International Parity

Question 1

What is Parity condition?

Answer 1

Parity condition - this is ecnomic theory that links interest rate, exchange rate, and price levels. Uncovered simply means accpeting currency risk, leaving it open for the duration.

(1+r) / (1+r*) =
Spot (expected in year 1) / Spot

Assumption is Pefrect Capital Market

1. No transaction cost
2. No taxes
3. Complete certainty

Question 2

What is UIRP?

Answer 2

Simplictic UIRP is approximately
R=r* + depreciation rate of domestic currency
The “uncovered” basis simply means accepting currency risk.

assumptions:

1. Identical deposit
2. No barriers for international transfer of funds
3. Investor exempt from all taxes
4. No risk premium

Question 3

What is CIRP?

Answer 3

CIRP is closing down the the transaction using availability of Forward exhcnage rate, so in other words no risk involved.
that is R = r* + forward premium

Three condition (rather weak) must meet for CIRP to hold

1. Enough liquidity for Forward exchange market
2. Well defined exchange market
3. Reasonably low transaction cost, otherwise instanteneous arbitrage will not occur

Question 4

What is link between IRP and PPP?

Answer 4

Nominal interest rate in each country are equal to the required real rate of return + compensation for expected inflation

Fisher equation:
r = R +dP(e)

Suppose Fisher applies in foreign country
Note: We allow all variables of foreign Fisher equation.

r-r* = (R-R) + (dP(e)-dP(e))

Nominal r differential must equal expected rate of depreciation ds (UIRP)
and absence of barriers for capital movement R=R* hence we have

ds(e) = dP(e) - dP*(e) it implies PPP applies to market expectations of inflation differentials and expected exchange rate depreciation
(this might be the explanation for PPP failure because wrong measure was used to test)

We know real exchange rate expected to remain constant. qs(e)=o

Suppose all economic agents know future P and P* and s with absolute accuracy =>

ds - (dP - dP) = dQ = R - R
From this dQ = R - R*
we see that movements in real exhcange rate reflect changes in rela interest rate differential.

We conclude in a world where
1. expectations are correct
2. same real interest rate across countries
3. risk neutral agents
any 2 of the following relationship implies the third
Fisher equation, UIRP, and PPP