Parity Relationships

Question 1

LOOP

Answer 1

Identical products, no costs, € x S = $

Question 2

Big Mac steps

Answer 2

Calculate implied PY/P$, Compare to actual (I-A)/A, minus undervalued plus overvalued

Question 3

Big mac problems

Answer 3

1) Local price reflect local conditions
2) Can’t trade across countries
3) No arbitrage occurs - people just eat them

Question 4

Empirical Test PPP Overall

Answer 4

1) Holds long run but not short (15%/year dampening of deviations)
2) Hold better high inflation, underdeveloped capital markets

Question 5

Rogoff (1996)

Answer 5

LOOP abject failure microeconomic data, PPP evidence tentative at best

Question 6

Frenkel (1978,1981)

Answer 6

Some evidence PPP holds in hyper inflation economies but not stable monetary environments

Question 7

Krugman (1978)

Answer 7

PPP Doesn’t hold stable monetary environments

Question 8

Expected future spot rate

Answer 8

S* = S x (1+pi_home)/(1+pi_foreign)

Question 9

Percentage change

Answer 9

(End rate - beg rate)/(Beg rate)

Question 10

Steps of RPPP adjustment

Answer 10

1) Higher pi
2) exports more expensive
3) imports cheaper
4) deficit BOP CA
5) excess supply home currency
6) currency depreciates

Question 11

Nominal FX index

Answer 11

Trade weighted average of actual FX rates with trading partners

Question 12

REER Definition

Answer 12

How weighted average purchasing power changes relative to base period

Question 13

REER Formula

Answer 13

E$R = E$N x C$/CFC

Question 14

REER Rates Q3

Answer 14

Euro 93.7
Dollar 118.1
Pound 96.9
China 120.3

Question 15

Pass through depends on

Answer 15

Elasticity - inelastic less price sensitive more of rate change pass through - elastic vice versa

Question 16

J Curve periods (depreciation of domestic currency)

Answer 16

1) currency contract - imports cost more but have to import anyway - trade balance falls
2) pass through - higher import cost reflected in good and services produced - US exports cheaper for foreigners - trade balance starts to increase
3) quantity adjustment - long term adjustment to lower ex rate

Question 17

Fisher effect words

Answer 17

Increase in inflation will result in equal increase in nominal interest rate (vice versa for decrease). Nominal interest rate differential will approx equal anticipated inflation differential.

Question 18

Generalised Fisher Equation

Answer 18

Home: ih = rh+ pih
Foreign: if = rf + pif

Question 19

Fisher’s Theory

Answer 19

Real rates should equalise across countries so:

ih - if = pih - pif

Question 20

International Fisher Effect words

Answer 20

Expected return investing at home equal expected home currency return from investing abroad. Low rates countries appreciate relative to high rate countries

Question 21

IFE Equation

Answer 21

S2 = S1 x (1+ih)/(1+if)

Question 22

IFE Empirical

Answer 22

Mishkin (1982) rejects UIP and Relative PPP combined, not directly IFE but indirectly rejects as IFE key in forming UIP. But generally high inflation and high interest rates correlated and high interest rate countries depreciate.

Question 23

Forward Rate Words

Answer 23

Rate quoted for settlement at some future date. Pure function of spot rate and interest rate differentials

Question 24

Forward Rate Equation 1 year

Answer 24

F = S x (1+ih)/(1+if)

Question 25

Forward Rate Equation n days

Answer 25

Fnh/f = Sh/f x (1+(ih x n/360)/1+(if x n/360))

Question 26

Forward contract elements

Answer 26

1) What is underlying asset
2) Are you buying or selling? (long/short)
3) When you will buy/sell? (forward date)
4) What price? (forward price)

Question 27

What does interest rate parity link?

Answer 27

FX markets and International Money Markets

Question 28

Whats the theory behind IRP?

Answer 28

National interest rate differential should be equal but opposite in sign to forward discount or premium against foreign currency (excluding transaction costs)

Question 29

Is there an excess return if two countries are in IRP?

Answer 29

No, the home return should equal foreign currency return if a covered interest arbitrage trade was performed.

Question 30

Derive IRP equal returns relationship

Answer 30

1) $ (home) return = 1+i$
2) Yen (foreign) return = Sy$ x (1+ iy) x 1/Fy$
3) 1+i$ = Sy$ x (1+ iy) x 1/Fy$
4) 1+i$/1+iy = S/F

Question 31

When can a CIA be profitable?

Answer 31

When IRP doesn’t hold for a currency pair

Question 32

Which currency do you conduct CIA in?

Answer 32

Whichever has larger premium versus interest rate differential. If premium is lower than differential, the one with lowest interest rate.

Question 33

Why do CIA trades push rates toward parity?

Answer 33

1) Purchase in spot of Yen = Yen current price up . Sale of Yen forward = Yen future price down. Premium narrows , converging to parity.
2) Yen securities demand up, rates down
US borrowing up, rates up. Interest rate differential narrows, converging to parity.

Question 34

Uncovered interest arbitrage theory

Answer 34

Borrow in low interest country, convert to currency of high interest country, invest in high interest country

Question 35

Why uncovered interest arbitrage?

Answer 35

No forward sold, thus relying on exchange rates staying stable.

Question 36

Yen Carry trade steps

Answer 36

1) Borrow in yen at low rate
2) Convert to higher rate currency (USD) at current sport rate
3) Invest in money market instruments
4) End of period convert back to yen at new spot rate
5) Pay off Yen loan and keep profits

Question 37

Carry trade recent news

Answer 37

1) George Saravelos - dollar euro new yen carry trade
2) Negative interest rates in eurozone - stability in €/$ rates - interest differential increased but not risk
3) Might be offset by doveish fed in future
4) Euro will now be subject to sharp appreciations if investors get spooked
5) Eva Szalay - rivaling yen as currency everyone wants to borrow but no one wants to own
6) Bloomberg - Dollar/rupee and dollar/lira higher interest spread but also higher risk
7) Highest world carry to risk ratios as of July 2019