4 - International Parity Conditions

Question 1

Law of One Price

Answer 1

Prices of identical goods traded in different markets should be the same
-If two identical goods are priced differently in two countries, then arbitrage will take place
-I.e. everyone will buy the cheaper one which leads to price increase, and no one will buy the expensive one which leads to price decrease, until prices converge
(currency is susceptible to arbitrage)

Question 2

Example: If the price of wheat is US$ 4 per bushel in the US and AU$ 6 in Aus, according to the law of one price, S(US$/A$) must be…

Answer 2

US$ 4 / A$ 6.4 = US$ /A$

Question 3

Purchasing Power Parity (PPP)

Answer 3

Deals with the relationship between the prices of goods and services, and the exchange rates:
-According to PPP, exchange rates would adjust to offset the difference in inflation rates between two countries

Question 4

Absolute PPP

Answer 4

• Exchange rates would adjust to offset the difference in price levels between countries
• I.e. one unit of currency has the same purchasing power globally
• The Law of One Price should hold for baskets of goods and services
• Absolute PPP: S($US / A$) = (Pus / Paus)

Question 5

Limitations of absolute PPP

Answer 5

Difficult to test because:
-baskets may vary between countries
-not all goods are traded internationally
-thus, prices may not conform to PPP, even if the law of one price holds
Absolute PPP ignores differences in trade restrictions (e.g. Tariffs, quotas, transportation costs, transaction costs)

Question 6

Relative PPP

Answer 6

-States that the exchange rate of one currency against another will adjust to reflect changes in the price levels (inflation rates) of the two countries

Question 7

Implications of relative PPP

Answer 7

• If inflation in the home country exceeds inflation in the foreign country, the home currency will depreciate relative to foreign currency
• Currency with high inflation rates should depreciate relative to currency with low inflation rates
• If inflation rates of both home and foreign country are the same, there should be no change in the exchange rate

Question 8

Spot rate calculation (given PPP)

Answer 8

e(t) = e0* ((1+Ih)^t/(1+If)^t)
where Ih = home inflation
If = foreign inflation
e0 = spot rate

Question 9

Fisher effect

Answer 9

-Shows the relationship between interest rate, inflation rate, and exchange rate
-The declared interest rate is always the nominal rate which reflect inflation
-Fisher effect states that nominal interest rates (r) are made up of a real required rate of return or real interest rate (a) and an inflation premium equal to the expected inflation (i)
So: 1+Nominal rate = (1+real rate)(1+expected inflation rate)
or: r = a + i + ai

Question 10

Implication of the Fisher Effect

Answer 10

Asserts that if expected real returns are higher in one country than another, capital would flow from the second to the first country currency. This process of arbitrage will continue until expected real returns are equalised. So (nominal) interest rate differential equals anticipated inflations between two currencies

Question 11

Equation implication of Fisher Effect

Answer 11

r(u$) - r(a$) = i(u$) - i(a$)
Where r = nominal IR and i = inflation rate
Implication: countries with higher expected inflation rates should have higher nominal interest rates

Question 12

Interest Rate Parity (IRP) (as a result of the Fisher Effect)

Answer 12

-The forward rate (F) differs from the spot rate (S) at equilibrium by an amount equal to the interest rate differential (Rh - Rf) between the two countries

Question 13

IRP and forward rate discounts/premiums

Answer 13

-Forward discount or premiums are closely related to the interest differentials between two currencies.
-Fwd discounts arise if the fwd rate is below spot rate and fwd premium exists if the fwd rate is above the spot rate
-The fwd premium or discount equals the interest rate differential:
(F - S)/S = (Rh - Rf)