international rate parity

7/30/2019 International Rate Parity

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7-1

International Parity Conditions

International parity conditions are the economic theories thatlink exchange rates,price levels, and interest ratestogether.

International Parity Conditions are only theories and do notalways work out to be true when compared to what isobserved in the real world,

BUT they are central to any understanding of how

multinational businesses are conducted in terms of theexchange rates.

The mistake is often not with the theory itself, but with theinterpretation and application of such theories.


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Prices and Exchange Rates: THELAW OF ONE PRICE

If two identical products are:

sold in two different markets; and

no restrictions exist on the sale; and

transportation costs of moving the product betweenmarkets are equal, then

the products price should be the same in both markets.

If not, ARBITRAGE will make them the same.

This is called the LAW OF ONE PRICE, andarbitrage adjust any discrepancy in prices.


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Prices and Exchange Rates: THELAW OF ONE PRICE

Because of the law of one price, prices for the sameproducts will be the same across countries if frictions(transportation costs, barriers) do not exist.

Lets say two identical products are traded in two countriesat prices Pd and Pf. Because of law of one price, afterconversion from one currency to the other, the value ofthese products should be the same:

Pd = S x Pf

As the prices are given, the exchange rate could be deduced

as:

S = Pd / Pf


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PURCHASING POWER PARITY

Purchasing Power Parity (PPP) is the law of one priceapplied to international trade.

If instead of prices of two identical products traded in twocountries, we used the price levels for a basket of

similar products in those countries (Pd ,Pf), we obtainthat:

S = Pd /Pf

PPP states that, as a result of the law of one price the

exchange rate between currencies of two countries shouldequal the ratio of the countriesprice levels.

Note that what is valid for a single product should be alsovalid for a basket of similar products. This the law of one

pice applied to international trade. 7-4


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PURCHASING POWER PARITY

In summary, the purchasing power parity (PPP) says thatthe exchange rate between currencies of two countries isdetermined by prices levels of those two countries, asfollows:

But, in practice PPP has proved not to be helpful in

determining what the spot rate should be.

f

d

P

PS


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7-6

ABSOLUTE PURCHASING POWERPARITY

Absolute purchasing power parity says that the purchasingpower parity exchange rate could be found bycomparing the prices of any pair of identical products.

Ex. Big Mags in China and USA.


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RPPP holds that the relative change in prices between twocountries over a period of time determines the change in theexchange rate over that period. RPPP focus on explaining thechange is S, rather than the true value of S.

The change in S due to an change in Pd and Pfis given by

RELATIVE PURCHASING POWERPARITY (RPPP)

f

d

P

P

S


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RELATIVE PURCHASING POWERPARITY (RPPP)

RPPP: A change in the differential rate of inflation betweentwo countries tend to be offset over the long run by an equal

but opposite change in the spot exchange rate.

If a country experiences inflation rate higher than othercountries (trading partners), and its exchange rate does not

change, its products become more expensive or lesscompetitive with comparable overseas products. Adepreciation will make domestic products morecompetitive.

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7-9

RPPP and Real Exchange Rate

When RPPP holds, the differential inflation rate betweentwo countries should be exactly offset by the exchange ratechange, and:

When RPPP is violated,

The expression is called real exchangerate

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7-10


Problem 1: Inflation rate is 6% per year in USA and4% in UK. If RPPP holds, how much should theexchange rate change?


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7-11


Problem 1: Inflation rate is 6% per year in USA and4% in UK. If RPPP holds, how much should theexchange rate change?

Sol: If RPPP holds, then: %92.11%)41(%)61(


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7-12


Problem 2: USA annual inflation rate is 5%, and 1% inUK. USD is depreciated 0.5% against the UK. Calculatethe real exchange rate and its probable consequences.


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7-13


Problem 2: USA annual inflation rate is 5%, and 1% inUK. USD is depreciate 0.5% against the GBP. Calculatethe real exchange rate and its probable consequences.

Sol:

The real effective exchange rate rises if domesticinflation exceed inflation abroad and the exchangerate fails to depreciate to compensate for the higherdomestic inflation rate.

Note that if the real exchange rate rises (falls) thedomestic country competitiveness declines (improves)

103.1

%)5.01(

%)11(%)51(


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7-14

Exchange Rates Pass-Through

Exchange rate fluctuations affect the prices of imported andexported goods, and then impact on domestic inflation.

PPP implies that all exchange rate changes are passed through byequivalent changes in prices to trading partners. But, empiricalresearch in the 80s questioned this long-held assumption.

Exchange rate pass-through is defined as the effect of exchangerate changes on domestic inflation.

Incomplete exchange rate pass-through is one reason that acountrys real effective exchange rate index can deviate

For example, a car manufacturer may or may not adjust pricingof its cars sold in a foreign country if exchange rates alter themanufacturers cost structure.


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Exchange Rates Pass-Through

Pass-through can also be partial as there are manymechanisms by which companies can absorb the impact ofexchange rate changes.

Price elasticity of demandis an important factor whendetermining pass-through levels.

