five parity conditions in ifm
TRANSCRIPT
UNIVERZA V LJUBLJANI FACULTY OF ECONOMICS
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UNIVERZA V LJUBLJANI FACULTY OF ECONOMICS
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1. The Purchasing Power Parity Theory2. The Interest Rate Parity Theory3. The Fisher Effect4. The International Fisher Effect5. Forward Rate as an Unbiased Predictor of the Future Spot
Rate6. Synthesis of the Parity Conditions Theories in
International Finance
CONTENTS AND PURPOSE
Purpose: get acquainted with the conceptual basis for the analysis of
exchange rate changes
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1. The Purchasing Power Parity Theory PPP Concept
Basic logic: the exchange rate between two currencies should ensure that the
Law of One Price holds not only with respect to one good, but with respect to an identical basket of goods and services in the two countries
Assumptions of the Law of One Price: zero transport costs, no barriers full information identical quality of goods and services, universal basket of goods
and services
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spot exchange rate is determined by the relative prices of similar baskets of goods
Absolute Version of PPP
DEMp
ps $
0
Relative Version of PPP and Mathematical Derivation
eDEM
eDEM
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1$
0
0
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Empirical Tests of PPP
interpretation problems: which prices should be used to calculate the price level? short run or long run?
problems of the theory: unrealistic assumptions statistical problems (identical basket of goods?) ignores capital flows cause-and-effect relationship between the exchange rate and
prices?
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Empirical Tests of PPP
Empirical tests results: long run traded goods and services sector countries that are geographically close to each other high rates of inflation in comparison to their trading partners
Best usage: long-run target exchange rate to which the exchange rate between
two currencies should move
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2. The Interest Rate Parity Theory (IRP) IRP Concept
Basic logic: capital flows between two countries occur as a result of differences in
their interest rates size of the difference is extremely important for the size of the difference
between spot and forward exchange rates of the two currencies forward rate discount/premium is closely related to the difference in the
national interest rates
Investor can invest at home or abroad: exchange the domestic currency for a foreign currency in the spot market,
invest the foreign currency in a foreign money market instrument, convert the resulting proceeds back to the domestic currency in the forward market
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IRP and Covered Interest Arbitrage (CIA)
IRP ensures that investments of similar risk yield similar profits
if an investment in a home country and an investment abroad yield the same profit, then there is no possibility for CIA
CIA: no exchange rate risk, because sale/purchase of a foreign currency
in the spot market occurs simultaneously with the sale/purchase of the same foreign currency in the forward market
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Empirical Tests of IRP
Deviations from IRP: transaction costs international capital flows barriers political risk investors wish to spread their wealth to decrease risk
Fairly convincing empirical support: especially euro-currency market transactions deviations from IRP are mainly the result of capital controls, taxes
and other capital transfer tariffs and transaction costs
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3. The Fisher EffectFE Concept
Basic logic: arbitrage causes the equalization of the real rates of return, the real
interest rates
balance will be reached when the difference in nominal interest rates will be equal to the difference in expected rates of inflation
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Empirical Tests of FE
countries with higher rates of inflation have higher nominal interest rates
arbitrage that occurs with enormous international capital flows forces the real interest rates in the most important countries to converge to the same level
national capital markets segmentation: main explanation for empirically low correlation between nominal interest rates and expected rates of inflation
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Assumptions: perfect competition in the goods market and in the financial
market all countries consume an identical basket of goods certainty and identical risk of domestic and foreign securities perfect international capital mobility
4. The International Fisher EffectIFE Concept
Basic logic: difference in real interest rates will initiate international capital
flows
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UIP: borrow domestic currency at a fixed interest rate and for a given
period of time in financial center A exchange the borrowed domestic currency into a foreign currency
in financial center B immediately, deposit at a fixed interest rate for the same period of time as the domestic currency was borrowed in financial center A
domestic currency is bought at the end of the period at the spot exchange rate that is prevailing at that time
risky transaction whose profit/loss depends on the difference in future and current spot exchange rate
The International Fisher Effect and Uncovered Interest Arbitrage (UIP)
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Empirical Tests of IFE
validity depends crucially on perfect exchangeability of domestic and foreign securities: perfect international capital mobility investors’ perception that investments at home and abroad are
equally risky
empirical tests support the idea that the countries with high rates of inflation and high nominal interest rates are usually also the countries whose currencies tend to depreciate
low support to the relationship between the differences in nominal interest rates and the expected movement of the spot exchange rate
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5. Forward Rate as an Unbiased Predictor of the Future Spot Rate
FUS Concept
Assumptions: all relevant information is quickly reflected in both the spot and
forward exchange markets low transaction costs perfect capital mobility and identical risk (financial instruments
are perfect substitutes)
spot and forward rate depend completely on the current expectations of economic agents
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Mathematical Derivation and Explanation of FUS
if there exists a forward premium on home currency with respect to the foreign currency, then the home currency is expected to appreciate with respect to the foreign currency
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sf t
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Empirical Tests of FUS
immediately after 1973: foreign exchange market quite efficient forward rate is the unbiased predictor of spot rate in the short run
newer empirical tests: impossible to test the foreign exchange market efficiency, the
foreign exchange market is not efficient forward discount currencies usually depreciate with respect to the
forward premium currencies even if we assume that the forward rate is an unbiased predictor of
the future spot rate in the long run, this is not true in every single moment
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6. Synthesis of the Parity Conditions Theoriesin International Finance
strong theoretical basis for the understanding and explanation of the international financial environment, especially the factors that influence changes in exchange rates
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Expected percentage change in spot exchange rate of
home currency relative to foreign currency
v odnosu na tujo valuto
Forward premium/discount on foreign currency
Difference in expected rates of inflation
Difference in interest rates
International Fisher effect
DEMt iis
ss
$
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0
Forward rate as an unbiased predictor of the future spot rate
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Purchasing power
parity
eDEM
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$
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Fisher effect eDEM
eDEMii $$
Interest rate parity
DEMiis
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