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International Parity Conditions (or chapter 4). 2 Agenda What is PPP & law of one price? What is exchange rate pass-through? How do interest rates & exchange.

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Presentation on theme: "International Parity Conditions (or chapter 4). 2 Agenda What is PPP & law of one price? What is exchange rate pass-through? How do interest rates & exchange."— Presentation transcript:

1 International Parity Conditions (or chapter 4)

2 2 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?

3 3 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. ¥ $

4 4 Purchasing Power Parity & Law of One Price Absolute purchasing power parity:  spot exchange rate is determined by relative prices of similar basket of goods. Relative purchasing power parity:  Relative change in prices b/n countries determines change in forex rate.

5 5 Absolute PPP: Big Mac Index  Economist’s Big Mac PPP: Big Mac in China costs Yuan Big Mac in US costs $2.71. Implied PPP exchange rate

6 6 Economist, 4/ 2003

7 7 Relative PPP % change spot rate foreign currency US$/ yen Inf JAPAN - Inf US PPP line P

8 8 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?

9 9 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.

10 10 Q: Can you tell when a currency is overvalued? Why the real exchange rate deviates from 100?

11 11 United States & Japan (1995 = 100) Real Effective Exchange Rate Indices

12 12 Exchange Rate Pass-Through  Pass-through: change in prices of imported/exported goods when exchange rate changes BMW made in Germany 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 $40,000. Pass-through: Degree of pass-through: % / 20 % = 0.71 or 71 % € €/$

13 13 Interest Rates & Exchange Rates?  What is a fair nominal interest rate? –Well, can ask a banker … or read Irvin Fisher… 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  i is nominal rate, r is real rate,  is expected rate of inflation. FE good for short maturity bonds, NOT long maturity ones. –Why?

14 14 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. FC

15 15 Forward Rate  Forward Rate A forward rate: exchange rate quoted today for future date

16 16 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.

17 17 Premium or discount?  Forward premium or discount : % difference b/n spot & forward rates in annual percentage terms. For indirect quotes (FC per home currency, FC/$) then Swiss franc sells premium 3.96% p. a. (takes 3.96% more US$ to get franc at 90-day forward rate) For direct quotes ($/FC), use (F-S)/S.

18 18 Currency Yield Curve & Forwards Eurodollar yield curve Euro yield curve Months Interest yield % 3.0 % 4.0 % 5.0 % 6.0 % 2.0 % Forward premium on low interest rate currrency

19 19 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

20 20 90 days S = SF /$ SF 1,480,000 Dollar money market $1,000,000$1,020,000  1.02 StartEnd i $ = 8 % per annum (2 % 90 days) Swiss franc money market SF 1,494,800  1.01 i SF = 4 % per annum (1 % 90 days) Interest Rate Parity (IRP) F 90 = SF /$ $1,019,993

21 21 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.

22 days S =¥ /$ ¥ 106,000,000 Eurodollar rate = 8.00 % per annum Dollar money market $1,000,000$1,040,000  1.04 StartEnd Yen money market ¥ 108,120,000  1.02 Euroyen rate = 4.00 % per annum Covered Interest Arbitrage (CIA) F 180 = ¥ /$ Arbitrage Potential $1,044,638

23 23 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.

24 24 Uncovered Interest Arbitrage (UIA): The Yen Carry Trade 360 days S =¥ /$ $ 83,333,333 Investors borrow yen at 0.40% per annum Japanese yen money market ¥ 10,000,000¥ 10,040,000 Repay  StartEnd US dollar money market $ 87,500,000  1.05 Invest dollars at 5.00% per annum S 360 = ¥ /$ ¥ 10,500,000 Earn ¥ 460,000 Profit Then exchanges the yen proceeds for US dollars, investing in US dollar money markets for one year

25 25 Interest Rate Parity (IRP) & Equilibrium Percent difference between foreign (¥) and domestic ($) interest rates Percentage premium on foreign currency (¥) X U Z Y 4.83

26 26 Forward Rate - Unbiased Predictor? S1S1 Exchange rate Time t 2 t 3 t 4 t 1 S2S2 S3S3 S4S4 Error F2F2 F1F1 F3F3


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