W2P4 - Asset Markets

Question 1

Explain the concept of ‘Absolute Purchasing Power Parity’

Answer 1

Absolute Purchasing Power Parity states that the real exchange rate is equal to 1 so that:
σ=SP/P* = 1
This would imply that the price of domestic and foreign goods and services is the same across countries when expressed in the same currency.
(there’s little empirical support for absolute purchasing power parity).

Question 2

Explain the concept of ‘Relative Purchasing Power Parity’

Answer 2

Relative Purchasing Power Parity states that the real exchange rate is not necessarily 1, it is rather a constant. This implies that changes in nominal exchange rates reflect changes in domestic and foreign prices.
So that:
(∆S/S) = (∆P/P) = (∆P/P)
(There seems to be more empirical support for relative purchasing power parity).

Question 3

Explain the concept of ‘Uncovered Interest Parity’

Answer 3

The Uncovered Interest Parity states that due to arbitrage, the rate of
return on a foreign bond and the rate of return on a domestic bond will
equalise when they are expressed in the same currency, assuming both
carry equal risk. Hence we have that:
(1+i(t)) = ((S(t).(1+i*(t))/S(t+1))
where
1+i(t) = return on domestic bond
S(t+1) = Return on Foreign Bond