Lessons IV and V: FX Parity Conditions · Foreign Exchange Markets An Overview of Parity Conditions Getting Started The Law of One Price and the Purchasing Power Parity The Uncovered
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InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Lessons IV and V: FX Parity Conditions
Monday 30th March, 2020
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Table of Contents
An Overview of Parity ConditionsGetting StartedThe Law of One Price and the Purchasing Power ParityThe Uncovered Interest Rate ParityThe Fisher-open conditionThe Forward Rate Unbiased
Focus on the Empirical EvidenceDoes the PPP Hold in Practice?Does the CIRP Hold in Practice?Does the UIRP Hold in Practice?
Terminology
To Put It into Practice
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Getting Started
Parity conditions should be thought of as break-evenvalues, where the decision-maker is indifferent between twoavailable strategies.Parity conditions rely heavily on the no free lunchprinciple⇒ violations of parities may give rise to arbitrageopportunities, that would be exploited and reabsorbed in avery short span of time.
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
The LoP: an Overview
Ceteris paribus, the price of a product, when converted intoa common currency using the spot exchange rate, is thesame in every country:
PiD = SDF· PiF
with i=i th product
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Ceteris Paribus...
There must be no frictions for the LOP to hold, meaningno legal restrictions on the movement of goods, notransportation costs and no tariffs.
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
From the LoP to the PPP
If the LOP were to hold for a certain basket of goods andservices, we get the Purchasing Power Parity relation (inabsolute or static form):
PD = SDF· PF
with P= price index of the underlying basket ofgoods/servicesIn intuitive terms, the CIRP applies to financial markets:the PPP can be conceived as a parallel parity conditionreferring to the products market.
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Rearranging the Terms...
SPPPDF
= PDPF
I Whenever SDF> SPPP ⇒ the domestic currency (D) is
undervalued or, equivalently, the foreign currency (F)is overvalued
I Whenever SDF< SPPP ⇒ the domestic currency (D) is
overvalued or, equivalently, the foreign currency (F) isundervalued
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
From Theory to Practice
In practice, however, it is difficult to test the validity of PPPin absolute form: different baskets of goods are used indifferent countries to compute price indexes, given thattastes and needs differ on an international scale, affectingwhat people buy.Price levels could be substituted with inflations rates⇒ PPPin relative or dynamic terms
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
From Static to Dynamic PPP I
Suppose that at time t0:
PD = SDF· PF
In 1 year time it will be:
PD · (1 + ∆PD) = SDF· (1 + ∆SD
F) · PF · (1 + ∆PF )
Divide the latter by the former and get:
(1 + ∆PD) = (1 + ∆SDF
) · (1 + ∆PF )
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
From Static to Dynamic PPP II
Rearranging the terms:
∆SDF
= (1+∆PD)(1+∆PF ) − 1
Or, equivalently:
∆SDF
= (∆PD−∆PF )(1+∆PF )
When inflation is relatively low, the above relationshipsimplifies to:
∆SDF' (∆PD −∆PF )
The exchange rate offsets inflation differentials betweencountries.
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
From the CIRP to the URIP
Based on the CIRP (Lesson III)
(1 + rD)n =Fn DF
SDF
(1 + rF )n
Assuming risk neutrality and zero transaction costs, itshould be that
FnDF
= SEDF
Substituting:
(1 + rD)n =SE
n DF
SDF
(1 + rF )n
Uncovered Interest Rate Parity: the mathematicalexpression is almost analogous to the one used for CIRP,apart from the fact that foreign exchange exposure is notcovered with a forward exchange contract
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Digging a Little Bit Deeper
By definition, it must be that:
SEDF
= SDF· (1 + ∆SE )n
Substituting
(1 + rD)n = (1 + ∆SE )n · (1 + rF )n
Taking the nth-root and multiplying yield
1 + rD = 1 + ∆SE + ∆SE · rF + rF
If we ignore interaction terms, we will get
∆SE = rD − rF
Higher-yield currencies are expected to depreciate
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Combining the PPP and the UIRP
If we now combine
∆SE = rD − rF
and
∆SDF
= (∆PD −∆PF )
we get
rD −∆PD = rF −∆PF
Fisher-open condition: real interest rates are equal indifferent countries
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Stated in simpler terms...
High-yield currencies carry more inflation risk and tend todepreciate over time
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
The Fwd Rate Unbiased
If we assume that
FnDF
= SE DF
we could infer that
Fn DF−SD
Fn·SD
F
=SEDF
−SDF
n·SDF
Fwd Rate Unbiased: Today’s fwd premium/discountequals the expected percentage change in the spot rate
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Does PPP hold in practice?
Testing the validity of PPP may be troublesome as aconsequence of:
I Different baskets of goods underlying the price index
I Non tradable goods
I Transaction costs (quotas, tariffs, duties)
I Different consumers’ preferences = Different priceindexes’ weighting schemes
I Oligopolistic markets
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Emerging Empirical Evidence
The emerging empirical evidence suggests that:
I PPP performs poorly in the short run
I Prices seem to revert to their PPP levels in the longrun⇒mean reverting processes
I The speed of adjustment towards the PPP level is apositive function of the size of the deviation
I PPP deviations may be permanent if a permanent realshock affects one country but not the other
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Persistent Deviations from the PPP
High productivity gains⇓
Higher real income growth⇓
Appreciating (non constant) real exchange rates⇓
Deviations from PPP
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
The Balassa-Samuelson Effect I
The Balassa-Samuelson effect focuses on the relationshipamong
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
The Balassa-Samuelson Effect II
Would you be able to explain why productivity gainsgenerally go hand in hand with RER appreciations?Can you explain why richer countries tend to exhibitrelatively higher price levels?
