Weeks 5-6 Flashcards
what is the law of one price
- Identical goods and services, measured in a common currency should cost the same in all markets.
what is purchase power parity theory
- PPP: theory suggesting that exchange rates will
adjust over time to reflect the differential in
inflation rates in the two countries; in this way, the
purchasing power of consumers when purchasing
domestic goods will be the same as that when they
purchase foreign goods.
– General inflation level “Basket of goods”
– CPI in practice
what is the absolute and relative form of PPP
Absolute Form of PPP: Without international barriers,
consumers shift their demand to wherever prices are
lower. Prices of the same basket of products in two
different countries should be equal when measured in
common currency.
Relative Form of PPP: Due to market imperfections,
prices of the same basket of products in different
countries will not necessarily be the same, but the rate
of change in prices should be similar when measured
in common currency
what is relative PPP
Theory stating that the rate of change in the prices of
products should be somewhat similar when measured in a
common currency, as long as transportation costs and
trade barriers are unchanged.
Expected Change in Spot Rate = Expected Inflation Differential
using PPP to estimate exchange rate effects
- The relative form of PPP can be used to estimate how an
exchange rate will change in response to differential
inflation rates between countries. - International trade is the mechanism by which the
inflation differential affects the exchange rate according
to this theory. - Using a simplified PPP relationship: The percentage change in the exchange rate should be
approximately equal to the difference in inflation rates between
the two countries.
empirical evidence of PPP
* Absolute PPP
– Commodity Index
* Relative PPP
– Graphically
* Choose two countries (such as the United States and a foreign
country) and compare the differential in their inflation rates to
the percentage change in the foreign currency’s value during
several time periods.
– Correlations / Regression
* Apply regression analysis to historical exchange rates and
inflation differentials.
– Real Value of the Currency
– Do we see mean-reversion?
what is purchasing power disparity
▪ Any points off of the PPP
line represent purchasing
power disparity.
▪ If the exchange rate does not
move as PPP theory suggests,
there is a disparity in the
purchasing power of the two
countries.
▪ Point C represents a
situation where home
inflation (ph) exceeds
foreign inflation (pf ) by
4%.
▪ Yet, the foreign currency
appreciated by only 1% in
response to this inflation
differential. Consequently,
purchasing power disparity
exists.
what are limitations to PPP tests
Results vary with the base period used. The base period chosen
should reflect an equilibrium position since subsequent periods are
evaluated in comparison to it. If a base period is used when the
foreign currency was relatively weak for reasons other than high
inflation, most subsequent periods could show higher appreciation
of that currency than what would be predicted by PPP.
use of PPP and limitations
Deviations from PPP are not as pronounced for longer time
periods, but they still exist. Thus, reliance on PPP to derive
a forecast of the exchange rate is subject to significant
error, even when applied to long-term forecasts.
– Transportation costs
– No substitutes for traded goods
– Product differentiation
– Sticky prices
– Non-traded goods and services
– Inflation index construction
– Productivity bias
– Shipping times
– Confounding effects
what are confounding effects
- A change in a country’s spot rate is driven by more than the
inflation differential between two countries. - Since the exchange rate movement is not driven solely by
ΔINF, the relationship between the inflation differential and
exchange rate movement cannot be as simple as the PPP
theory suggests. - Potential influences on the change in the spot rate include:
– Δ Inflation differentials
– Δ Interest differentials
– Δ Income differentials
– Δ Government controls
– Δ Expectations
what is unbiased expectations hypothesis?
Efficiency:
– Information incorporated into prices
– Spot and forward rates will move in tandem, in light
of news and expectations.
The forward rate should be an unbiased estimate of
the future spot rate.
