September 20, 2015Parity Conditions1 Eiteman and Stonehill Chapter 4 Parity Conditions

September 20, 2015Parity Conditions2 Big Mac index  The Big Mac, in real terms, should cost the same everywhere  Prices increase with inflation prices of Big Macs in Canada increase by 1.9% prices of Big Macs in US increase by 2.3%  If nothing real changes, exchange rates should adjust for the difference CD appreciates

September 20, 2015Parity Conditions3 The Law of one price  The Law of One Price does not hold - given an exchange rate of

September 20, 2015Parity Conditions4 Example - the Law of One Price  Price = 3.41 usd in January 2007 Expected inflation 2.7% in 2007 Price = 3.50 usd in January 2008  Price = 3.80 cd in January 2007 Inflation 1.7% in 2007 Price = 3.86 cd in January 2008  Implied exchange rate 3.80 cd / 3.41usd = cd / 1 usd Jan cd / 3.50 usd = cd / 1 usd Jan 08

September 20, 2015Parity Conditions5 Purchasing Power Parity (PPP)  Absolute PPP - the law of one price the price of any good is the same after adjusting for exchange rate changes and relative inflation rates  Relative PPP exchange rates adjust to take into account relative inflation rates

September 20, 2015Parity Conditions6 Purchasing Power Parity  Absolute parity  Relative parity

September 20, 2015Parity Conditions7 Purchasing Power Parity  The exchange rate changes to accommodate differential rates of inflation If this is so, then relative PPP holds

September 20, 2015Parity Conditions8 Theory behind relative PPP  international competition in efficient goods markets will cause arbitrage of real prices of goods  relative inflation will cause internal prices to change  exchange rates will adjust for relative inflation so that real prices remain unchanged

September 20, 2015Parity Conditions9 PPP for forecasting  Known: forecasts of Expected cd inflation, Expected usd inflation  Known: the current exchange rate Calculate the expected future spot Compare to the quoted future spot

September 20, 2015Parity Conditions10 Relative Purchasing Power Parity % chg in spot % chg in relative inflation x

September 20, 2015Parity Conditions11 Empirical does PPP hold ?  international goods mkts not efficient short run barriers to trade, transactions costs measurement problems  indices measure changes in a market basket of goods, not traded goods differences exist in tastes, level of development, income  approximately efficient in the long run

September 20, 2015Parity Conditions12 Exchange Rate pass through  exchange rate adjusts for relative inflation relative inflation means  some prices increase faster than inflation  some slower  some prices decrease  relative real prices of goods may change internationally

September 20, 2015Parity Conditions13 Real exchange rates

September 20, 2015Parity Conditions14 Real effective exchange rates 100

September 20, 2015Parity Conditions15 Differential Price movements  Calculate the expected price of buying US  Expected greater than actual price if you are selling this product, you may face competitive pressures to lower price

September 20, 2015Parity Conditions16 Price elasticity of demand  How do the revenues of the firm react to changes in price  revenues decline if elasticity of own demand is less than 1

September 20, 2015Parity Conditions17 Inelastic own demand P Q Decrease in revenue due to price decrease Increase in revenue due to increased sales P0P0 PTPT Q0Q0 QTQT

September 20, 2015Parity Conditions18 Elastic own demand P Q Decrease in revenue due to price decrease Increase in revenue due to increased sales P0P0 PTPT Q0Q0 QTQT

September 20, 2015Parity Conditions19 The Fisher Effect  The nominal interest rate  relative nominal interest rates are proportional to relative inflation rates

September 20, 2015Parity Conditions20 Empirical evidence  capital market integration real returns are equal across economies efficient capital markets will arbitrage differences  capital market segmentation investor preferences may lead to real interest rate differentials each economy is a separate market

September 20, 2015Parity Conditions21 International Fisher Effect  expected future spot should accommodate any interest rate differentials

September 20, 2015Parity Conditions22 Interest Rate parity  interest rate differentials are covered by the forward rate

September 20, 2015Parity Conditions23 Covered Interest Arbitrage  If US interest rates are higher than interest rate parity would forecast Buy usd denominated bonds  100,000 cd* =84,846 usd  receive 84,846 * = 89,369 usd in one year  Forward contract at deliver of 104,195 cd in one cd/usd in one year  Invest in Canada 100,000 cd * = 104,180

September 20, 2015Parity Conditions24 Unbiased forward expectations  forward rate is the best predictor of the expected future spot market determined it is the best predictor? it is not unbiased predictor?

Comparative statistics September 20, 2015Parity Conditions25 US T-bill rates Canadian T-bill rates Canadian forward rates One month Three month 5.13%4.27% Six month 5.21%4.30% One year 5.09%4.34%1.1520

Purchasing Power Parity September 20, 2015Parity Conditions26 Three months Six months One year

Fisher Effect September 20, 2015Parity Conditions27 Three months Six months One year

Interest rate parity International Fisher effect September 20, 2015Parity Conditions28 Three months Six months One year