3chapter-paritytheories

8/7/2019 3chapter-paritytheories

1/20

Parity theories

Hemchand J


2/20

Parity Conditons

Summary of Parity Conditions

Purchasing power parity

Interest rate parity

Fisher effect

International Fisher effect

Forward rate as an unbiased predictor(Forward Parity)


3/20

Purchasing Power Parity

Purchasing power parity

% in spot rates = % in relative expectedinflation rates.

Purchasing power parity (PPP) theoryprovides a system for the determination ofthe exchange rate. According to this theory,the exchanged value of a unit of currencyshould be able to purchase the same quantityof goods/services regardless of where (whichcountry) the transaction takes place.


4/20

PPP contd..

Hence, when there is a differentiation ininflation rate between two countries, theexchange rate will adjust, providing an

equilibrium exchange rate that satisfies thePPP.. . When the inflation rate in Australia ishigher than its trading partners, the Australiandollar tends to depreciate over time.However, as identified by many researchers,

such an effect does not take placeimmediately but with a lag. This lag masksthe true reliability of the PPP in explaining theexchange rate trends.


5/20

PPP Two versions

Absolute PPP: The price of internationally

traded commodities should be the same in

every country, that is, one unit of homecurrency should have the same

purchasing power

worldwide. The absolute version, popularly

called the law of one price, is written as

S= Ph/Pf or Ph = SPf.


6/20

Absolute form of PPP

S ! spot exchange rate in direct quotes

(i.e., the number of units of home currency

that can be purchased for one unit offoreign currency), Ph! the price of the good

in the

home country, and Pf = the price of thegood in the foreign country.


7/20

Relative form of PPP

Relative PPP: The relative version of

purchasing power parity says that the

exchange rate of one currency againstanother will adjust to reflect changes in the

price levels of the two countries.

Purchasing power parity can be

summarized as follows: Expected spotrate ! current spot rate expecteddifference in inflation rate.


8/20

Relative form of PPP

Mathematically,

S2/S1 = (1 + Ih)/ (1 +If)

where S1

and S2

= the spot exchange rate (directquote) at the beginning of the period and the

end of the period, If= foreign inflation rate,

measured by price indexes, and Ih = home

(domestic) inflation rate.


9/20

Fisher Effect

The Fisher effect, named after theeconomist Irving Fisher, states that whilethe inflation rate can be used as an

indicator for the future direction of anations currency, the inflation rate itselfcould be predicted by comparing theinterest rates among the countries. TheReserve Bank has identified that inflationand the countrys exchange rate areinversely related to each other.


10/20

Fisher Effect contd..

When the inflation rate is higher than that ofits trading partners, the domestic currencytends to depreciate, stimulating export

activities. This preserves globalcompetitiveness by compensating for thehigh inflation rate. There is no evidence of ashort-term Fisher effect as changes in the

interest rate affect the system with a lag. However, in the long run, a change in interest

rates indicates inflationary expectation.


11/20

International Fisher Effect (IFE)

The international Fisher effect (IFE)

suggests that an interest rate differential

between two countries results in a trend

for the exchange rates to move in the

opposite directions. For instance, when

comparing Australia and the United States,

a higher interest rate in Australia will resultin the long-term appreciation of the USdollar.


12/20

IFE contd

More importantly, the international Fisher

effect also recognises that in the short-

term, countries with higher interest rates

(in this case, Australia) will experience an

appreciation in their currency. A higher

interest rate tends to attract foreign capital

inflow into the country, resulting in theappreciation of the currency.


13/20

Interest Rate Parity

The interest rate differential holds the key

to explaining exchange rate movements in

the short term. According to the interest

rate parity (IRP) theory, a discrepancy

between the forward and spot rate of a

currency is due to the differentiation

between interest rates in two countries.


14/20

IRP contd..

Interest arbitrage creates short-termmovement in the flow of money, and theforward rate discount/ premium eventually

brings the currencies back to equilibrium. Forinstance, let us suppose that the Australiannominal interest rate is currently set at 5.5%and the US at 4.75%. Under the IRP model,

the capital flow will cause an inflow of USdollars into Australia because investors areseeking a higher return on investment (ROI).


15/20

IRP contd.

In order to prevent the occurrence of the so-called covered interest arbitrage (CIA), thedifference of forward rate in these two

currencies would include the difference ininterest rate. Nevertheless, while the IRPtheory states that discrepancies betweeninterest rates in the two countries can cause

exchange rate movement, it is sometimesvery difficult to clearly determinate thecausality of such movement in reality.


16/20

Forward Rate as an Unbiased Predictor

Unbiased expectations hypothesis

This hypothesis states that forward rate is

MARK

ETs prediction of the expected futurespot rate.

Under risk neutrality, market discounts the

expected spot rate at the interest differential.

Current spot rate increases when the expected

value of future spot rate increases.


17/20

Forward Parity

It also states that increase in foreign interest

rates results in increase in the current spot

rate (depreciation of home currency). An

unbiased predictor intuitively implies that

the distribution of possible future actual spot

rates is centered on the forward rate. This,

however, does not mean the future spot ratewill actually be equal to what the future rate

predicts.


18/20

Forward Parity

It merely means that the forward rate will, on

an average, under- and over-estimate the

actual future spot rates in equal frequency

and degree. As a matter of fact, the forward

rate may never actually equal the future spot

rate.


19/20

Forward Parity

The relationship between these two rates

can be restated as follows:

T

he forward d

ifferential (premium ordiscount) equals the expected change in

the spot exchange rate.

Difference between forward and spot rate

(F-S/S) equals Expected change in spot

rate (S2 S1/S1)


20/20

Forward Parity

Algebraically, With Indirect quotes,

(Spot Forward)/Spot = (Beginning Rate

Ending rate)/ EndingR

ate. With Direct Quotes, (Forward- Spot)/Forward

= (Ending Rate Beginning rate)/ Beginning

Rate.

3chapter-paritytheories

Documents