1. Lecture 8: Parity Models and Foreign Exchange Rates Evaluating Current Spot Rates and Forecasting Rates with Parity Models: The Purchasing Power Parity Model

2. Where is this Financial Center?

3. What are Parity Models? Parity is defined as a state of equilibrium. Foreign exchange parity models “estimate” what the equilibrium spot exchange rate should be (under the model’s assumptions):  (1) Is today’s spot rate appropriate?  (2) What might the spot rate be in the future (forecasting future spot rates). Generally involving a long term forecasting horizon. Parity models have an economic basis (i.e., theory) for their spot rate determination.

4. Why are Parity Models Important? Testing the “correctness” of a spot rate.  Could be important for a trading strategy.  Is the currency overvalued or undervalued? Overvalued: perhaps a sell short strategy. Undervalued: perhaps a buy long strategy. Establishing a future spot rate  Could be important for: International capital budgeting decisions  Converting estimated foreign currency cash flows into MNC’s home currency as part of the capital budgeting process (location decision). Investment and Financing decisions  Converting estimated investment inflows from investments into home currency equivalents and converting estimated financing outflows into home currency equivalents.

5. Two Major Spot FX Parity Models (1) Purchasing Power Parity (PPP)  Model assumes relative rates of inflation (or relative prices) between two countries as the major determinant of future spot exchange rates. The subject of this lecture (2) International Fisher Effect (IFE)  Model assumes relative rates of long term interest between two countries as the major determinant of future spot exchange rates. The subject of the next lecture

6. Purchasing Power Parity Theory The Purchasing Power Parity (PPP) explains and quantifies the relationship between inflation and spot exchange rates. The theory states that the spot exchange rate between two currencies should be equal to the ratio of the two countries’ price levels.  Idea was first proposed by the classical economist, David Ricardo, in the 19 th century.  The concept was expanded by the Swedish economist, Gustav Cassel, during the years after WW1 (1918 -) when countries in Europe were experiencing hyperinflation.

7. Two Forms of PPP Absolute PPP:  At a point in time, the equilibrium exchange rate is that rate which results in the prices of similar goods in two different countries being equal. This form of the PPP can be used to test how “appropriate” a current spot exchange rate is and to indicate a future move in the exchange rate. Relative PPP:  Over time, the change in the exchange rate between two currencies should be equal to the rate of change in the prices of similar goods between the two countries. This form of the PPP is used to forecast the equilibrium spot exchange rate in the future and generally over a long time horizon.

8. Rationale Behind the PPP: The Law of One Price The Purchasing Power Parity model is based on the Law of One Price:  The Law of One Price states that all else equal (i.e., no transaction costs or other frictions, like tariffs or cultural differences) a product’s price (adjusted by the exchange rate) should be the same in all markets.  Why will the product’s price be the same? The principle of competitive markets assumes that prices will equalize as consumers shift their purchases to those markets (or countries) where prices are the lowest. Also arbitrage activities will (might) result in similar prices.

9. Law of One Price Formulas The Law of One Price assumes that prices for similar products between two countries should be the same after adjusting for exchange rates, or  The price of product A in the United States in U.S. dollars (P USD ), adjusted by the spot exchange rate, should equal the foreign currency price (P FC ) of product A in a foreign country. Law of One Price formulas:  P USD  Spot FX rate ET = P FC Where ET = European Terms quote  P USD /Spot FX rate AT = P FC Where AT = American Terms quote

10. Example 1: Law of One Price Assume:  A Big Mac hamburger costs $4.00 in the United States and  The current yen spot exchange rate (USD/JPY) is ¥76.75 According to the Law of One Price, the “equilibrium” Big Mac hamburger price in Japan should be: P USD  Spot FX Rate ET = P ¥ $4.00 x ¥76.75 = ¥307  At these two local currency prices ($4.00 and ¥307) and given the spot exchange rate (76.75) there is no difference in exchange rate adjusted prices for a Big Mac in the United States and Japan.

