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Presented by Parin sanghvi Aakash chougule Amey Chaudankar Vikas Chaturvedi Surbhi Gautam Priti Bidasaria Rasika jalan Dipti Prabhupatkar
It plays essential role in foreign exchange markets. The difference between the interest rates in any two countries is the same as the difference between the forward and the spot rates of their respective currencies.
Interest rate parity A currency is worth what it can earn. The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period. When the returns on two currencies are equal, interest rate parity prevails.
Explanation
The relationship can be seen when you follow the two methods an investor may take to convert foreign currency into U.S. dollars. Option A would be to invest the foreign currency locally at the risk-free rate for a specific time period. Then convert the proceeds from the investment into U.S. dollars at the maturity. Option B would be to invest the same dollars in the (U.S.) market for the same time period. When no arbitrage opportunities exist, the cash flows from both options are equal.
Mathematically
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
Violation of IRP
If interest rate parity is violated, then an arbitrage opportunity exists. The simplest example of this is what would happen if the forward rate was the same as the spot rate but the interest rates were different, then investors would: borrow in the currency with the lower rate convert the cash at spot rates enter into a forward contract to convert the cash plus the expected interest at the same rate invest the money at the higher rate convert back through the forward contract repay the principal and the interest, knowing the latter will be less than the interest received.
Implications of IRP
If domestic interest rates are less than foreign interest rates, you will invest in foreign country at higher interest rates. Domestic investors can benefit by investing in the foreign market
Implications of IRP
If domestic interest rates are more than foreign interest rates, you will invest in domestic market at higher interest rates Foreign investors can benefit by investing in the domestic market
Purpose
Differences in living standards between nations because PPP takes into account the relative cost of living and the inflation rates of the countries,
Assumption
In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency.
Example
For example, a TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver due to which the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again the same price.
Fluctuations
PPP rate fluctuations are mostly due to different rates of inflation in the two economies which would result in the difference in prices at home and abroad
PPP numbers can vary with the specific basket of goods used, making it a rough estimate. Differences in quality of goods are hard to measure and thereby reflect in PPP.
Rank Country
1 2 United States China
GDP (PPP) $M
14,264,600 7,916,429
3
4 5 6
Japan
India Germany Russia
4,354,368
3,288,345 2,910,490 2,260,907
27
Pakistan
439,558
Factors effecting
IRP and PPP
Factors of PPP
Technology Luxury goods Raw materials Energy prices
Formulas
}
Fo = forward rate So = current spot rate ic = interest rate in country c ib = interest rate in country b
IRP
PPP
S1 = expected spot rate So = current spot rate ic = expected inflation rate in country c ib = expected inflation rate in country b
Question IRP
A Canadian company is expected to receive Kuwaiti dinars in 1 years time. The spot rate is CAD/Dinar 5.4670. The company could borrow in dinars at 9% or in Canadian dollars at 14%. There is no forward rate for one years time. Predict what the exchange rate is likely to be in one year
Solution
F = 5.7178
Question PPP
The spot exchange rate between UK sterling and Danish kroner is 1 = 8 kroners. Assuming that there is now purchasing parity an amount of commodity costing 110 in UK will cost 880 kroners in Denmark. Over the next year price inflation in denmark is expected to be 5% while in UK it is expected to be 8%. What is the expected spot exchange rate at the end of the year?
Solution
So = 8 ic = 5% or 0.05 ib = 8% or 0.08
S1 = 8 x (1 + 0.05) (1 + 0.08)
S = 7.78
1
UK price = 110 x 1.08= 118.80 Danish price = 880 x 1.05= 924 Kroner
= 924 118.80 = 7.78
Thank you