Topic 4 - IR Parity Relationships and Forecasting Flashcards
Give a full definition of arbitrage.
Arbitrage can be defined as the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits.
Discuss the implications of the interest rate parity for the exchange rate determination.
Assuming that the forward exchange rate is roughly an unbiased predictor of the future spot rate, IRP can be written as (exchange rate: $/£): S = [(1 + i£)/(1 + i$)]E[St+1|It]. The exchange rate is thus determined by the relative interest rates, and the expected future spot rate, conditional on all the available information, It, as of the present time. One thus can say that expectation is self-fulfilling. Since the information set will be continuously updated as news hit the market, the exchange rate will exhibit a highly dynamic, random behavior.
Explain the conditions under which the forward exchange rate will be an unbiased predictor of the future spot exchange rate.
The forward exchange rate will be an unbiased predictor of the future spot rate if (i) the forward risk premium is insignificant and (ii) foreign exchange markets are informationally efficient.
Discuss the implications of the deviations from the purchasing power parity for countries’ competitive positions in the world market.
If exchange rate changes satisfy PPP, competitive positions of countries will remain unaffected following exchange rate changes. Otherwise, exchange rate changes will affect relative competitiveness of countries. If a country’s currency appreciates (depreciates) by more than is warranted by PPP, that will hurt (strengthen) the country’s competitive position in the world market.
Researchers found that it is very difficult to forecast the future exchange rates more accurately than the forward exchange rate or the current spot exchange rate. How would you interpret this finding?
This implies that exchange markets are informationally efficient. Thus, unless one has private information that is not yet reflected in the current market rates, it would be difficult to beat the market.
The law of one price.
The law of one price (LOP) refers to the international arbitrage condition for the standard consumption basket. LOP requires that the consumption basket should be selling for the same price in a given currency across countries.
Absolute PPP.
Absolute PPP holds that the price level in a country is equal to the price level in another country times the exchange rate between the two countries.
Relative PPP.
Relative PPP holds that the rate of exchange rate change between a pair of countries is about equal to the difference in inflation rates of the two countries.
Evaluate the usefulness of relative PPP in predicting movements in foreign exchange rates on:
a. Short-term basis (for example, three months)
b. Long-term basis (for example, six years)
a. PPP is not useful for predicting exchange rates on the short-term basis mainly because international commodity arbitrage is a time-consuming and costly process.
b. PPP is more useful for predicting exchange rates on the long-term basis.
Purchasing Power Parity (PPP)
the exchange rate between currencies of two countries should be equal to the ratio of the countries’ price levels
International Fisher Effect (IFE)
the nominal interest rate differential reflects the expected change in exchange rate
Interest Rate Parity (IRP)
is a “no arbitrage” condition that must hold when international financial markets are in equilibrium
Fisher effect
holds that an increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country
efficient market hypothesis
financial markets are said to be efficient if the current asset prices fully reflect all the available and relevant information
random walk hypothesis
suggests that today’s exchange rate is the best predictor of tomorrow’s exchange rate
