CHAPTER 4

PARITY CONDITIONS AND CURRENCY FORECASTING

1

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.

ARBITRAGE AND THE LAW OF ONE PRICE

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

ARBITRAGE AND THE LAW OF ONE PRICE

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

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).

ARBITRAGE AND THE LAW OF ONE PRICE

E.

Inflation and home currency depreciation:

1. jointly determined by the growth of domestic money supply; 2. Relative to the growth of domestic money demand.

ARBITRAGE AND THE LAW OF ONE PRICE F. THE LAW OF ONE PRICE
- enforced by international arbitrage.

PART II. PURCHASING POWER PARITY I. THE THEORY OF PURCHASING POWER PARITY:
states that spot exchange rates between currencies will change to the differential in inflation rates between countries.

PURCHASING POWER PARITY

II. ABSOLUTE PURCHASING POWER PARITY
A. Price levels adjusted for

exchange rates should be

equal between countries

PURCHASING POWER PARITY

II. ABSOLUTE PURCHASING POWER PARITY
B. One unit of currency has same purchasing

power globally.

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.

PURCHASING POWER PARITY

1. In mathematical terms:

et e0
where

ih if 1
et e0 ih if t = = = = = future spot rate spot rate home inflation foreign inflation the time period

t t

PURCHASING POWER PARITY

2. If purchasing power parity is expected to hold, then the best prediction for the one-period spot rate should be

et e0

i 1
f

ih 1

t t

PURCHASING POWER PARITY

3. A more simplified but less precise relationship is

et ih i f e0
that is, the percentage change should be approximately equal to the inflation rate differential.

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.

PURCHASING POWER PARITY

B. Real Exchange Rates:
the quoted or nominal rate adjusted for a countrys inflation rate is

e et
' t

(1 i f ) (1 ih )

PURCHASING POWER PARITY

C. Real exchange rates
1. If exchange rates adjust to inflation differential, PPP states that real exchange rates stay the same.

PURCHASING POWER PARITY

C. Real exchange rates
2. Competitive positions: domestic and foreign firms

are unaffected.

PART III. THE FISHER EFFECT (FE) 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

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 = i h - i f

THE FISHER EFFECT

C. According to the Fisher Effect,
countries with higher inflation rates have higher interest rates.

THE FISHER EFFECT

D. Due to capital market integration globally, interest rate differentials are eroding.

PART IV. THE INTERNATIONAL FISHER EFFECT (IFE)

I. IFE STATES:
A. the spot rate adjusts to the interest rate differential between two countries.

THE INTERNATIONAL FISHER EFFECT IFE = PPP + FE

et (1 rh ) t e0 (1 rf )
t

THE INTERNATIONAL FISHER EFFECT

B. Fisher postulated
1. The nominal interest rate differential should reflect the inflation rate differential.

THE INTERNATIONAL FISHER EFFECT B. Fisher also postulated that

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

THE INTERNATIONAL FISHER EFFECT

C. Simplified IFE equation: (if rf is relatively small)

rh rf

e1 e0 e0

THE INTERNATIONAL FISHER EFFECT

D. Implications of IFE
1. Currency with the lower interest rate is expected to appreciate relative to the one with a higher rate.

THE INTERNATIONAL FISHER EFFECT D. Implications of IFE

2. Financial market arbitrage:

insures interest rate differential is an unbiased predictor of change in future spot rate.

PART VI. 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 differential (rh - rf) between two countries.

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

INTEREST RATE PARITY THEORY

3. In equilibrium, returns on currencies will be the same i. e. No profit will be realized and interest parity exists which can be written

F 1 rh S 1 rf

INTEREST RATE PARITY THEORY

B. Covered Interest Arbitrage
interest rate differential does

1. Conditions required:
not equal the forward premium or discount.

2. Funds will move to a country with a more attractive rate.

INTEREST RATE PARITY THEORY

3.

Market pressures develop:

a. b. c. As one currency is more demanded spot and sold forward. Inflow of fund depresses interest rates. Parity eventually reached.

INTEREST RATE PARITY THEORY

C. Summary: Interest Rate Parity states:
1. Higher interest rates on a currency offset by forward discounts. 2. Lower interest rates are offset by forward premiums.

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 ft = e t

PART VI. CURRENCYFORECASTING I. FORECASTING MODELS

A. Created to forecast exchange rates in addition to parity conditions. B. Two types of forecast: 1. Market-based 2. Model-based

CURRENCY FORECASTING
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.

CURRENCY FORECASTING
MODEL-BASED FORECASTS: include 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