11. Example 2: Law of One Price Assume:  A Big Mac hamburger costs $4.00 in the United States and  The current British pound spot exchange rate (GBP/USD) is $1.5380 According to the Law of One Price, the “equilibrium” Big Mac hamburger price in the UK should be: P USD /Spot FX Rate AT = P £ $4.00/$1.5380 = £2.60  At these two local currency prices ($4.00 and £2.60) and given the spot exchange rate (1.5380) there is no difference in exchange rate adjusted prices for a Big Mac in the United States and the United Kingdom.

12. The Absolute PPP Exchange Rate The absolute PPP spot exchange rate is the exchange rate which results in the prices of similar goods between two countries being the same. For European Terms quoted currencies the absolute PPP formula is:  Absolute PPP FX Rate ET = P FC /P USD  Where P FC is the price in the foreign market  And P USD is the price in the U.S. market

13. Example: The Absolute PPP Exchange Rate For European Terms Quotes  Example: Assume the price of a Starbuck’s grande vanilla latte in the United States is $3.75 and 7.40CHF in Switzerland. Given this information, calculate the absolute PPP USD-CHF spot exchange rate.  Absolute PPP FX Rate ET = P FC /P USD  USD-CHF ______________

14. The Absolute PPP Exchange Rate: American Terms Quotes For American Terms quoted currencies the absolute PPP formula is:  Absolute PPP FX Rate AT = P USD /P FC  Where P FC is the price in the foreign market  And P USD is the price in the U.S. market Example: Assume the price of an official NBA basketball in the U.S. is $180 and in the U.K the price is 105 pounds. Calculate the Absolute PPP Exchange Rate.

15. Evaluating Spot Rates Once we have calculated the absolute PPP exchange rate, we can compare that rate to the actual spot rate as one test of the “correctness” of the actual spot rate as well as the future move in the exchange rate. Using the Absolute PPPs on the previous slides and actual spot rates (Oct 26, 2012), comment on the data (is the foreign currency overvalued or undervalued? What about the U.S. dollar?):  (1) USD-CHF PPP ET = 1.9733 (actual spot = 0.9346)  (2) GBP/USD PPP AT = 1.7143 (actual spot = 1.6106)

16. Answers Using the Absolute PPPs on the previous slides and actual spot rates (Oct 26, 2012), comment on the data. Is the foreign currency overvalued or undervalued? What about the U.S. dollar?:  (1) USD-CHF PPP ET = 1.9733 (actual spot = 0.9346) CHF is overvalued (USD is undervalued)  (2) GBP/USD PPP AT = 1.7143 (actual spot = 1.6106) GBP is undervalued (USD is overvalued)

17. Rules for the Absolute PPP The Absolute PPP can be used to “estimate” whether a foreign currency’s spot rate is overvalued or undervalued and possible future move by using the following rules: Absolute PPP European Terms:  If PPP Spot < Current Spot, then the currency is undervalued (thus currency may appreciate). E.g.: PPP = 100; Current Spot = 110  If PPP Spot > Current Spot, then the currency is overvalued (thus currency may depreciate). E.g.: PPP = 100; Current Spot = 90 Absolute PPP American Terms:  If PPP Spot > Current Spot, then the currency is undervalued (thus currency may appreciate). E.g.: PPP = $1.20; Current Spot = $1.00  If PPP Spot < Current Spot, then the currency is overvalued (thus currency may depreciate). E.g.: PPP = $1.20 Current Spot = $1.40

18. Using the Absolute PPP In theory, the “absolute” PPP Spot exchange rate can be used to assess the “correctness” of a current spot rate on the basis of similar goods in different countries.  It suggests the possibility that a currency is overvalued or undervalued, and by how much?  Perhaps we can use this model for forecast the future move of a currency. Where can we get data for the Absolute PPP model?  One source is the Economist "Big Mac” index.  http://www.economist.com/markets/Bigmac/Index.cfm http://www.economist.com/markets/Bigmac/Index.cfm

19. Big Mac Index October 14, 2010 Interpreting the Data In the United States, a Big Mac costs $3.71. While in China, a Big Mac costs 14.5 yuan.  Given the Oct 2010 exchange rate (USD/CNY) of 6.6514 a Big Mac in China worked out to $2.18 (14.5/6.6514). Note this is the Big Mac price on the chart. The Absolute PPP for the yuan is the ratio of the yuan cost to the dollar cost, or: 14.5/3.71 = 3.9084. Comparing spot (6.6514) to PPP (3.9084) suggested that the yuan was undervalued by 41%  (6.6514-3.9084/6.6514 =.41%)

