International parity conditions are the economic theories that link exchange rates, price levels, and interest rates together.
International Parity Conditions are only theories and do not always work out to be true when compared to what is observed in the real world,
BUT they are central to any understanding of how multinational businesses are conducted in terms of the exchange rates.
The mistake is often not with the theory itself, but with the interpretation and application of such theories. 7-2 Prices and Exchange Rates: THE LAW 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 between markets 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, and arbitrage adjust any discrepancy in prices. 7-3 Prices and Exchange Rates: THE LAW OF ONE PRICE Because of the law of one price, prices for the same products will be the same across countries if frictions (transportation costs, barriers) do not exist.
Lets say two identical products are traded in two countries at prices P d and P f . Because of law of one price, after conversion from one currency to the other, the value of these products should be the same: P d = S x P f As the prices are given, the exchange rate could be deduced as: S = P d / P f
PURCHASING POWER PARITY Purchasing Power Parity (PPP) is the law of one price applied to international trade.
If instead of prices of two identical products traded in two countries, we used the price levels for a basket of similar products in those countries (P d ,P f ), we obtain that: S = P d /P f
PPP states that, as a result of the law of one price the exchange rate between currencies of two countries should equal the ratio of the countriesprice levels.
Note that what is valid for a single product should be also valid for a basket of similar products. This the law of one pice applied to international trade. 7-4 7-5 PURCHASING POWER PARITY In summary, the purchasing power parity (PPP) says that the exchange rate between currencies of two countries is determined by prices levels of those two countries, as follows:
But, in practice PPP has proved not to be helpful in determining what the spot rate should be.
f d P P S = 7-6 ABSOLUTE PURCHASING POWER PARITY
Absolute purchasing power parity says that the purchasing power parity exchange rate could be found by comparing the prices of any pair of identical products.
Ex. Big Mags in China and USA.
) 1 ( ) 1 ( ) 1 ( ) 1 ( ) 1 ( 1 ) 1 ( ) 1 ( ) 1 ( 1 2 1 2 f d f d f d S S S S e t t t t t t + + = + + = + + + = + ) 1 ( ) 1 ( ) 1 ( ) 1 ( ) 1 ( ) 1 ( ) ( ) ( ) ( f d f f f d d d f f d d S S P P P P P P S S S P P P P S S t t + + = A + A + A + = A + A + A + = A + RPPP holds that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period. RPPP focus on explaining the change is S, rather than the true value of S.
The change in S due to an change in P d and P f is given by RELATIVE PURCHASING POWER PARITY (RPPP) f d P P S = 7-8 RELATIVE PURCHASING POWER PARITY (RPPP) RPPP: A change in the differential rate of inflation between two 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 other countries (trading partners), and its exchange rate does not change, its products become more expensive or less competitive with comparable overseas products. A depreciation will make domestic products more competitive.
) 1 ( ) 1 ( ) 1 ( ) 1 ( ) 1 ( 1 2 f d f d e or S S t t t t + + = + + + = 7-9 RPPP and Real Exchange Rate When RPPP holds, the differential inflation rate between two countries should be exactly offset by the exchange rate change, and:
When RPPP is violated,
The expression is called real exchange rate
1 ) 1 ( ) 1 ( ) 1 ( = + + + e f d t t 1 ) 1 ( ) 1 ( ) 1 ( ) > + + + e a f d t t 1 ) 1 ( ) 1 ( ) 1 ( ) < + + + e b f d t t ) 1 ( ) 1 ( ) 1 ( e f d + + + t t 7-10 RPPP and Real Exchange Rate Problem 1: Inflation rate is 6% per year in USA and 4% in UK. If RPPP holds, how much should the exchange rate change? 7-11 RPPP and Real Exchange Rate Problem 1: Inflation rate is 6% per year in USA and 4% in UK. If RPPP holds, how much should the exchange rate change?
Sol: If RPPP holds, then:
% 92 . 1 1 %) 4 1 ( %) 6 1 ( = + + 7-12 RPPP and Real Exchange Rate Problem 2: USA annual inflation rate is 5%, and 1% in UK. USD is depreciated 0.5% against the UK. Calculate the real exchange rate and its probable consequences.
7-13 RPPP and Real Exchange Rate Problem 2: USA annual inflation rate is 5%, and 1% in UK. USD is depreciate 0.5% against the GBP. Calculate the real exchange rate and its probable consequences.
Sol:
The real effective exchange rate rises if domestic inflation exceed inflation abroad and the exchange rate fails to depreciate to compensate for the higher domestic inflation rate.
Note that if the real exchange rate rises (falls) the domestic country competitiveness declines (improves)
1 03 . 1 %) 5 . 0 1 ( %) 1 1 ( %) 5 1 ( > = + + + 7-14 Exchange Rates Pass-Through Exchange rate fluctuations affect the prices of imported and exported goods, and then impact on domestic inflation.
PPP implies that all exchange rate changes are passed through by equivalent changes in prices to trading partners. But, empirical research in the 80s questioned this long-held assumption.
Exchange rate pass-through is defined as the effect of exchange rate changes on domestic inflation.
Incomplete exchange rate pass-through is one reason that a countrys real effective exchange rate index can deviate
For example, a car manufacturer may or may not adjust pricing of its cars sold in a foreign country if exchange rates alter the manufacturers cost structure.
