Parity Conditions in International Finance and Currency Forecasting

1
Parity Conditions in International Finance and
Currency Forecasting

• Chapter 8

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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.
• B. Theoretical basis
• If the price after exchange-rate
• adjustment were not equal, arbitrage in
  the goods worldwide ensures eventually it will.

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ARBITRAGE AND THE LAW OF ONE PRICE

• C. Five Parity Conditions Result From
• These Arbitrage Activities
• 1. Purchasing Power Parity (PPP)
• 2. The Fisher Effect (FE)
• 3. The International Fisher Effect
• (IFE)
• 4. Interest Rate Parity (IRP)
• 5. Unbiased Forward Rate (UFR)

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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).

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ARBITRAGE AND THE LAW OF ONE PRICE

• E. Inflation and home currency depreciation
  are
• jointly determined by the growth of domestic
  money supply relative to the growth of
• domestic money demand.

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PART II.PURCHASING POWER PARITY

• I. THE THEORY OF PURCHASING
• POWER PARITY
• is based on law of one price,
• and the no-arbitrage condition
• (internationally)

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PURCHASING POWER PARITY

• II. ABSOLUTE PURCHASING
• POWER PARITY
• A. Price levels (adjusted for
• exchange rates) should be
• equal between countries
• B. One unit of currency has same
• purchasing power globally.

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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.
• B. Real exchange rate stays the
• same.

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PURCHASING POWER PARITY

• 1. In mathematical terms
• et (1 ih)t
• e0 (1 if)t
• where et future spot rate
• e0 spot rate
• ih home inflation
• if foreign inflation
• t time period

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PURCHASING POWER PARITY

• 2. If purchasing power parity is
• expected to hold, then the best
• prediction for the one-period
• spot rate should be
• e1 e0(1 ih)1
• (1 if)1

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PURCHASING POWER PARITY

• 3. A more simplified but less precise
• relationship is
• e1 - e0 ih - if
• e0
• that is, the percentage change should be
  approximately equal to
• the inflation rate differential.

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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.

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PURCHASING POWER PARITY

• B. Real Exchange Rates
• the quoted or nominal rate adjusted
• for its countrys inflation rate
• et et (1 if)t e0
• (1 ih)t
• real exchange rate remains constant

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PURCHASING POWER PARITY

• C. Real exchange rates
• 1. If exchange rate adjust to inflation
  differential, PPP states that real exchange
  rates stay the same.
• 2. Competitive positions of
• domestic and foreign firms
• are unaffected.

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PART III.THE FISHER EFFECT

• 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

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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 ih - if

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THE FISHER EFFECT

• C. According to the Fisher Effect,
• countries with higher inflation rates have
  higher interest rates.
• D. Due to capital market integration
  globally, interest rate differentials are
  eroding.
• E. Real interest rate differences can exists
  due to currency risk and country risk.

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PART IV.THE INTERNATIONAL FISHER EFFECT

• I. IFE STATES
• A. the spot rate adjusts to the interest rate
  differential between two countries.
• B. PPP FE ---gt IFE
• et (1 rh)t
• e0 (1 rf)t

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THE INTERNATIONAL FISHER EFFECT

• B. Fisher postulated
• 1. The nominal interest rate differential
  should reflect the inflation rate
  differential.
• 2. Expected rates of return are equal in the
  absence of government intervention.

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THE INTERNATIONAL FISHER EFFECT

• C. Simplified IFE equation
• rh - rf e1 - e0
• e0
• interest rate differential is equal to change in
  the exchange rate

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THE INTERNATIONAL FISHER EFFECT

• D. Implications if IFE
• 1. Currency with the lower interest rate
  expected to appreciate relative to one
• with a higher rate.
• 2. Financial market arbitrage
• insures interest rate differential
• is an unbiased predictor of
• change in future spot rate.
• 3. Holds if the IR differential is
• due to differences in expected
• inflation.

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PART V.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 rate differential (rh -
  rf) between two countries.

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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

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INTEREST RATE PARITY THEORY

• 3. In equilibrium, returns on
• currencies will be the same
• i. e. No profit will be realized
• and interest rate parity
• exits which can be written
• (1 rh) F
• (1 rf) S

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INTEREST RATE PARITY THEORY

• Interest rate parity is assured by the
  no-arbitrage condition.
• 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.

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INTEREST RATE PARITY THEORY

• 3. Market pressures develop
• a. As one currency is more
• demanded spot and sold
• forward.
• b. Inflow of funds depresses
• interest rates.
• c. Parity eventually reached.

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INTEREST RATE PARITY THEORY

• C. Interest Rate Parity states
• 1. Higher interest rates on a
• currency offset by forward
• discounts.
• 2. Lower interest rates are offset
• by forward premiums.
• Deviations from IRP are small and
  short-lived.
• Deviations may be caused by taxes, transaction
  costs, capital controls.

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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
• f0(t) et
• C. Usually holds, at least in terms of the
  direction (not necessarily the magnitude).

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PART VII.CURRENCY FORECASTING

• I. FORECASTING MODELS
• A. have been created to forecast exchange rates
  in addition to parity conditions.
• B. Two types of forecast
• 1. Market-based
• 2. Model-based

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CURRENCY FORECASTING

• 1. 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.

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CURRENCY FORECASTING

• 2. MODEL-BASED FORECASTS
• Employ 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