International Parity Conditions and Currency Forecasting

1. International Parity Conditions and Currency Forecasting International Financial Management Dr. A. DeMaskey

2. Learning Objectives • What is the “law of one price?” • How does arbitrage link goods prices and asset returns internationally? • What are parity conditions and why should we study them? • What currency forecasting techniques can be used under a fixed versus a floating rate system?

3. What are Parity Conditions? • Parity Conditions • Pricing relationships based on the law of one price • Hold if no arbitrage opportunities exist • Law of One Price • Identical products should sell for the same price everywhere • Otherwise, arbitrage opportunities will exist • Arbitrage • Profit-guaranteeing strategy of “Buy low, sell high” • No investment and no risk

4. Why Study Parity Conditions? • They provide the foundation of international finance. • They are useful in: • Explaining the determinants of foreign exchange rates. • Forecasting the long-run trend in an exchange rate.

5. International Parity Conditions • Purchasing Power Parity (PPP) • Absolute PPP • Relative PPP • Fisher Effect (FE) • Generalized Fisher Effect (GFE) • International Fisher Effect (IFE) • Interest Rate Parity (IRP) • Unbiased Forward Rate (UFR)

6. Purchasing Power Parity • Absolute PPP • Asks what should be the current exchange rate • Is based on price levels • Relative PPP • Asks how the exchange rate should change • Is based on price changes

7. Absolute PPP • Application of the “law of one price” to national price levels • The foreign exchange rate is given as: • The law of one price is stated as:

8. The Big Mac Hamburger Standard • The Economist developed the Big Mac Standard to track PPP: • Assuming that the Big Mac is identical in all countries, it serves as a comparison point as to whether or not currencies are trading at market prices • Big Mac in Switzerland costs Sfr6.30 while the same Big Mac in the US costs $2.54 • The implied PPP of this exchange rate is • However, on the date of the survey, the actual exchange rate was Sfr1.73/$

9. How Well Does the Absolute PPP Work? • Based on the assumption of free trade • It has limited usefulness due to: • Differentiated goods • Costly information • Transportation costs • Differential tariffs, quotas, and other restrictions on free trade • Thus, the Relative PPP is more commonly used today because is has more reasonable assumptions

10. Relative PPP • The exchange rate change is equal to: • Parity in the new foreign and domestic price index is stated as: • Relative PPP states that:

11. Simplified PPP • PPP can be approximated as: • PPP states that currencies with high rates of inflation devalue relative to currencies with low rates of inflation.

12. Nominal versus Real Exchange Rates • Nominal exchange rate • Price of one currency in terms of another • Real exchange rate • Real purchasing power of one currency relative to another • PPP and real exchange rates • If an exchange rate adjusts fully to the inflation differential according with PPP, the real exchange rate remains constant. • PPP holds if real exchange rates are stable over time.

13. Real Exchange Rate • Quoted exchange rate adjusted for the country’s inflation rate. • The real exchange rate is equal to:

14. How Well Does Relative PPP Work? • PPP does not hold over the short-run • Sticky goods prices (lagged changes) • Changes in exchange rates precede changes in prices. • PPP holds over the long-run • Clear relationship between relative inflation rates and changes in nominal exchange rates • PPP holds more closely when price indices cover tradable goods. • PPP holds better in high-inflation cases.

15. Fisher Effect • Describes the relationship between the nominal interest rate, real interest rate, and the inflation rate. • Fisher equation:

16. Simplified FE • The Fisher Effect can be approximated as: • The nominal rate equals the real rate plus inflation.

17. Generalized Fisher Effect • GFE says that real rates are equal among countries. • GFE states that currencies with high rates of inflation should bear higher interest rates than countries with lower rates of inflation.

18. How Well Does the FE (GFE) Work? • The FE (GFE) generally holds. • However, real interest rate differentials exist due to: • Currency risk • Inflation risk • Political risk • Differing tax policies • Regulatory barriers to free flow of capital

19. International Fisher Effect • Similar to Relative PPP except it uses interest rate rather than inflation rate differentials to explain exchange rate changes. • The effective return on a home bank deposit is equal to: • The effective return on a foreign bank deposit is equal to:

20. International Fisher Effect • Equality in effective return on a home and foreign investment is stated as: • The IFE states that:

21. Simplified IFE • The IFE can be approximated as: • IFE states that currencies with low interest rates should appreciate relative to currencies with high interest rates.

22. How Well Does IFE Work? • Lend some support to IFE. • Nominal interest rate equals real interest rate plus expected inflation. • If real interest rate increases, the nation’s currency appreciates. • If expected inflation increases, the nation’s currency depreciates. • Considerable short-run deviations do occur. • Uncovered interest arbitrage

23. Interest Rate Parity • Spot and forward rates are related by IRP • Relative returns on domestic and foreign investment: • IRP states that:

24. Interest Rate Parity (IRP): Example • Suppose you have $1 million to invest for 90 days and the following choices: • Invest in dollar-denominated securities for 90 days earning 8.00% per annum, or • Invest in Swiss franc-denominated securities of similar risk and maturity earning 4.00% per annum • Suppose you have the following quotes: • Spot rate of SF1.4800/$ • 90-day forward rate of SF1.4655/$ • Would you invest in the U.S. or Switzerland?

25. Covered Interest Arbitrage • Spot and forward market are not in equilibrium. • Relative forward differential does not equal relative interest differential.

26. Generalization of Covered Interest Arbitrage • If: • If:

27. How Well Does IRP Work? • Small deviations from IRP do occur. • Covered interest arbitrage opportunities • Lack of arbitrage profit opportunities due to: • Transactions costs • Differential tax rates • Government controls • Political risk • Time lag

28. Unbiased Forward Rate • Interest rate differential • Unbiased nature of the forward rate f1 = E(e1) • Market efficiency does not require that f1 = E(e1)

29. Are Forward Prices Unbiased? • Evidence that forward rates are biased predictors of future spot rates. • Risk premium • Appears to change signs • Averages near zero • Market efficiency • It appears that it does pay to use resources to forecast exchange rates.

30. Currency Forecasting • Successful currency forecasting is difficult. • Currency forecasting can lead to consistent profits only if forecaster has: • Superior forecasting model • Access to information before other investors • Exploit small, temporary deviations from equilibrium • Ability to predict government intervention in foreign exchange market

31. Forecasting Fixed Exchange Rates • Forecasters must focus on predicting government action, since devaluations and revaluations are political decisions. • Basic forecasting methodology involves: • Determine pressure on a currency to devalue or revalue • Determine political will of leaders to persist with current level of disequilibrium

32. Forecasting Floating Exchange Rates • Market-Based Forecasts • Forward rate • Interest rate • Model-Based Forecasts • Fundamental analysis • Technical analysis

33. Parity Conditions

34. Interest Rate Differential Expected Inflation Rate Differential Forward Differential Expected Change in Spot Rate International Parity Conditions FE IFE IRP PPP UFR