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INTERNATIONAL

FINANCIAL MARKETS
Topic 3
INTERNATIONAL PARITY CONDITIONS
AND FORECASTING EXCHANGE RATES

Outline
1.

The Parity Framework

2.

Law of One Price and Purchasing Power Parity

3.

Interest Rate Parity

4.

Fisher Effects and exchange rate forecasting

5.

Forward Rate Unbiased Property

6.

Empirical evidences on parity conditions

The Parity Framework

The framework is founded upon:


assumptions of rational economic behavior
the

ability to transact freely at no cost in the markets for goods and


credit as well as the market for foreign exchange

Simple models that describe relationships between:


the spot exchange rate
the forward exchange rate
the interest rates
the inflation rates

Relevance and usefulness

Empirical evidence supporting each individual parity condition is


mixed
How much do they hold in the real world? depends on the
extent to which trade barriers restrain the activities of traders
from enforcing the law of one price through arbitrage
Collectively, they constitute a useful way of ordering ones
thinking about the economic forces governing exchange rate
movements international financial benchmarks or breakeven values

Law of one price (LOP)

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

Enforced by arbitrage across markets buying where the product is


cheap and selling where the product is dear
LOP can prevail over the long run due to the forces of supply and
demand

Purchasing Power Parity (PPP)

PPP establishes a formal link between a countrys price level or


inflation rates (relative to another country) and the prevailing
exchange rate between the two countries
Absolute PPP based on price levels in 2 countries:
Pt[US] = Spott [USD/GBP] x Pt[UK]
the

exchange rate will adjust to eliminate discrepancies in


price levels OR
price levels will adjust to eliminate discrepancies in
exchange rates

Purchasing Power Parity (PPP)

Relative PPP based on price indexes in 2 countries:


S1HC/FC 1+ HC
=
; - inflation rate
0
SHC/FC 1+ FC

S PPP
The

S1PPP S 0
S0

1 HC

1 HC FC
1 FC

spot exchange rate adjusts perfectly to inflation differentials: if


goods prices rise in HC relative to FC, then HCs currency must
depreciate to maintain a similar real price for the goods in the two
countries
The change in the exchange rate is roughly equal to the difference in
inflation rates (inflation differential)

Purchasing Power Parity - example


Switzerland inflation rate
US inflation rate
Spot rate0

1
PPP

4% p.a.
2% p.a.
1.50 CHF/USD

1.04
1.50
1.5295 CHF/USD
1.02

(The USD will appreciate and CHF depreciate accordingly)


SPPP

1.04
1 1.96% 4% - 2%
1.02

PPP predicts a 2% appreciation of USD against CHF and a 2%

depreciation of CHF against USD

Purchasing Power Parity Line


S HC/FC

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

we are on the PPP line


and PPP holds
SHC-FC HC - HC

-2
-3
-4
-5
-6
-7

we are not on the PPP line


and PPP does not hold

Real exchange rate

Assume FC > HC and HC is constant FC is expected to depreciate


against HC, according to PPP

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

Real exchange rate

These deviations from PPP are measured using the real


exchange rate and changes in real exchange rate
Real exchange rate
Spot(Actua l, t)
Spot(Real, t) = qt
Spot(PPP,t)
Interpreting q values:

q=1 PPP holds (benchmark value)


q>1 FC appreciates in real terms against HC
HC depreciates in real terms against FC
q<1 FC depreciates in real terms against HC
HC appreciates in real terms against FC

Real exchange rate example


Case 1
Sactual =1.50 CHF/USD
SPPP =1.50 CHF/USD
Case 2
Sactual =1.55 CHF/USD
SPPP =1.50 CHF/USD
Case 3
Sactual =1.45 CHF/USD
SPPP =1.50 CHF/USD

1.50
q
1
1.50

CHF and USD are at


their values

1.55
q
1.033
1.50

USD overvalued
CHF undervalued

1.45
q
0.967
1.50

USD undervalued
CHF overvalued

Changes in real exchange rate


S actual SPPP
q
S actual S PPP
SPPP

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

PPP predicts a 4.55% depreciation of EUR against

USD

Changes in real exchange rate


Example (contd)
3 possible cases regarding S1actual:

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

-0.45% EUR depreciated in real


terms by 0.45% against
USD

Nominal depreciation of EUR

No change in q
EUR appreciated in real
terms by 0.55% against
USD

Trade-weighted real exchange rates

Spot (actual, t) contains the sum of nominal exchange rates for


different currencies multiplied by the price levels of different
countries weighted by the proportion of trade conducted with that
country

Rationale: a given currency rarely strengthens or weakens relative to all


foreign currencies by the same amount

Such real exchange rates are critical determinants of international


trade

NEER

NEER (nominal effective exchange rate)


tracks

changes in the value of a given countrys currency


relative to the currencies of its principal trading partners
It is calculated as a weighted average of the bilateral exchange
rates with those currencies.
Five alternative groups of competitor countries are considered
by DG ECFIN:
a broad group of 41 countries (broad group)
a group of 36 industrial countries (IC36)
a group of 24 industrial countries (IC24)
the 27 Member States of the European Union (EU) and the euroarea countries (EA)

