Parity Relationships Flashcards
LOOP
Identical products, no costs, € x S = $
Big Mac steps
Calculate implied PY/P$, Compare to actual (I-A)/A, minus undervalued plus overvalued
Big mac problems
1) Local price reflect local conditions
2) Can’t trade across countries
3) No arbitrage occurs - people just eat them
Empirical Test PPP Overall
1) Holds long run but not short (15%/year dampening of deviations)
2) Hold better high inflation, underdeveloped capital markets
Rogoff (1996)
LOOP abject failure microeconomic data, PPP evidence tentative at best
Frenkel (1978,1981)
Some evidence PPP holds in hyper inflation economies but not stable monetary environments
Krugman (1978)
PPP Doesn’t hold stable monetary environments
Expected future spot rate
S* = S x (1+pi_home)/(1+pi_foreign)
Percentage change
(End rate - beg rate)/(Beg rate)
Steps of RPPP adjustment
1) Higher pi
2) exports more expensive
3) imports cheaper
4) deficit BOP CA
5) excess supply home currency
6) currency depreciates
Nominal FX index
Trade weighted average of actual FX rates with trading partners
REER Definition
How weighted average purchasing power changes relative to base period
REER Formula
E$R = E$N x C$/CFC
REER Rates Q3
Euro 93.7
Dollar 118.1
Pound 96.9
China 120.3
Pass through depends on
Elasticity - inelastic less price sensitive more of rate change pass through - elastic vice versa
J Curve periods (depreciation of domestic currency)
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
Fisher effect words
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.
Generalised Fisher Equation
Home: ih = rh+ pih
Foreign: if = rf + pif
Fisher’s Theory
Real rates should equalise across countries so:
ih - if = pih - pif
International Fisher Effect words
Expected return investing at home equal expected home currency return from investing abroad. Low rates countries appreciate relative to high rate countries
IFE Equation
S2 = S1 x (1+ih)/(1+if)
IFE Empirical
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.
Forward Rate Words
Rate quoted for settlement at some future date. Pure function of spot rate and interest rate differentials
Forward Rate Equation 1 year
F = S x (1+ih)/(1+if)
Forward Rate Equation n days
Fnh/f = Sh/f x (1+(ih x n/360)/1+(if x n/360))
Forward contract elements
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)
What does interest rate parity link?
FX markets and International Money Markets
Whats the theory behind IRP?
National interest rate differential should be equal but opposite in sign to forward discount or premium against foreign currency (excluding transaction costs)
Is there an excess return if two countries are in IRP?
No, the home return should equal foreign currency return if a covered interest arbitrage trade was performed.
Derive IRP equal returns relationship
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$/1+iy = S/F
When can a CIA be profitable?
When IRP doesn’t hold for a currency pair
Which currency do you conduct CIA in?
Whichever has larger premium versus interest rate differential. If premium is lower than differential, the one with lowest interest rate.
Why do CIA trades push rates toward parity?
1) Purchase in spot of Yen = Yen current price up . Sale of Yen forward = Yen future price down. Premium narrows , converging to parity.
2) Yen securities demand up, rates down
US borrowing up, rates up. Interest rate differential narrows, converging to parity.
Uncovered interest arbitrage theory
Borrow in low interest country, convert to currency of high interest country, invest in high interest country
Why uncovered interest arbitrage?
No forward sold, thus relying on exchange rates staying stable.
Yen Carry trade steps
1) Borrow in yen at low rate
2) Convert to higher rate currency (USD) at current sport rate
3) Invest in money market instruments
4) End of period convert back to yen at new spot rate
5) Pay off Yen loan and keep profits
Carry trade recent news
1) George Saravelos - dollar euro new yen carry trade
2) Negative interest rates in eurozone - stability in €/$ 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
