Download - International parity condition
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International Parity
Condition
Maica Jimena BatiancelaBSBA Financial Management
Saint Louise de Marillac College of Sorsogon
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DEFINITION
The parity conditions are equilibrium conditions that establish linkage between financial prices in the
absence of arbitrage.
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IMPLICATION
☺Provide guidelines for financial strategic decisions suggested by each side of parity condition.
☺The parity conditions define international financial ´break-even points encompassing alternative strategies yielding identical financial outcomes suggested by each side of parity condition.
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☺ From private investors point of view, parity conditions help to make optimal (beneficial) financial decisions regarding the choice of currency for borrowing , location of plants in different countries, measuring currency risk exposure.
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☺From public policy makers point of view, parity conditions help to evaluate the strength of national currencies, the efficiency of national capital markets , and the effectiveness of fiscal and monetary policies towards achieving macroeconomic policies
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International
Arbitrage
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• Arbitrage can be loosely defined as capitalizing on a discrepancy in quoted prices to make a riskless profit.
• The effect of arbitrage on demand and supply is to cause prices to realign, such that no further risk-free profits can be made.
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• As applied to foreign exchange and international money markets, arbitrage takes three common forms:–locational arbitrage–triangular arbitrage–covered interest arbitrage
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LOCATIONAL ARBITRAGE
• Locational arbitrage is possible when a bank’s buying price (bid price) is higher than another bank’s selling price (ask price) for the same currency.
• ExampleBank C Bid Ask Bank D Bid AskNZ$ $.635 $.640NZ$ $.645 $.650
• Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645. Profit = $.005/NZ$.
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TRIANGULAR ARBITRAGE
• Triangular arbitrage is possible when a cross exchange rate quote differs from the rate calculated from spot rate quotes.
• Example Bid AskBritish pound (£) $1.60 $1.61Malaysian ringgit (MYR) $.200 $.202British pound (£) MYR8.10 MYR8.20
• MYR8.10/£ X $.200/MYR = $1.62/£• Buy £ @ $1.61, convert @ MYR8.10/£, then sell MYR @
$.200. Profit = $.01/£.
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COVERED INTEREST ARBITRAGE
• Covered interest arbitrage is the process of capitalizing on the interest rate differential between two countries while covering for exchange rate risk.
• Covered interest arbitrage tends to force a relationship between forward rate premiums and interest rate differentials.
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• Example£ spot rate = 90-day forward rate = $1.60U.S. 90-day interest rate = 2%U.K. 90-day interest rate = 4%
Borrow $ at 3%, or use existing funds which are earning interest at 2%. Convert $ to £ at $1.60/£ and engage in a 90-day forward contract to sell £ at $1.60/£. Lend £ at 4%.
Note: Profits are not achieved instantaneously.
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Currency Future
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DEFINITION☺Are standardized contracts, with fixed,
standardized contract sizes and fixed expiration dates, that are exchange-traded, i.e., traded as securities on organized exchanges.
☺Futures contracts have secondary markets, can be traded many times during life of contract, like a bond (vs. bank loan).
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PARTICIPANTS IN FUTURES
1. Speculators Pure speculative bet/investment using
futures contracts, with no business interest in the underlying commodity/currency
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2. Hedgers Someone with a business/personal
interest in the underlying currency, and is using futures trading to minimize, eliminate or control currency risk, e.g., MNCs, banks, exporters, importers, etc.
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Currency Option
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DEFINITION☺A contract that grants the holder the right, but not
the obligation, to buy or sell currency at a specified exchange rate during a specified period of time.
☺For this right, a premium is paid to the broker, which will vary depending on the number of contracts purchased.
☺Currency options are one of the best ways for corporations or individuals to hedge against adverse movements in exchange rates.
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☺Investors can hedge against foreign currency risk by purchasing a currency option put or call.
☺For example, assume that an investor believes that the USD/EUR rate is going to increase from 0.80 to 0.90 (meaning that it will become more expensive for a European investor to buy U.S dollars). In this case, the investor would want to buy a call option on USD/EUR so that he or she could stand to gain from an increase in the exchange rate (or the USD rise).
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Parity Conditions
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Parity Conditions Resulting Arbitrage Activities:
1. Purchasing Power Parity (PPP)2. The Fisher Effect (FE)3. The International Fisher Effect
(IFE)4. Interest Rate Parity (IRP)
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PURCHASING POWER PARITY (PPP)
• states that spot exchange rates between currencies will change to the differential in inflation rates between countries.
• Can be:–Absolute Purchasing Power Parity–Relative Purchasing Power Parity
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ABSOLUTE PURCHASING POWER PARITY
• Price levels adjusted for exchange rates should be equal between countries
• One unit of currency has same purchasing power globally.
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RELATIVE PURCHASING POWER PARITY
• states that the exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries.
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In mathematical terms:
where et = future spot rate
e0 = spot rate
ih = home inflation
if = foreign inflation
t = the time period
tf
tht
i
i
e
e
1
1
0
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• If purchasing power parity is expected to hold, then the best prediction for the one-period spot rate should be:
tf
th
ti
iee
1
10
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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• According to the Fisher Effect , countries with
higher inflation rates have higher interest rates.
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THE INTERNATIONAL FISHER EFFECT (IFE)
• the spot rate adjusts to the interest rate differential between two countries.
• IFE = PPP + FE•
tf
tht
r
r
e
e
)1(
)1(
0
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Simplified IFE equation:(if rf is relatively small)
rh - rf = e1 - e0
e0
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Interest Rate Parity (IRP)
• As a result of market forces, the forward rate differs from the spot rate by an amount that sufficiently offsets the interest rate differential between two currencies.
• Then, covered interest arbitrage is no longer feasible, and the equilibrium state achieved is referred to as interest rate parity (IRP).
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• When IRP exists, the rate of return achieved from covered interest arbitrage should equal the rate of return available in the home country.
• End-value of a $1 investment in covered interest arbitrage = (1/S) x (1+iF) x F
= (1/S) x (1+iF) x [S x (1+p)]
= (1+iF) x (1+p)
• where p is the forward premium.
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• End-value of a $1 investment in the home country
= 1 + iH• Equating the two and rearranging terms:
p = (1+iH) – 1
(1+iF)
i.e.
forward = (1 + home interest rate) – 1
premium (1 + foreign interest rate)