REER

REER (real effective exchange rate)

aims to assess a countrys (or currency areas) price or cost competitiveness


relative to its principal competitors in international markets
it corresponds to the NEER deflated by selected relative price or cost deflators

Deflators used in DG ECFIN reports are consumer price indices (CPI


and HICP where available), the GDP deflator, the price deflator of
exports of goods and services, and unit labor costs in the economy as
a whole and in the manufacturing sector

NEER and REER USD

NEER and REER RON

Empirical evidences on LOP and PPP

LOP is fragrantly and systematically violated


Tests on PPP show that it is strongly violated on the short-run, but
describes a long-run phenomenon
PPP does not hold precisely in the real world for a variety of reasons :

transportation costs

existence of non-tradables

differences in consumption preferences


PPP-determined exchange rates still provide a valuable benchmark
for:

currency forecasting

determining over- and under-valuation of currencies

management of foreign exchange risk

A test of PPP - Big Mac Index

One test of the Law of One Price


is the Big Mac index, which has
been published annually in The
Economist since 1986.

It was devised as a light-hearted


guide to whether currencies are
at their correct level, based on
PPP.

Big Mac Index July 2013

Big Mac Index - July 2013

Pitfalls of the Big Mac test

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

is a differentiated product with an implied warranty associated with


the reputation of the McDonalds Corp.
Big Macs are generally produced locally, with local labor and on local
land, usually with locally produced materials
In many countries, Big Macs do not have close substitutes

McDonalds sets the profit-maximizing price in a country, ignoring the


prospect of Big Mac arbitrage

Empirical evidences for PPP USD/EUR


Peak of EUR
overvaluation (July
2008)
PPP satisfied at 1.16
USD/EUR in Jan 1999

Overvaluation of USD
40.7% (Feb 1985)

Source: Bekaert and Hodrick, 2011

25.9% overvaluation of
USD (Oct 2000)

Interest rate parity

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

Empirical evidences on IRP

Various empirical studies indicate that IRP holds in free, deregulated


markets (within a transaction cost band)
Deviations may occur due to

capital controls
taxes (on repatriated capital)
market incompleteness

Quite large deviations in closed less-developed countries, since smaller


currencies can be borrowed and lent only domestically
Bankers often use IRP to quote forward rates

Empirical evidences on IRP

CIA opportunities during the crisis

The Fisher Effects

Fisher parities describe how information regarding expected inflation and


expected exchange rates are captured in interest rates
Fisher closed equation that links nominal interest rate and inflation
expectations for a single economy

(1 i) (1 r) (1 )

ir

(approximation)

Fisher closed represents another example of arbitrage between real


assets and financial assets within a single economy

The International Fisher Effect (Fisher Open or UIP)

Interest rates across countries must be set with an eye toward


expected exchange rate changes
The derivation of IFE is another straightforward application of arbitrage
an interest arbitrage but uncovered
E(S1 ) 1+ iHC
=
S0
1+ iFC

or approximat ely

E(S1) - S 0
iHC - iFC
S0

the expected spot exchange rate between two currencies should


change by an equal amount but in opposite direction to the
difference in interest rates between the two countries
% expected exchange = % interest differential
rate change

IFE and exchange rate predictions

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

Computation of the markets implied future spot rate:


1+ iHC
E(St+1) =
St
1+ iFC

IFE and Real Interest Rate Parity

Suppose Fisher closed is valid in HC and FC

iHC rHC HC

iFC rFC FC

iHC iFC (rHC rFC ) (HC FC )


assume rHC rFC 0

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

Empirical evidences on IFE

Empirical evidences on IFE

The Forward Rate Unbiased Property

Follows directly from IRP and IFE:


Ft,t 1
St

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

% Forward premium = % Expected Exchange Rate


Change

Forward rate is an unbiased predictor of the future


spot rate forward rates and interest differentials
neither systematically over- and underestimate the
future spot rate

Empirical evidences on Forward rate unbiased


property

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

Combining the parity relations

S0 = 1.3250 CHF/USD

F0,360 = 1.3509 CHF/USD

CHF = 4% pa; USD = 2% pa CHF - USD = 2%

iCHF = 5% pa; iCHF = 3% pa iCHF iUSD = 2%

Forward premium on USD


F0,360 S 0
4% 2% 2%
S0

Forecast change in the spot rate

S 360 S 0
4% 2% 2% (USD expected to appreciate )
S0

International parity relations in equilibrium


Forecast change in spot
exchange rate
+2%
(USD strengthens)

Forward rate unbiased


property
(5)

Forecast premium on
foreign currency
+2%

Purchasing Power
Parity
(1)

International Fisher
Effect
(4)

Interest rate parity


(2)

Forecast difference in
rates of inflation
+2%
(higher in Switzerland)

Fisher closed
(3)
Difference in nominal
interest rates
+2%
(higher in Switzerland)