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International Parity Conditions: - Forward premium - Expected change in spot exchange rate to cross currency differentials in nominal interest rates - Inflation Real exchange rate: - A measure of currency s purchasing power relative to other currencies
4.1 The law of one price - an asset must have the same value regardless of the currency in which it is measured - if the Purchasing Power Parity (PPP) does not hold opportunity to make arbitrage profit
Arbitrage Profit - profitable position with o NO net investment o NO risk - Arbitrage opportunities are quickly exploited drives prices back to equilibrium - Pf: price of asset in foreign currency Pd: price of asset in domestic currency - Law of one price: o The value of an asset has to be the same whether value is measured in foreign or domestic currency o Spot rate of exchange = value in the foreign currency to the value in the domestic currency o Pd / Pf = S d/f o If this equality does not hold opportunity for riskless arbitrage profit in cross currency transactions - assume the transaction costs are relatively small - PPP always hold in liquid markets because the potential for arbitrage ensures that prices are in equilibrium - PPP does not always hold in illiquid markets as they involve high transaction costs / policies that prevent the law of one price to hold Transactions costs and the no arbitrage condition - NO arbitrage opportunities PPP must hold within the bounds of transaction costs for identical assets bought / sold simultaneously in two / more locations - Market frictions may restrain arbitrage from working o Barriers of cross border flow of capital o Trade barriers o Taxes o Financial market controls - Buying / selling asset involves a greater costs than trading a financial claim on the real asset o E.g.: transporting gold is more expensive than buying the ownership of gold o Currency all be stored conveniently in the Eurocurrency market at a competitive interest rate - Actively traded financial assets are more likely to conform to the law of one price than similar real asset
4.3 Interest Rate Parity and Covered Interest Arbitrage Ft d/f/S0d/f = [(1+id) / (1+if)]t - Forward premium / discount reflects the interest rates differential on the right hand side of the equation - No arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries - Because the nominal interest rate, spot rate and forward rate contracts are actively traded in the interbank market the IRP always hold within the bounds of transaction costs in these markets. -
E[Std/f] /S0d/f = [(1+id) / (1+if)]t Nominal interest rates reflect expected changes in exchange rates (vice versa) Interest rate Parity Interest rate differential [(1 + id) / (1 + i f)]t Forward Premium Ftd/f / S0d/f
[(1+E[pd] / (1+E[pf])]t
Expected Inflation differential
= E[Std/f] /S0d/f
Expected change in spot rate
Relative PPP 4.5 The Real Exchange Rate - Identify the real changes in spot rates of exchange adjust nominal exchange rates for the effects of inflation in foreign and domestic currencies Real Changes in Purchasing Power - Use the RPPP to find out the expected future spot rate nominal exchange rate - Real exchange rate captures changes in the purchasing power of a currency relative to other currencies by backing out the effects of inflation from changes in nominal exchange rates - Refer to P.74 (figure 4.10) The Real Exchange Rate
Chapte 4
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he nte national
The re e change rate is the nominal e change rate adj sted for relative changes in domestic and foreign price levels The real e change rate as a % of the beginning spot rate
nflation adj stment: o whether this change in the nominal e change rate reflects the acc mulated inflation differential between the two currencies f change in the nominal spot rate of e change e actly offsets the mean inflation differential the real e change rate will remain at 100% of its base level The real e change rate provides a measure of the purchasing power of two currencies relative to a base period The change in real e change rate totally depends on the change in the o Nominal e change rate o Inflation rate differentials during the period ic a base period in which the purchasing power of the two currencies if close to e uilibrium If the answer is >1 it does not mean the currency is overvalued because as we can pic any year as the base period, the currency might have been undervalued in the base period and remains undervalued
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Xtd/f / Xt-1d/f