Module 5.2: Mark-to-Market Value, and Parity Conditions Flashcards
Mark-to-Market Value
The value of a forward currency contract prior to expiration
Mark-to-Market Value Formula
Covered interest rate parity
forward premium or discount exactly offsets differences in interest rates
Covered interest rate parity formula
Uncovered interest rate parity
Expected future spot rates relating to interest rate differentials
Uncovered Interest Rate Parity Formula
(Domestic) Fisher Relation
the nominal rate of return is (approximately) the sum of the real rate and the expected rate of inflation.
(Domestic) Fisher Relation Formula
real interest rate parity
real interest rates are assumed to converge across different markets
international Fisher effect
tells us that the difference between two countries’ nominal interest rates should be equal to the difference between their expected inflation rates.
international Fisher effect formula
absolute purchasing power parity
compares the average price of a representative basket of consumption goods between countries
absolute purchasing power parity formula
Relative purchasing power parity formula
Relative purchasing power parity
states that changes in exchange rates should exactly offset the price effects of any inflation differential between two countries
ex-ante version
same as relative purchasing power parity except that it uses expected inflation
Several observations can be made from the relationships among the various parity conditions:
- Covered interest parity holds by arbitrage. If forward rate parity holds, uncovered interest rate parity also holds (and vice versa).
- Interest rate differentials should mirror inflation differentials. This holds true if the international Fisher relation holds. If that is true, we can also use inflation differentials to forecast future exchange rates—which is the premise of the ex-ante version of PPP.
- If the ex-ante version of relative PPP as well as the international Fisher relation both hold, uncovered interest rate parity will also hold.