Price elasticity of demand for any good is the percentagechange in quantity of the good demanded as a result of the

percentage change in the goods own price.


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INTEREST RATE ANDEXCHANGE RATES

Fisher Effect (interest rate and inflation)

International Fisher Effect (exchange rate an in terest rate)

Interest Rate Parity (interest rate, spot exchange rate, forw ard

exchange rate)

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INTEREST RATES AND EXCHANGES RATESFisher Effect

Irving Fisher: nominal interest rates in each countrymust be equal to the required real rate of return pluscompensation for expectated inflation

i = nominal interest rate

r = real interest rate

= inflation rate

Fisher Effect applied to USA and Japan should be as follows:

7-18

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rrri )1)(1(

ri

JYJYJY

riJapan

riUSA

:

: $$$


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INTEREST RATES AND EXCHANGES RATESInternational Fisher Effect

If a USA investor buys a 10-year japanese yen bond earning4% interest, instead of a 10-year dollar bond earning 6%interest, the USA investor must be expecting the japaneseyen to appreciate against the dollar by at least 2% during10 years.

If not, the USA investor would be better off remaining indollars, and if the japanese yen appreciates more than 2%during the 10-year period, the USA investor would earn ahigher return.

International Fisher effectpredicts that an investorshould be indiffirent to whether his bond is in dollars or yen,because if there are opportunities to earn other investorswould see the same opportunity and compete among them(LAW OF ONE PRICE)

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INTEREST RATES AND EXCHANGES RATESInternational Fisher Effect

The relationshipbetween the percentage change in the spotexchange rate over time and the differential betweeninterest rates in different countries is known as theInternational Fisher effect.

International Fisher effect: the spot exchange rate shouldchange in an equal amount but in the opposite directionto the difference in interest rate between countries.

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Forward Rate and Forward ChangeAgreement

A forward rate is an exchange rate quoted today forsettlement at some future date.

A forward exchange agreementbetween currencies

states the rate of exchange at which a foreign currency willbe bought forward or sold forward at a specific date in thefuture (after 30,60,90,180,270, or 360 days)

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INTEREST RATES AND EXCHANGES RATESInternational Rate Parity

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The theory of Interest Rate Parity (IRP) provides the linkagebetween the foreign exchange rates and the interest rates oftwo countries.

IRP: the difference in the interest rates for two financialassets of similar risk and maturity should be equal to,but opposite in sign to, the forward rate for the foreigncurrency.

IRP is an arbitrage condition that must be hold wheninternational financial markets are in equilibrium, otherwisearbitrage and the LAW OF ONE PRICE will make theequilibrium possible.


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7-23

Assume that an investor has $1 million. If the investorchooses to invest dollar money market instrument, theinvestor would earn the dollar rate of interest. This results in(1+ i$) at the end of the period.

But the investor may choose to invest in a Swiss Francsmoney market instrument of identical risk and maturity forthe same period.

The investor will exchange the US$ for SF at the spot rateS, and immediatelysellthe SF in a forward exchangeagreementto avoid the exchange rate riskby locking theforward rate atF and convert the resulting proceed back

to US$. The comparison of returns would be as follows:

$/

$/$ 1)1()1(SF

SFSF

FiSi


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7-24

IRP:

The left hand side of the equation is the gross return theinvestor would earn by investing in USD.

The right hand side is the gross return the investor wouldearn by exchanging USD for SF at the spot rate S,investing the SF in the SF money market instrument andsimultaneously selling the principal plus interest in SF forUSD at the current forward rate.

$/

$/$ 1)1()1(SF

SFSF

FiSi


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7-25

IRP:

If the returns are the same for the two alternativeinvestments, the spot (S) and the forward rate (F) areconsidered to be at IRP.

Arbitrage states the that the future dollars proceeds frominvesting in two equivalent investments must be the same(no one should be able to make profits as other

investors will do the same until profits become zero)

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$/$ 1)1()1(SF

SFSF

FiSi

)1(

)1($$/

$/

i

i

S

F SF

SF

SF

0)1()1(

$/$$/

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7-26

WhenIRP holds, you will be indifferent between investingyour money in USD and investing in SF with forwardexchange agreements.

However, if IRP is violated, you will prefer one to

another.

WhenIRP doesnt holdthe situation gives rise toCOVERED INTEREST ARBITRAGE opportunities.


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The following adjustment will occur to the initial market conditions

This adjustments will rise the left -hand side and, at the same time lowerthe right-hand side until both side are equlized, restoring IRP


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Interest Ratesand Exchange Rates

A deviation from covered interest arbitrage is uncoveredinterest arbitrage (UIA).

In this case, investors borrow in countries and currenciesexhibiting relatively low interest rates and convert theproceed into currencies that offer much higher interestrates.

The transaction is uncovered because the investordoes no sell the higher yielding currency proceeds

forward, choosing to remain uncovered and accept thecurrency risk of exchanging the higher yield currencyinto the lower yielding currency at the end of the period.

international rate parity

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