20. Big Mac Index, January 2012

21. Changes in Currencies, 2007 - 2012

22. A Test of the Big-Mac: 1999, The Introduction of the Euro The Euro was introduced on January 1, 1999. The first day trading price was $1.1874.  According to the Big-Mac data, at the time of the euro’s introduction the Absolute PPP Spot rate could be calculated as follows: Average price of a Big-Mac in the euro zone = €2.53 Average price of a Big-Mac in the U.S. = $2.63 Absolute PPP Spot Rate AT = $2.63/€2.53 = $1.04  What does the Absolute PPP spot rate suggest about the euro on the day it was introduced?  Comparing the actual spot ($1.1874) to the Absolute PPP Spot ($1.04) suggested the euro was overvalued by about 12.5% on the day it began trading.

23. What Happened to the Euro? January 1, 1999 – December 31, 1999

24. Absolute PPP in Practice In practice, use of the absolute PPP to test the “correctness” of a spot exchange rate depends on a number of factors:  Goods that are tradable; necessary for the assumption of competitive markets.  Goods that are comparable. Are the goods really similar in quality and quantity?  Are there government policies (tariffs and quotas) which render such goods not useful for absolute PPP calculations?  Are there cultural differences which render such goods not useful for absolute PPP calculations?

25. Impacts of Cultural Differences and Government Policy on Absolute PPP Cultural Differences (Melons) Tariffs and Quotas (Rice)

26. Examining Discrepancies Between Absolute PPP and Actual FX Rates When the actual FX rate differs from the Absolute PPP rate, one needs to examine reasons for the discrepancy to determine if the spot rate will, or will not, move towards the Absolute PPP. (1) Examine the exchange rate regime and the commitment of the government for that regime.  Does this account for the discrepancy between the Absolute PPP and the spot rate?  Chinese yuan and Hong Kong dollar. (2) Are there economic or financial conditions which could account for the observed discrepancy and how long might they dominate the spot rate?  Relative economic performance, interest rates, trade balances, capital flows, safe haven effects, etc.  Swiss franc

27. Other Sources of Absolute PPP To this point, we have focused on single goods when explaining and using the absolute PPP model. However, a better use of the Absolute PPP model would probably involve a market basket of goods, not just one.  Market basket PPP exchange rates are published by both the OECD and the World Bank. http://stats.oecd.org/Index.aspx?datasetcode=SNA_TAB LE4 http://stats.oecd.org/Index.aspx?datasetcode=SNA_TAB LE4

28. OECD PPP Exchange Rates and Actual Rates FX200520062007200820092010 USD/JPY 110.22116.30117.75103.3693.5787.78 PPP: 129.55124.61120.16116.84115.35111.38 USD/CHF 1.24521.25381.20041.08311.08811.0429 PPP: 1.74271.65931.59971.55051.53131.5104 USD/CNY 8.1943 7.9734 7.6075 6.9487 6.8314 6.7703 PPP: 3.448 3.465 3.622 3.821 3.764 3.946 EUR/USD1.24361.25451.36871.46481.38921.3244 PPP: 1.1670 1.2035 1.2157 1.2383 1.2505 1.2357 GBP/USD1.81821.84002.00011.83841.55781.5452 PPP: 1.5719 1.5949 1.5506 1.5638 1.5570 1.5349 AUD/USD0.76370.75300.83680.83880.77990.9173 PPP: 0.7203 0.7095 0.7008 0.6761 0.6887 0.6611

29. Comparing Actual to PPP

32. Relative Purchasing Power Parity The second PPP model, the Relative Purchasing Power Parity model, is concerned with the “change” in the exchange rate over time.  The Relative Purchasing Power is not assessing the “correctness” of the current spot rate. The relative PPP model suggests that spot exchange rates move in a manner opposite to the inflation differential between the two countries.  Specifically, the Relative PPP model suggests that the percent change in a spot exchange rate should be equal to, but opposite in direction to, the difference in the rates of inflation between countries.  This is a model which may be used to forecast an actual future spot rate.

