forward
premium or discount.
2. Funds will move to a country
with a more attractive rate.
INTEREST RATE PARITY THEORY
3.
Market pressures develop:
a.
As one currency is more demanded spot
and sold forward.
b.
Inflow of fund depresses interest rates.
c.
Parity eventually reached.
INTEREST RATE PARITY THEORY
C.
Summary:
Interest Rate Parity states:
1.
Higher interest rates on a
currency offset by
forward discounts.
2.
Lower interest rates are
offset by forward premiums.
PART VI. THE RELATIONSHIP
BETWEEN THE
FORWARD AND THE FUTURE SPOT
RATE
I. THE UNBIASED FORWARD RATE
A. States that if the forward rate is unbiased,
then it should reflect the expected future
spot rate.
B. Stated as
ft = e t
PART VI. CURRENCYFORECASTING
I. FORECASTING MODELS
A. Created to forecast exchange rates in
addition to parity conditions.
B. Two types of forecast:
1.
Market-based
2.
Model-based
CURRENCY FORECASTING
MARKET-BASED FORECASTS:
derived from market indicators.
A. The current forward rate contains implicit
information about exchange rate changes
for one year.
B. Interest rate differentials may be
used to predict exchange rates
beyond one year.
CURRENCY FORECASTING
MODEL-BASED FORECASTS:
include fundamental and technical
analysis.
A. Fundamental relies on key
macroeconomic variables and
policies which most like affect
exchange rates.
B. Technical relies on use of
1. Historical volume and price data
2. Charting and trend analysis