IRP & PPP Flashcards
Explain arbitrage
The act of simultaneously buying and selling the same asset for the purpose of making a profit
Explain Interest Rate Parity
The interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
Also that the forward premium or discount should be equal to the interest rate differential between two countries.
What is interest rate differential?
The difference between two countries interest rates
i$ - i£
What is the Interest Rate Parity formula?
F = S[(1+i$)/(1+i£)]
Suppose US has an int. rate of 5%. The UK has an int. rate of 8%. The spot is S(1.80/£), and the forward exchange for a one year maturity is, F($1.78/£). First check if IRP holds, and if not, you have $1million you want to invest what do you do?
Borrow from US at the lower interest rate, Buy the spot pound, and sell the pound forward contract
F/S(1+i£)=(1.78/1.80)(1.08)=1.068, and (1+.05)=1.05, therefore not equal IRP doesn’t hold, arbitrage opportunity. Borrow $1mill from US at 5% int. Convert into pounds at spot rate, £555k. Invest the pounds at the UK int. rate of 8%, £600k. Sell the forward and exchange for dollars, £600k*1.78 = $1,068,000. Pay back loan from borrowings and total profit is $1,068,000 - $1,050,000 = $18,000
You borrow $1mill from US at 5% int. rate. You lend in the UK at the 8% int. rate, and buy at a the spot rate in the UK, and sell a pound forward contract. What happens the both the US and UK int. rates, and what happens to the pound in the spot and forward markets?
1) US int. rate increases, people want to borrow
2) UK int. rate decreases, people want to lend
3) £ appreciates in spot market, people buying pounds
4) £ depreciates in forward market, people selling contracts
What is currency carry trade?
Buying a high yielding currency and funding it with a low yielding currency, without any hedging
IRP usually holds but may not all the time and mainly for two reasons, what are they?
Transaction Costs & Capital Controls
When an arbitrager buys foreign exchange, where does he buy it and where does he sell it?
He must buy at the higher ask price and sell at the lower bid price, essentially the spread is the cost.
Ask - Bid = Spread
Explain Purchasing Power Parity
A theory that states the exchange rate between currencies of two countries should be equal to the ratio of the countries’ price levels. Example, in 1920’s Germany, Hungary, and Russia experienced hyperinflation, and the purchasing power of the currencies sharply declined in those countries, and at the same time, they sharply depreciated against more stable currencies like the US dollar.
What is the Purchasing Power Parity formula (absolute)?
S = P$/P£ P = Price of a standard commodity basket
What is the relative Purchasing Power Parity formula?
e = [(inflation$-inflation£)/(1+inflation£)] or
inflation$ - inflation£, basically the same thing
e = rate of change in in the exchange rate
What is the real exchange rate formula?
q = [(1+inflation$)/(1+e)(1+inflation£)] e = rate of change in the exchange rate
The annual inflation rate of US is 5%, and the annual inflation rate in the UK is 3.5%. The pound appreciates against the dollar by 4.5%, what is the real exchange rate, and what does it mean?
q = 1.05/(1.045)(1.035) = .97
q
For the real exchange rate (q), what does it mean when it equals 1, is less than 1 or greater than 1?
q =1: Competitiveness of the domestic country unaltered
q < 1: Competitiveness of the domestic country improves
q > 1: Competitiveness of the domestic country deteriorates
