Lecture 4: The International Parity Conditions Flashcards
What are the 5 relationships refered to as ‘international parity conditions’?
- Unnbiased Forward Rates (UFR)
- Interest Rate Parity (IRP)
- *aka Covered Interest Parity (CIP)
- Purchasing Power Parity (PPP)
- The Domestic Fisher Effect
- The International Fisher Effect (IFE)
- or Unccovered Interest Parity (UIP)
Note:
- Some parity conditions hold up extremerly well (e.g. IRP)
- Others hold up OK but only in the very long term PPP
- some are wrong but nevertheless may be approx. true.
What are the underlying assumptions of parity conditions?
- Markets are competitive (including markets that determine interest rates and EX rates)
- Markets are informationally efficient
- No government intervention in markets
- Free movement of funds between countries (currencies)
What are the notations used in parity condition equations?
r = the interbank interest rate for a term T-t.
Ft,T = the forward indirect quote exchannge rate at date t for delivery on date T
S = the spot inndirect quote exchange rate betweenn HC and FC
p = inflation rate
E(x) = the expectation operator
Explain the basis for UFR?
Unbiased forward rates claims that the forward exchange rate is equal to the expected future spot rate
Ft,T = E(ST)
UFR assumes risk neutrality and that there is no systematic risk in currency investment.
Explain the basis for IRP?
Interest rate parity claims that the forward foreign exchannge rate premium (or discount) in % terms is closely related to the different in interest rates between two currencies.
What is the purchasing power parity (PPP) condition?
Explain the basis for PPP; how are its effects felt?
The expected percentage channge inn the spot rate is approximately equal to the expected difference in the inflation rates in the two countries.
PPP is a long-run concept. In the long term we should see the actual appreciation/depreciation of a currency aligned with the actual inflationary experience of the two countries. To achieve parity (or at least a maintenance level) we must hace the higher expected inflation rate currency depreciating by the differential in nominal inflation rates.
What is the Law of One Price (LOOP)
Explain the relationship between PPP and the LOOP?
The LOOP states that the HC equivalent price of anything should e the same everywhere in the world.
LOOP is related to PPP such that it is called absolute PPP. That is to say the LOOP represents the situation where PPP holds unequivocally.
What is a stable price ratio?
How does it relate to PPP?
The stable price ratio states the assumption that the ratio of HC prices between the two countries isnt necessarily 1.
Stable price ratio is referred to as relative PPP as it demonstrates a consistent different in PPP between countries.
Should PPP work in the real world?
NO, because:
- Non-tradinng G&S: many things arent traded internationally so their prices don’t feed into EX rates.
- Frictions: relative prices are often distorted (e.g. tariffs, transport costs).
- Government interventions: many of the EX rates we see are affected by GOV interventions.
- Measurement problems: difficulty in estimating inflation rate (statistical errors); different measures of inflation rates.
Yes (only in the long term), because:
- Its only a long-term concept is about expected inflation and expected EX rates.
- Frictions, Gov. interventions and measurement problems are less relevent in the long-term.
How might PPP be used in real life situations?
- Exchange Rate Policy: PPP may be used by Gov’s to guide them to the magnitude and direction a shift in a peg should be.
- Exchange Rate Prediction: some people use PPP to try and predict future EX rates.
If you can predict inflation rate difference and,
If you can rely on PPP holding in the forecast time period
Then you can predict the EX rates.
- But these are very big ‘if’s*
- Calc the PPP EX Rate: turning PPP ‘on its head’ can calculate what EX rate would be if PPP holds.*
What are the two main uses of PPP EX rates?
- Some people use the gap betweenn PPP rate and Market rate as an innput trying to forcast the direction oof market rate.
- As a means to compare living costs in two countries.
What is the domestic fisher effect?
The higher the expected inflation rate, the higher the nominal interest rate today for that period.
This is because lenders will require the nominal interest rate to be at least equal to inflation, otherwise through lending they go backwards.
*high inflation rates should mean high interest rates.
How is the domestic fisher effect calculated?
What are the implications?
Some countries should have different requires real interest rates if:
- There is high political risk.
- If the expected inflation rate is very high.
Why might the required real interest rates be different?
High Political Risk: the significant chance of a large loss due to expropriation.
Very High Expected Inflation: a high inflation rate could lead to significantly different real interest rates due to componding.
*Uncovered Interest Parity
What is the International Fisher Effect?
Countries with high (low) nominal interest rates will tend to have a depreciating (appreciating) currency.
*Not consistent with traditional wisdom
How do you link the Parity conditions?
- Clockwise:
IF** IRP is true **and, IF UFR is true THEN UIP is true.
- Anticlockwise:
IF** the Fisher Effect is true in H **and**, **IF** the Fisher Effect is true in F **and** **IF** E(ireal) in H=F **and**, **IF** PPP holds **THEN IFE is true.
* If IFE or UIP doesn’t hold then _NO_ risk-free arbitrage opportunity opens up but _RISKY_ opportunnities do.