– If the forward rate is biased, excess profit could be achieved.
what happens when there is a bias in the estimate
- Assume f0 is a biased estimate of st.
e.g. Assume st is, on average, greater than f0. - The trading rule:
1. Buy the currency forward
2. Sell the currency when the contract matures
e.g., f0 = .8740 but st = .88 - When contract matures,*
Buy @ forward .8740
Sell @ spot .8800
Gain 60 points
what are the problems with unbiased expectations hypothesis
- Relies on the certainty assumption
- The previous example is not an arbitrage
The investor is not receiving a risk premium - What if investors are risk averse?
f0- s*0 = p p=/ 0
p may be either positive or negative
i.e. paid by some investors and received by others
what is the fisher effect
Fisher’s Equation:
i ≈ r + p
(1 + nominal) = (1 + real rate) (1 + inflation rate)
- The Fisher effect suggests that the nominal interest
rate contains two components:
a. Expected inflation rate
b. Real interest rate - The real rate of interest represents the return on the
investment to savers after accounting for expected
inflation
how to apply the fisher effect?
Use the Fisher Effect to Derive Expected Inflation per
Country
▪ The first step is to derive the expected inflation rates of the
two countries based on the Fisher effect. The Fisher effect
suggests that nominal interest rates of two countries differ
because of the difference in expected inflation between the
two countries.
Rely on PPP to Estimate the Exchange Rate Movement
▪ The second step is to apply the theory of PPP to determine
how the exchange rate would change in response to those
expected inflation rates of the two countries.
what are IFE derivation/implications
What if IFE holds?
Equating the average yield from domestic and international
investments.
Two cautions:
* known rates vs. unexpected interest rate movements
* present vs. expected future movements in exchange rates
what are implications of international fisher effect
The international Fisher effect (IFE) theory suggests that currencies with
high interest rates will have high expected inflation (due to the Fisher
effect) and the relatively high inflation will cause the currencies to
depreciate (due to the PPP effect).
illustration of IFE line - when ER changes perfectly offset interest rate differentials
▪ All the points along the IFE
line reflect exchange rate
adjustments to offset the
differential in interest rates.
This means investors will end
up achieving the same yield
(adjusted for exchange rate
fluctuations) whether they
invest at home or in a foreign
country.
▪ Points below the IFE line
generally reflect the higher
returns from investing in
foreign deposits.
▪ Points above the IFE line
generally reflect returns from
foreign deposits that are
lower than the returns
possible domestically.
what are the tests of the IFE
Plot: If the actual points (one for each period) of interest rates
and exchange rate changes were plotted over time on a graph,
we could determine whether:
* the points are systematically below the IFE line (suggesting
higher returns from foreign investing)
* above the line (suggesting lower returns from foreign investing)
* evenly scattered on both sides (suggesting a balance of higher
returns from foreign investing in some periods and lower foreign
returns in other periods)
Statistical Test of the IFE
* Apply regression analysis to historical exchange rates and the
nominal interest rate differential.
what are the limitations of the IFE
The IFE theory relies on the Fisher effect and PPP
Limitation of the Fisher Effect
* The difference between the nominal interest rate and actual
inflation rate is not consistent. Thus, while the Fisher effect can
effectively use nominal interest rates to estimate the market’s
expected inflation over a particular period, the market may be
wrong.
Limitation of PPP
* Other country characteristics besides inflation (income levels,
government controls) can affect exchange rate movements.
Even if the expected inflation derived from the Fisher effect
properly reflects the actual inflation rate over the period, relying
solely on inflation to forecast the future exchange rate is subject
to error.
IFE versus reality
- The IFE theory contradicts how a country with a high interest
rate can attract more capital flows and therefore cause the local
currency’s value to strengthen (Ch. 4). - IFE theory also contradicts how central banks may purposely try
to raise interest rates in order to attract funds and strengthen the
value of their local currencies (Ch. 6). - Whether the IFE holds in reality is dependent on the countries
involved and the period assessed. - The IFE theory may be especially meaningful to situations in
which the MNCs and large investors consider investing in
countries where the prevailing interest rates are very high.
comparison of IRP, PPP and IFE
Although all three theories relate to the determination of
exchange rates, they have different implications.
* IRP focuses on why the forward rate differs from the spot rate
and on the degree of difference that should exist. It relates to a
specific point in time.
* PPP and IFE focus on how a currency’s spot rate will change
over time.
* Whereas PPP suggests that the spot rate will change in
accordance with inflation differentials, IFE suggests that it will
change in accordance with interest rate differentials.
* PPP is related to IFE because expected inflation differentials
influence the nominal interest rate differentials between two
countries
