Lecture 7 Flashcards
What is Absolute PPP?
Purchasing power parity: One dollar can buy the same bundle of goods across countries. Requires essentially that all prices are the same (across countries) when measured in common currency.
What does PPP assume?
1: Law of one price in international trade, P(US) x S= P(Jpn). 2: Prices of non-tradables identical. Ad. 1 violations: transport costs, taxes, menu costs. Ad. 2 violations: non-tradables have different prices across countries. In other words, PPP in the absolute sense does certainly not hold.
Explain PPP with the Hamburger Standard.
Actually, a bad example (hamburgers are non- tradables). Consider the following Big Mac prices: Yuan 13.2, USD 3.73; implied PPP exchange rate: 13.2/3.73=3.54 Yuan per USD. Actual exchange rate: 6.78. Yuan undervaluation: (3.54-6.78)/6.78= - 48%. If Hamburgers should have the same prices in common currency the Yuan should appreciate from 6.78 Yuan per USD to 3.54
What is Relative PPP?
P(US) x S= (cons)xP(Jpn), where S is Yen per USD. Cons is a proportionality factor (prices in the US are proportional to prices in Japan). Relative PPP is not saying prices are the same but relative prices are constant.
What does Relative PPP say about R (real exchange rate)?
Price change in the US (measured in Yen) equals price change in Japan. If a country has higher inflation than another one its exchange rate will depreciate by the inflation differential. According to this hypothesis the real exchange rate should be constant. The real exchange rate is constant over the long run according to relative PPP (R=P(us)S/P(jpn). In this case R=constant). Thus, inflation differentials are a good indication to exchange rate changes in the long run.
When is Relative PPP relevant?
Relative PPP is very relevant for the medium- and long-term (don’t forget that if you invest in high inflation countries). Relative PPP is relevant and useful when we look at countries who are at the same level of development.
What happens to countries with higher inflation than trading partners in the long run?
Countries with higher inflation than trading partners tend to have depreciating currencies in the long term.
What is CIA and UIP(UIA)?
Interest rate parities. Covered Interest Arbitrage/Parity. Uncovered Interest Parity/Arbitrage.
Explain UIA (UIP)?
Assumes investors take unhedged positions. In equilibrium the expected rate of return on investing in the US should equal the expected return in Japan or in any other market (regardless of risk). Investors are said to be risk neutral.
Example of PPP.
5% inflation in Brazil. 2% inflation in DK. We make a 10-year investment. In Brazil we assume a 8% annual ROI: 100*(1,08)^10=216 in Brazil currency after 10 years. (1,03)^10=1,35 because the outcome have to be traded into DKK. 216/1,35=160. This gives annual return of 5% instead of 8%. This shows that the higher inflation depreciates the currency. This happens most of the time, but not always.
Example of CIA.
CIA describes situations where you can invest in bonds in fx US or Switzerland, where you cover your position by not having any exchange rate risk (an american sells his Swiss Franc as soon as he invests, so he don’t get that risk).
What does UIA say about carry trade?
UIA is basically saying that expected return on UK and US assets are the same when we take currency movements into account. Carry trade assumes that currency movements do not fully offset interest rate differentials. E.g. Borrow in cheap interest rate markets (Yen, Swiss franc). Invest in high yielders like Australia, New Zealand, and UK. Has led to an overvaluation of the Kiwi and the Australian dollar
Which is a better predictor: Forward rate or lagged spot rate?
Lagged Spot is better. It is also consistent with the Random Walk hypothesis.
When does CIA hold?
CIA holds always between advanced markets (F is always a reflection of interest rate differentials).
Can we forecast S in the short term?
Forecasting the spot S is essentially impossible in the short term. Don’t take banks’ short term forecasts too serious - they can on average not do better than the lagged spot.
