Parity conditions in International Finance

A summary

Predicting Exchange Rates

International Parity Approach: use arbitrage arguments.

Fundamental Approach: use macro models
Technical Approach: use time series

Objective

Learn how to predict foreign exchange rates using

arbitrage arguments

Outline
On arbitrage and speculation
Purchasing Power Parity (PPP)
The International Fisher Effect (IFE)
Interest Rate Parity (IRP)

Arbitrage
ENCYCLOPDIA BRITANNICA

Business operation involving the purchase of foreign exchange,

gold, financial securities, or commodities in one market and their
almost simultaneous sale in another market, in order to profit from
price differentials existing between the markets.
Arbitrage generally tends to eliminate price differentials between
markets.

Mind the distinction

Arbitrage: attempt at exploiting short-term market inconsistencies in order
to extract risk-free profits
Speculation: betting that the market will go up or down in the short-term.
Speculators take on tremendous risks.

Whenever there is high risk involved, arbitrage becomes speculation

Arbitrage in the foreign exchange market

Uncovered (Speculation)
Covered (True arbitrage)

Example of uncovered arbitrage

i(us) = 5%
i(uk) = 8%
s = $1.5

Borrow in $ at 5%
Buy pounds and lend at 8%
At maturity exchange back pounds for $
Hope that youll have enough to repay the loan and
make an arbitrage profit

Example of covered arbitrage

i(us) = 5%
i(uk) = 8%
s = $1.5
f = $1.48

Borrow in $ at 5%
Buy pounds and lend at 8%
At maturity exchange back pounds for $

Repay the loan and make an arbitrage profit

Purchasing Power Parity

Absolute PPP
Goods and services should cost the same regardless of
the country
Relative PPP
The exchange rate is expected to adjust in order to
reflect expected relative differences in purchasing
power.

PPP: Background

The basis for PPP is the "law of one price".

Competitive markets will equalize the price of an
identical good in two countries (expressed in the same
currency).

Exemplification
A particular DVD player sells for:
C$ 700 in Sherbrooke
US$ 500 in Burlington
Exchange rate: US$ 1.50/C$.
Consequences
Consumers in Burlington would prefer buying it in Sherbrooke.
Result:
The DVD player price in Sherbrooke should increase to C$750

Caveats
(1) Transportation costs, barriers to trade, and other can make a
difference.

(2) There must be competitive markets for the goods and services
in question in both countries.

(3) The law of one price only applies to tradable goods .

PPP: Implications

When a country's domestic price level is increasing

(inflation), the exchange rate must depreciated in order
to return to PPP.

Relative PPP: Calculation

E(st)/s0 = (1+inflationh)t/(1+inflationf)t
when t=1
E(s1)/s0 = (1+inflationh)/(1+inflationf)

The Big Mac Index

Food for thought

Jan 7th 1999

From The Economist print edition

For more than a decade, The Economists Big Mac index has offered a light-hearted guide to
whether currencies are at their correct level.
It is based on the theory of purchasing-power parity (PPP)the notion that a basket of goods
and services should cost the same in all countries.
Thus if the price of a Big Mac is lower in one country than in America, this suggests that its
currency is undervalued relative to the dollar and vice versa.
The price of a Big Mac varies in the euro area, from euro3.36 in Finland to a bargain euro2.19 in
Portugal. The weighted average price in the 11 countries is euro2.53, or $2.98 at current
exchange rates.
In America a Big Mac costs only $2.63 (taking the average of three cities).
So the Euro is 13% overvalued against the dollar.

Big MacCurrencies
Apr 27th 2000

From The Economist print edition

Some people read tea leaves to predict the future. We prefer hamburgers
Some readers beef that our Big Mac index does not cut the mustard. They are right
that hamburgers are a flawed measure of PPP, because local prices may be distorted
by trade barriers on beef, sales taxes or big differences in the cost of non-traded
inputs such as rents. Thus, whereas Big Mac PPPs can be a handy guide to the cost
of living in countries, they may not be a reliable guide to future exchange-rate
movements. Yet, curiously, several academic studies have concluded that the Big
Mac index is surprisingly accurate in tracking exchange rates over the longer term.
Indeed, the Big Mac has had several forecasting successes. When the euro was
launched at the start of 1999, most forecasters predicted that it would rise. But the
euro has instead tumbledexactly as the Big Mac index had signaled. At the start of
1999, euro burgers were much dearer than American ones. Burgernomics is far from
perfect, but our mouths are where our money is.

The Fisher Effect

The Simple Fisher Effect

The International Fisher Effect

The Fisher Effect

Simple Fisher Effect:
Nominal interest rates equal real interest rates plus inflation
premium:
(1+ni) = (1+ ri)(1+inflation)
ni = ri + inflation + (ri)(inflation),
When (ri)(inflation) is a very small number:
ni = ri + inflation

International Fisher Effect (IFE)

The exchange is expected to change in order to reflect
expected relative differences in nominal interest rates.
IFE assumes differences in nominal interest rates are driven
by expected relative differences in inflation.
E(st)/s0 = (1+nih)t/(1+nif)t
E(s1)/s0 = (1+nih)/(1+nif), when t=1

Interest Rate Parity (IRP)

The forward exchange rate reflects expected relative
differences in nominal interest rates.
IRP also assumes differences in nominal interest rates are
driven by expected relative differences in inflation.

ft/s0 = (1+nih)t/(1+nif)t
f1/s0 = (1+nih)/(1+nif), when t=1

What is the relationship between forward and future

expected exchange rates?

Some believe f = E(s)

Some believe f = E(s) + risk premium

Summary
The Law of One Price - the arbitrage argument - says
that goods and services should be worth the same when
compared across borders
An increase in inflation and the resulting increase in the
nominal interest rate should cause the domestic currency
to depreciate.
And vice-versa.