1

Parity Conditions in International Finance and

Currency Forecasting

Chapter 8

2

PART I.ARBITRAGE AND THE LAW OF

ONE PRICEI. 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.

3

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)

4

ARBITRAGE AND THE LAW OF ONE PRICE

D. Five Parity Conditions Linked by

1. The adjustment of variousrates and prices to inflation.

2. The notion that money should

have no effect on real variables (since they have

beenadjusted for price changes).

5

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.

6

PART II.PURCHASING POWER PARITY

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

7

PURCHASING POWER PARITY

II. ABSOLUTE PURCHASING POWER PARITYA. Price levels (adjusted for

exchange rates) should beequal between countries

B. One unit of currency has same

purchasing power globally.

8

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 thesame.

9

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

10

PURCHASING POWER PARITY

2. If purchasing power parity is expected to hold, then the bestprediction for the one-periodspot rate should be

e1 = e0(1 + ih)1

(1 + if)1

11

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 tothe inflation rate differential.

12

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.

13

PURCHASING POWER PARITY

B. Real Exchange Rates:the quoted or nominal rate

adjustedfor it’s country’s inflation rate

e’t = et (1 + if)t = e0

(1 + ih)t

*real exchange rate remains constant

14

PURCHASING POWER PARITY

C. Real exchange rates1. If exchange rate adjust to

inflation differential, PPP states that real exchange

rates stay the same.2. Competitive positions of

domestic and foreign firmsare unaffected.

15

PART III.THE FISHER EFFECT

I. THE FISHER EFFECTstates that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations.

R = a + i

16

THE FISHER EFFECT

B. Real Rates of Interest1. Should tend toward equality everywhere through arbitrage.2. With no government interference nominal rates vary by inflation differential or

rh - rf = ih - if

17

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.

18

PART IV.THE INTERNATIONAL FISHER

EFFECTI. IFE STATES:

A. the spot rate adjusts to the interest rate differential between two

countries.B. PPP & FE ---> IFE

et = (1 + rh)t

e0 (1 + rf)t

19

THE INTERNATIONAL FISHER EFFECT

B. Fisher postulated1. The nominal interest rate

differential should reflect the inflation rate differential.

2. Expected rates of return are equal in the absence of government intervention.

20

THE INTERNATIONAL FISHER EFFECT

C. Simplified IFE equation:

rh - rf = e1 - e0

e0

interest rate differential is equal to change in the exchange rate

21

THE INTERNATIONAL FISHER EFFECT

D. Implications if IFE1. Currency with the lower

interest rate expected to appreciate relative to

onewith a higher rate.

2. Financial market arbitrageinsures interest rate differentialis an unbiased predictor of

change in future spot rate.3. Holds if the IR differential is

due to differences in expectedinflation.

22

PART V.INTEREST RATE PARITY

THEORY

I. INTRODUCTIONA. 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.

23

INTEREST RATE PARITY THEORY

2. The forward premium ordiscount equals the

interestrate differential. F - S/S = (rh - rf)

where rh = the home rate

rf = the foreign rate

24

INTEREST RATE PARITY THEORY

3. In equilibrium, returns oncurrencies will be the samei. e. No profit will be realized

and interest rate parity exits which can be

written

(1 + rh) = F

(1 + rf) S

25

INTEREST RATE PARITY THEORY

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

B. Covered Interest Arbitrage1. Conditions required:

interest rate differential doesnot equal the forward premiumor discount.

2. Funds will move to a countrywith a more attractive rate.

26

INTEREST RATE PARITY THEORY

3. Market pressures develop:

a. As one currency is moredemanded spot and soldforward.

b. Inflow of funds depressesinterest rates.

c. Parity eventually reached.

27

INTEREST RATE PARITY THEORY

C. Interest Rate Parity states:1. Higher interest rates on a

currency offset by forwarddiscounts.

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.

28

PART VI.THE RELATIONSHIP BETWEEN THE FORWARD AND THE FUTURE SPOT

RATEI. THE UNBIASED FORWARD RATE

A. States that if the forward rate isunbiased, then it should reflect

the expected future spot rate.

B. Stated asf0(t) = et

C. Usually holds, at least in terms of the direction (not necessarily the

magnitude).

29

PART VII.CURRENCY FORECASTINGI. 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

30

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.

31

CURRENCY FORECASTING

2. MODEL-BASED FORECASTSEmploy 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 data2. Charting and trend analysis