18-08-2012, 02:58 PM
International Parity Conditions
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Introduction
Managers of multinational firms, international investors, importers and exporters, and government officials must deal with these fundamental issues:
Are changes in exchange rates predictable?
How are exchange rates related to interest rates?
What, at least theoretically, is the “proper” exchange rate?
To answer these questions we need to first understand the economic fundamentals of international finance, known as parity conditions.
Parity Conditions
Parity Conditions provide an intuitive explanation of the movement of prices and interest rates in different markets in relation to exchange rates.
The derivation of these conditions requires the assumption of Perfect Capital Markets (PCM).
no transaction costs
no taxes
complete certainty
NOTE – Parity Conditions are expected to hold in the long-run, but not always in the short term.
Purchasing Power Parity (PPP)
PPP is based on the notion of arbitrage across goods markets and the basic building block of PPP is the Law of One Price (LOP).
LOP states that the price of an identical good should be the same in all markets (assuming no transactions costs).
Otherwise, one could make profits by buying the good in the cheap market and reselling it in the expensive market.
Relative PPP
Relative PPP implies that the change in the exchange rate will offset the difference between the relative inflation of two countries.
The previous formula can be approximated as:
where, πD and πF refers to the percentage change in domestic and foreign price levels respectively and s to the percentage change in the exchange rate.
If domestic inflation > (<) foreign inflation, PPP predicts the domestic currency should depreciate (appreciate).
How well does PPP work?
We have seen that the strictest version of PPP – that all goods and financial assets obey the law of one price – is demonstrably false.
However, there is clearly a relationship between relative inflation rates and changes in exchange rates.
Currencies that have had the largest relative decline (gain) in purchasing power see the sharpest erosion (appreciation) in their foreign exchange values.
Relative Purchasing Power Parity
Applications of Relative PPP:
Forecasting future spot exchange rates.
Calculating appreciation in “real” exchange rates. This will provide a measure of how expensive a country’s goods have become (relative to another country’s).
Unbiased Forward Rate (UFR)
Some forecasters believe that for the major floating currencies, foreign exchange markets are “efficient” and forward exchange rates are unbiased predictors of future exchange rates.
The unbiased forward rate (UFR) concept states that the forward exchange rate, quoted at time t for delivery at time t+1, is equal to the expected value of the spot exchange rate at time t+1.
Empirical Tests of UFR
A consensus is developing that rejects the efficient market hypothesis.
It appears that the forward rate is not an unbiased predictor of the future spot rate and that it does pay to use resources in an attempt to forecast exchange rates.
The existence and success of foreign exchange forecasting services suggest that managers are willing to pay a price for forecast information even though they can use the forward rate to forecast at no cost.
Covered Interest Arbitrage
Covered interest arbitrage should continue until interest rate parity is re-established, because the arbitrageurs are able to earn risk-free profits by repeating the cycle.
But their actions nudge the foreign exchange and money markets back toward equilibrium:
Purchase of Pounds in the spot market and sale of £ in the forward market narrow the premium on forward pounds.
The demand for pound-denominated securities causes pound interest rates to fall, while the higher level of borrowing in Australia causes dollar interest rates to rise.