International parity relationships Flashcards
What is covered interest arbitrage
This is the process of capitalizing on the interest rate differential between 2 countries, while covering for exchange rate risk (Spot and Forward is fixed today)
Interest arbitrage - process of capitalizing on interest rate difference
Covered - uses a forward contract to cover the transaction in future
What is the impact of covered interest arbitrage
-An efficient market does not allow profit to be made without taking risk
-The normal assumption is that the forward rate will adjust to other variables (Spot rate, UK interest and EU interest rate)
-In practice, future expectation drives all 4 variables at
What 2 investment options do you have with this if you have £10k to invest
1) Deposit your money in a UK bank for a year
2)Convert your money to euros today and deposit them at the eurozone rate for one year, and convert back into pounds
Is it better to do option 1 or 2 ??
What is the interest rate parity ??
Is a “no arbitrage” condition which suggests that forward exchange rates are defined by todays spot exchange rates grossed up and down by the future value interest factors
What does the interest rate parity result in ?
A country with a higher interest rate will NOT offer a higher return to the foreign investor because the forward rate offsets the gain in interest rates
Why does the the market reach the equilibrium state ??
Market forces will cause the interest rates to adjust such that covered interest arbitrage is no longer feasible, this is the IRP
What is the no arbitrage condition within IRP
Where option 1 is equal to option 2
What is the generic equation for the forward rate ?
How to you derivate from forward rate to get the equation for the forward premium ??
What is the forward premium denoted by ??
Denoted by p
How does the forward premium relate to forward and spot rates ?
The forward rate is = to the spot rate multiplied by 1 + the forward premium
What can we approximate about the forward premium if both foreign and home interest rates are low ??
That the forward premium is approx the home interest - foreign interest
Now looking at the example from before what return are we given for option 1 and 2
What does LOOP state about identical goods or financial assets ??
That identical goods or financial assets with identical risks traded in 2 different markets must have the same price in both markets
What are the 2 kinds of purchasing power parity (PPP)
1) Absolute PPP
2) Relative PPP
What is absolute PPP ?
Extends the law of one price (LOOP) to bundles of identical goods
-In the absence of barriers to trade and transportation
Implication: Prices of the same basket of products in two different countries should be equal when measure in a common currency, the problem is finding identical goods
Solution: The big Mac index
What is relative PPP ?
Accepts deviations from absolute PPP, focuses on changes in exchange rates and prices (inflation)
How can absolute PPP be expressed ?
Based of this, what is the equation for the spot rate ?
What does this mean
-A bundle of products costs £100 in the UK
-The same bundle costs 900YEN in china
-Then the PPP spot exchange should be £0.1111/YEN
What happens if the good is cheaper in china than in the UK ?
-UK consumers will now import that good from China, meaning the demand will shift from the UK to china
What does higher demand in China relative to in the UK means what ?
Prices in China must increase for UK consumers until the discrepency disappears and the following relationship holds again
you are given this, for absolute PPP to hold what does the spot FX rate need to be ??
If this is the spot rate for absolute PPP to hold, but you observe a spot FX rate of £0.6579/$ than what needs to be done for absolute PPP to hold again
Provide the 3 main points about PPP
-It implies exchange rates will adjust to equalize the purchasing powers of same bundle of products
-The key is that the differences in prices across countries should be reflected in the relative price of the currencies i.e. the exchange rate
-If it is not reflected than there is arbitrage opportunity, i.e. you can buy cheap and sell high
What does relative PPP account for that absolute does not ??
It accounts for market imperfections such as transportation costs, tariffs and quotas
-This is why the spot FX may not satisfy the absolute PPP
What happens to the price of the iphone in the UK
-The price of Iphone in the UK now increases £1050 and not £1000 so the absolute PPP is violated
What does relative PPP state about the difference in prices in percentage terms ??
That they should be constant
- If iPhone is %5 more expensive in UK than in US today
-Than in 1 years time the iPhone should still be 5% more expensive in the UK than US
Whats the difference between todays price and 1 year time ???
INFLATION
What does relative PPP say about movements in the exchange rate
That it moves in such a way that it compensates the inflation differentials in the 2 countries, and such that price differentials are kept constant
What will the expected price indexes be ??
What happens if Ih > If and the FX rate does not change ??
For a home country’s customers, the purchasing power will be greater when buying foreign goods (Higher external purchasing power) than home goods (Foreign goods are cheaper)
What happens if Ih < If and the FX rate does not change ??
For home country’s customers, the purchasing power will be greater when buying home goods (Higher internal purchasing power) than foreign goods (Home goods are cheaper)
What does the PPP suggest about exchange rate ??
That the exchange rate will adjust in such a way that maintains the parity (equality) in purchasing power
What does ef denote in the foreign price index ??
Let it denote the percentage change in the value of foreign currency for the consumers in home country
What does the foreign price index become from the home consumers perspective if inflation occurs and the exchange rate of the foreign currency changes ??
What is the formula for relative PPP
We assume that Ph = Pf
What is the formula for the change in the value of currency ??
What happens if Ih > If
When would foreign currency appreciate ?
If home countries inflation is grater than foreign countries inflation and vice versa
What is real change in income ??
What is the International Fisher Effect ??
According to Fisher, the nominal or monetary interest rate is approximately equal to real interest rate and inflation
If real return is constant, than the differences in expected nominal interest rates should be equal to differences in expected inflation, what is this called ??
This is the International Fisher Effect
What does the IFE link international differences in nominal interest rates to ??
Links to changes in the direct spot exchange rate
IFE example
IRP based on arbitrage, what is the forward premium rate
What is the absolute form of PPP
What is the relative form of PPP
What is the equation for IFE