33. PPP Over the Long Term, 1980 - 2000 Lower Rates of Inflation High Inflation Countries

34. Relative PPP Formula: American Terms For an American Term quoted currency:  PPP Spot Rate AT = Current Spot Rate AT x ((1 + INF US ) n /(1 + INF FC ) n ) Where:  PPP Spot Rate AT is the expected American Terms quoted spot rate some date in the future.  Current spot rate expressed in American terms.  INF US is the expected annual rate of inflation in the United States.  INF FC is the expected annual rate of inflation in the foreign country.  N is the number of years in the future (which corresponds to the forecasted time period).

35. Relative PPP Formula: American Terms Assume:  Current spot rate for British pounds (GBP/USD = $1.80  Expected annual rate of inflation in the U.S. = 2.0%  Expected annual rate of inflation in the U.K. = 3.0% Given this data, calculate the Relative PPP spot pound FX rate 2 years from now using: PPP Spot Rate AT = Current Spot Rate AT x ((1 + INF US ) n /(1 + INF FC ) n )

36. Relative PPP Formula: European Terms For European Term quoted currency:  PPP Spot Rate ET = Current Spot Rate ET x ((1 + INF FC ) n /(1 + INF US ) n ) Where:  PPP ET spot rate is the expected European Terms quote spot rate at some date in the future.  Current spot rate expressed in European terms.  INF FC is the expected annual rate of inflation in the foreign country.  INF US is the expected annual rate of inflation in the United States.  N is the number of years in the future (which corresponds to the forecasted time period).

37. Relative PPP Formula: European Terms Assume:  Current spot rate for Japanese yen = 111.00  Expected annual rate of inflation in the U.S. = 2.0%  Expected annual rate of inflation in Japan = 1.0% Given this data, calculate the Relative PPP spot yen FX rate 2 years from now using: PPP Spot Rate ET = Current Spot Rate ET x ((1 + INF FC ) n /(1 + INF US ) n )

38. Testing the PPP Model The PPP model has been the subject of many empirical tests. The tests involving the absolute PPP have generally concluded that commodity price arbitrage does not exist.  Thus, prices of similar goods do not seem to equalize between countries.  Perhaps this is explained on the basis of barriers to commodity price arbitrage across borders (e.g., transportation, tariffs,,culture). Tests of the relative PPP, over long periods of time, are more encouraging (recall the slide of the Relative PPP from 1980 – 2000)

39. PPP Over the Long Term, 1980 - 2000 Lower Rates of Inflation High Inflation Countries

40. Is the Relative PPP Useful for Short Time Periods? While some studies have validated the reliability of the relative PPP model for “explaining” the long term relationship between inflation and exchange rate, studies which have examined the short term relationship have shown that actual FX rates can often move against the PPP rate.  See slide which follow (EUR and CAD). Perhaps this can be explained on the basis of short term potential factors which can move the exchange rate away from PPP.  Safe haven effects, government intervention, carry trade transactions, dirty floats, etc.

41. Tests of the PPP over the Short Run: The Euro and CAD The Euro The Canadian Dollar

42. PPP Over the Short Term: G-9 Countries Quarterly Data; 1974 - 1998 Quarterly inflation differentials to the U.S. against the exchange rate change. Source: Catherine Ho, “Time to Equilibrium in Exchange Rates, Global Financial Journal, 2012

43. The Relative PPP in Practice While some historical data tends to validate the relative PPP over long periods of time, the practical issue for users is estimating future rates of inflation. How can we do this?  Use recent historical data to estimate the future, or for a benchmark starting point.  Combine historical data with likely outcomes which might affect inflation (e.g., government deficits, economic growth, monetary policy)  Use independent forecasts of inflation date

44. Historical Inflation Data Historical and Current Data:  Visit Central Bank Web sites at: http://www.bis.org/cbanks.htm  Or visit the Economist http://www.economist.com/index.html  Link to Economic and Financial Indicators (go to output, prices and jobs data).