CHAPTER 4
PARITY CONDITIONS
AND
CURRENCY
FORECASTING
CHAPTER OVERVIEW
I.
II.
III.
IV.
V.
VI.
ARBITRAGE AND THE LAW OF
ONE PRICE
PURCHASING POWER PARITY
THE FISHER EFFECT
THE INTERNATIONAL FISHER
EFFECT
THE RELATIONSHIP BETWEEN
THE FORWARD AND FUTURE
SPOT RATE
CURRENCY FORECASTING
FIVE KEY THEORETICAL
RELATIONSHIPS
UFR
D%e
IFE
PPP
forward
discount or
premium
interest rate
differential
IRP
expected
inflation
differential
FE
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 of the goods ensures
eventually they will worldwide.
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.
ARBITRAGE AND THE LAW OF
ONE PRICE
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
1  ih

e0
1 i f

where
et
e0
ih
if
t
=
=
=
=
=

t

t
future spot rate
spot rate
home inflation
foreign inflation
the time period
PURCHASING POWER
PARITY
2.
If purchasing power parity is
expected to hold, then the best
prediction for the one-period
spot rate should be
1  ih 
t
et  e0
1  i 
t
f
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 country’s
inflation rate is
'
t
e
 et
(1  i f )
(1  ih )
t
t
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 = ih - if
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.
THE FISHER EFFECT
D. Capital market integration
has homogenized markets
around the world
CAPITAL MARKET
SEGMENTATION
Real
interest
rates
aus
DU.S.
SU.S.
Drw
Srw
arw
credit
CAPITAL MARKET
INTEGRATION
DU.S. + Drw = DW
Real
interest
rates
aw
SU.S. + Srw = SW
credit
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  r f ) 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 postulated
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 expected to
appreciate relative to 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 V. 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.
CURRENCY FORECASTING
I. FORECASTING MODELS
A. have been 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