7-15 Exchange Rates Pass-Through Pass-through can also be partial as there are many mechanisms by which companies can absorb the impact of exchange rate changes.
Price elasticity of demand is an important factor when determining pass-through levels.
Price elasticity of demand for any good is the percentage change in quantity of the good demanded as a result of the percentage change in the goods own price.
INTEREST RATE AND EXCHANGE RATES Fisher Effect (interest rate and inflation)
International Fisher Effect (exchange rate an interest rate)
Interest Rate Parity (interest rate, spot exchange rate, forward exchange rate) 7-17 INTEREST RATES AND EXCHANGES RATES Fisher Effect Irving Fisher: nominal interest rates in each country must be equal to the required real rate of return plus compensation 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 ) 1 )( 1 ( ) 1 ( t + + = + r i t t t + + = + + = r r r i ) 1 )( 1 ( t + = r i JY JY JY r i Japan r i USA t t + = + = : : $ $ $ INTEREST RATES AND EXCHANGES RATES International Fisher Effect If a USA investor buys a 10-year japanese yen bond earning 4% interest, instead of a 10-year dollar bond earning 6% interest, the USA investor must be expecting the japanese yen to appreciate against the dollar by at least 2% during 10 years.
If not, the USA investor would be better off remaining in dollars, and if the japanese yen appreciates more than 2% during the 10-year period, the USA investor would earn a higher return.
International Fisher effect predicts that an investor should be indiffirent to whether his bond is in dollars or yen, because if there are opportunities to earn other investors would see the same opportunity and compete among them (LAW OF ONE PRICE)
7-19 INTEREST RATES AND EXCHANGES RATES International Fisher Effect The relationshipbetween the percentage change in the spot exchange rate over time and the differential between interest rates in different countries is known as the International Fisher effect.
International Fisher effect: the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rate between countries.
7-20 ) 1 ( ) ( 2 1 2 d d f i i i S S S +
Forward Rate and Forward Change
Agreement A forward rate is an exchange rate quoted today for settlement at some future date.
A forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought forward or sold forward at a specific date in the future (after 30,60,90,180,270, or 360 days) 7-21 INTEREST RATES AND EXCHANGES RATES International Rate Parity 7-22
The theory of Interest Rate Parity (IRP) provides the linkage between the foreign exchange rates and the interest rates of two countries.
IRP: the difference in the interest rates for two financial assets of similar risk and maturity should be equal to, but opposite in sign to, the forward rate for the foreign currency. IRP is an arbitrage condition that must be hold when international financial markets are in equilibrium, otherwise arbitrage and the LAW OF ONE PRICE will make the equilibrium possible. INTEREST RATES AND EXCHANGES RATES International Rate Parity 7-23 Assume that an investor has $1 million. If the investor chooses to invest dollar money market instrument, the investor 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 Francs money market instrument of identical risk and maturity for the same period. The investor will exchange the US$ for SF at the spot rate S, and immediately sell the SF in a forward exchange agreement to avoid the exchange rate risk by locking the forward rate at F and convert the resulting proceed back to US$. The comparison of returns would be as follows: $ / $ / $ 1 ) 1 ( ) 1 ( SF SF SF F i S i + = + INTEREST RATES AND EXCHANGES RATES International Rate Parity 7-24
IRP:
The left hand side of the equation is the gross return the investor would earn by investing in USD.
The right hand side is the gross return the investor would earn by exchanging USD for SF at the spot rate S, investing the SF in the SF money market instrument and simultaneously selling the principal plus interest in SF for USD at the current forward rate.
$ / $ / $ 1 ) 1 ( ) 1 ( SF SF SF F i S i + = + INTEREST RATES AND EXCHANGES RATES International Rate Parity 7-25 IRP:
If the returns are the same for the two alternative investments, the spot (S) and the forward rate (F) are considered to be at IRP.
Arbitrage states the that the future dollars proceeds from investing 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)
$ / $ / $ 1 ) 1 ( ) 1 ( SF SF SF F i S i + = + ) 1 ( ) 1 ( $ $ / $ / i i S F SF SF SF + + = 0 ) 1 ( ) 1 ( $ / $ $ / = + + SF SF SF i S i F Or INTEREST RATES AND EXCHANGES RATES International Rate Parity 7-26 When IRP holds, you will be indifferent between investing your money in USD and investing in SF with forward exchange agreements.
However, if IRP is violated, you will prefer one to another.
When IRP doesnt hold the situation gives rise to COVERED INTEREST ARBITRAGE opportunities.
INTEREST RATES AND EXCHANGES RATES International Rate Parity 7-27 INTEREST RATES AND EXCHANGES RATES International Rate Parity 7-28 INTEREST RATES AND EXCHANGES RATES International Rate Parity 7-29 The following adjustment will occur to the initial market conditions This adjustments will rise the left -hand side and, at the same time lower the right-hand side until both side are equlized, restoring IRP 7-30 Interest Rates and Exchange Rates A deviation from covered interest arbitrage is uncovered interest arbitrage (UIA). In this case, investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceed into currencies that offer much higher interest rates. The transaction is uncovered because the investor does no sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period.