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FINANCIAL MARKETS
Topic 3
INTERNATIONAL PARITY CONDITIONS
AND FORECASTING EXCHANGE RATES
Outline
1.
2.
3.
4.
5.
6.
Identical goods will sell for the same price in two markets, taking into
account the exchange rate
Pt[US, wheat] = Spott [$/] x Pt[UK, wheat]
Example: $4.50
bushel
$1.50
3.00
bushel
S PPP
The
S1PPP S 0
S0
1 HC
1 HC FC
1 FC
1
PPP
4% p.a.
2% p.a.
1.50 CHF/USD
1.04
1.50
1.5295 CHF/USD
1.02
1.04
1 1.96% 4% - 2%
1.02
S1actual S 0
S0
Given an Sactual:
SHC-FC = HC - HC
5
4
3
2
HC FC
1
0
-7
-6
-5
-4
-3
-2
-1 -1 0
-2
-3
-4
-5
-6
-7
this does not necessarily mean that the real value of HC purchases of goods and
services across borders has become lower
if the increase in PFC has exactly offset the decline in value of the FC, then PPP
would remain the same
there has been a nominal depreciation of FC, but not a real depreciation
What matters for PPP across any two countries is the change in the
nominal value of a currency after adjustment for changes in the
relative inflation rates between the two countries
1.50
q
1
1.50
1.55
q
1.033
1.50
USD overvalued
CHF undervalued
1.45
q
0.967
1.50
USD undervalued
CHF overvalued
S1actual S 0
S0
S1PPP S 0
S0
Example:
S0=1USD/EUR; $=5% p.a.; =10% p.a.
S1 1 1.05 0.9545 USD/EUR
PPP
1.10
S PPP
1.05
1 4.55%
1.10
USD
S1actual
(USD/EUR)
Sactual(%)
SPPP(%)
q(%)
Interpretation
0.9545
0.9600
-4.55
-4.00
-4.55
-4.55
0
+0.55
0.9500
-5.00
-4.55
No change in q
EUR appreciated in real
terms by 0.55% against
USD
NEER
REER
transportation costs
existence of non-tradables
currency forecasting
The Big Mac Index shows the extent to which international price
discrimination is possible for a particular product
The Big Mac is a non-tradable and nondurable product
It
Overvaluation of USD
40.7% (Feb 1985)
25.9% overvaluation of
USD (Oct 2000)
Interest rate parity (IRP) states that the forward premium or discount for
the quoted currency reflects the difference in interest rates for banking
deposits in the two currencies
(1+iHC) =
FHC/FC
SHC/FC
(1+iFC )
The currency with the higher interest rate is at a discount, the one with the
lower interest rate is at a premium
If IRP did not hold, then it would be possible for an arbitrageur to make
money exploiting the arbitrage opportunity covered interest arbitrage
capital controls
taxes (on repatriated capital)
market incompleteness
(1 i) (1 r) (1 )
ir
(approximation)
or approximat ely
E(S1) - S 0
iHC - iFC
S0
IFE predictions
interest rates > FC interest rates HC is expected to depreciate
E(S1) > S0 logic: investors must be paid a higher interest rate to
compensate them for a unit of account that is expected to depreciate
in value
HC interest rates < FC interest rates HC is expected to appreciate
E(S1) < S0 logic: investors willingly accept a lower interest rate
when they hold a unit of account that is expected to appreciate in
value
HC
iHC rHC HC
iFC rFC FC
iHC iFC HC FC
assume PPP holds
E(S1) S 0
iHC iFC
(IFE)
S0
IFE implicitly assumes that real interest rates are equal across
countries
1 iHC E(St+1) - S t
=
1 iFC
St
Ft,t+1 - St
St
Ft,t 1 E(St 1)
E(St+1) - St
=
St
Empirical tests generally show that the forward rate is not a good predictor
of the level of the future spot rate
However, there is strong evidence that the forward rate does a better job
of predicting at least the direction of changes to future spot rate rather
than do about two-thirds of the better known foreign exchange forecasting
services
S0 = 1.3250 CHF/USD
S 360 S 0
4% 2% 2% (USD expected to appreciate )
S0
Forecast premium on
foreign currency
+2%
Purchasing Power
Parity
(1)
International Fisher
Effect
(4)
Forecast difference in
rates of inflation
+2%
(higher in Switzerland)
Fisher closed
(3)
Difference in nominal
interest rates
+2%
(higher in Switzerland)