International Parity Conditions, Interest Rates & Exchange Rate Determination Flashcards
What is the law of one price?
If identical products or services can be sold in two different markets, and no restrictions exist on the sale or transportation of product between markets, the product’s price should be the same in both market although price is states in different terms:
P($) xS = P(yen)
The challenge in applying the theory in the real world is that there exist few products that are truly identical across markets. And if they are identical, are they truly “transportable” across markets with nearly zero transportation costs and fee
What is the difference between absolute and relative PPP?
Absolute PPP: the spot exchange rate is determined by the relative prices of similar baskets of goods
Relative PPP: if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate
How close does the Big Mac Index conform to the theoretical requirements for a one price measurement of purchasing power parity?
- The Big Mac may be a good candidate for applying the law of one price and measuring under- or overvaluation
- The product is nearly identical in each market as a result of product consistency, process excellence, and McDonald’s brand image and pride.
- the product is a result of predominantly local materials and input costs. This means that its price in each country is representative of domestic costs and prices and not imported ones, which exchange rates themselves would influence.
- BUT Big Macs cant be traded across borders, and costs and prices are influenced by a variety of other factors in each country
According to the theory of purchasing power parity, what should happen to a currency which is undervalued?
Theoretically, if the currency is undervalued then market participants, in search of potential profits, will continue to purchase the currency until they drive its price up eliminating the undervaluation
Explain how a nominal effective exchange rate index is constructed
An exchange rate index is an index that measures the value of a given country’s exchange rate against all other exchange rates in order to determine if that currency is overvalued or undervalued.
A nominal effective exchange rate index is based on a weighted average of actual exchange rates over a period of time. It is unrelated to PPP and simply measures changes in the exchange rate (i.e., currency value) relative to some arbitrary base period. It is used in calculating the real effective exchange rate index
Define the Fisher effect and give the formula
The Fisher effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation.
Formula: derived from (1 + r)(1 + π) – 1:
𝑖 = 𝑟 + 𝜋 + 𝑟𝜋
I is the nominal rate of interest,
r is the real rate of interest, and
π is the expected rate of inflation over the period for which funds are to be lent
What is the approximate form of the Fisher effect, and why is it frequently used?
The final compound term, r times π, is frequently dropped from consideration due to its relatively minor value. The Fisher effect then reduces to (approximate form):
𝑖 = 𝑟 + 𝜋
Define the international Fisher effect
The real return in different countries should be the same, so that if one country has a higher nominal interest rate, the gain from investing in that currency will be lost by a deterioration of its exchange rate. Internationally, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries.
(S1 − 𝑆2 / 𝑆2) × 100 = 𝑖$ − 𝑖¥
Does the intl Fisher effect exist in practice?
Empirical tests using ex-post national inflation rates have shown the Fisher effect usually exists for short-maturity government securities such as treasury bills and notes. Comparisons based on longer maturities suffer from the increased financial risk inherent in fluctuations of the market value of the bonds prior to maturity. Comparisons of private sector securities are influenced by unequal creditworthiness of the issuers. All the tests are inconclusive to the extent that recent past rates of inflation are not a correct measure of future expected inflation
What does the interest rate parity theory state?
The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs.
What is the difference between covered and uncovered interest arbitrage?
Covered interest arbitrage: when the market is not in equilibrium, the potential for “riskless” or arbitrage profit exists. The arbitrager who recognizes such an imbalance will move to take advantage of the disequilibrium by investing in whichever currency offers the higher return on a covered basis. (when market not in equilibrium)
Uncovered interest arbitrage: investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. It’s uncovered bc investors choose to remain uncovered + accept currency risk of exchanging the higher yield currency into lower yield currency at the end of period
If someone you were working with argued that the current forward rate quoted on a currency pair is the market’s expectation of where the future spot rate will end up, what would you say?
The forward rate is a calculation, using three observable market rates: the spot exchange rate, the domestic interest rate, and the foreign interest rate. It is technically categorized as a foreign currency loan agreement by the financial institution, and the rate makes that evident. Its calculation has no “predictive” element, although many people in the market commonly use it as a forecast. In fact, the forward rate has been repeatedly tested over time as to its forecasting accuracy, and it generally performs pretty well when forecasting out 30 to 90 days
If transaction costs for undertaking covered or uncovered interest arbitrage were large, how do you think it would influence arbitrage activity?
It would result in large discrepancies between market rates and quotes, as a higher transaction cost would dissuade many arbitragers from making the trades for small amounts.
What is foreign currency intervention?
active management, manipulation, intervention in the market’s valuation of a country’s currency
Why intervene in the market of a currency?
fight inflation (strong currency)
fight slow economic growth (weak currency)