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Does the CIRP Hold in Practice?
Very closely, but not exactly as a consequence of:
I Execution risk
I Transaction costs (Is it really so? Step back to LessonIII...)
I Political risk
I Tax advantages
I Liquidity risk
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
CIRP and Execution Risk
There might be time lags during execution, thus implyingsome extra risk⇒ placing orders takes time and marketprices may change.This tends to create a band around the CIRP line.
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
CIRP and TC
Transaction costs do not always contribute to deviationsfrom IRP: Round-trip arbitrages tend to create a bandaround the CIRP line, whilst one-way arbitrages do not(Lesson III)
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
CIRP and Political Risk
Political risk involves the uncertainty that while funds areinvested in a foreign country, they may be frozen (theycannot be repatriated), confiscated or even madeinconvertible into other currencies.Investors typically require a risk premium from foreigninvestments versus domestic investments: Political riskcreates a band around the CIRP line.Watch out: The band does not have to be of equal widthon the two sides of the CIRP line, if one country is seen asriskier than the other.
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
CIRP and Taxation
As long as tax rates depend on the country in which fundsare borrowed/invested, the interest parity condition will beaffected.
I Withholding taxes
I Differences between the tax rate on income (τI ) andthe tax rate on capital gains (τK )
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Withholding tax
Withholding tax: tax applied to foreigners at the source oftheir earnings.Withholding taxes are unlikely to create any band aroundthe parity line if the rate of withholding ≤ the tax rate thatwould be applied to the earnings at home, since domesticwithholding tax credits (purposely designed to avoid doubletaxation) will offset the tax withheld.
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Income vs K gains taxation I
rD − rF = 1−τK1−τI
· n ·F 1
nDF−SD
FSD
F
As long as τK < τI ,
1−τK1−τI
> 1
Investors (borrowers) with favourable capital gains treatmentwill prefer investments denominated in currencies trading ata forward premium (discount).
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Income vs K gains taxation II
If τK 6= τI , the slope of the CIRP line may be affected.After taxes, if capital gains taxes are paid on foreignexchange earnings, even when hedged, the investor willreceive only (1− τI ) of the interest and (1− τK ) of the gainfrom the forward premium (considered as a K gain).
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
CIRP and Liquidity Preferences
Liquidity: refers to how easily, quickly and cheaply anasset can be converted into cash.Suppose the funds put in a covered foreign investment areneeded earlier ⇒ The investor might incur in potentiallosses when monetizing the original investment⇒ Liquiditypreference is likely to create a band around the coveredinterest-parity line.The potential width of the band due to liquiditypreference depends on the likelihood that the funds willbe needed earlier
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Empirical Evidence
Empirically, the CIRP seems to hold:
I in the eurocurrency market
I for short term lending/borrowing
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Emerging Empirical Evidence
The empirical evidence reveals that the UIRP holds poorlyin the short run.
I Whenever short term interest rates are high, currenciestend to appreciate
I Carry trade strategies are profitable in the short run
I Basket carry trade strategies perform even better
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Carry Trade in practice (Q2-2012) I
Intensifying worries about PIIGS⇒ IncreasingGovernment bond yields
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Carry Trade in practice (Q2-2012) II
Growing unemployment rates
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Carry Trade in practice (Q2-2012) III
Explosive growth in DEBT/GDP ratios
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Carry Trade in practice (Q2-2012) IV
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Carry Trade in practice (Q2-2012) V
Speculative bet against the EuroWithin our mandate, the ECB is ready to do whatever ittakes to preserve the Euro. And believe me, it will beenough - July 26, 2012
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Real Exchange Rate
Real Exchange Rate: broad summary measure of the pricesof one country’s goods and services relative to the prices ofanother’s⇒ useful to asses the purchasing power of acurrency in a foreign country
qDF
=SD
F·PF
PD
Watch out: If PPP holds, the real exchange rate isperfectly constant.
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Risk Neutrality
Risk Neutrality: investor attitude according to which thevalue of a sure chance of gain or loss is considered to beequal to an unsure chance of the same amount of gain orloss (Source: The Business Dictionary)
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
Carry Trade
Carry Trade: Trading strategy consisting in selling arelatively low interest rate currency and using the fundsto purchase another yielding a higher interest rate
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
To Put It into Practice I
5.1: You have been given the following information:
rUSD rGBP SUSDGBP
Fn USDGBP
0.05 0.06 1.5 1.4895
where
I rUSD= annual interest rate on USD short term paper
I rGBP= annual interest on GBP short term paper
On the basis of the foregoing data:
I In which paper would you invest?
I In which currency would you borrow?
I What is the profit from interest arbitrage?
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
To Put It into Practice II
5.2: Focus on the table below
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
To Put It into Practice III
I Which is the most overvalued currency? Why?
I Which is the most undervalued currency? Why?
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
To Put It into Practice IV
5.3: Assume that the inflation rate in Brazil is expected toincrease substantially. How will this affect Brazil’s nominalinterest rates and the value of its currency? If the IFE holds,how will the nominal return to U.S. investors who invest inBrazil be affected by the higher inflation in Brazil? Justifyyour claims.
InternationalFinancial and
Foreign ExchangeMarkets
An Overview ofParity Conditions
Getting Started
The Law of One Priceand the PurchasingPower Parity
The UncoveredInterest Rate Parity
The Fisher-opencondition
The Forward RateUnbiased
Focus on theEmpirical Evidence
Does the PPP Hold inPractice?
Does the CIRP Holdin Practice?
Does the UIRP Holdin Practice?
Terminology
To Put It intoPractice
To Put It into Practice V
5.4: Assume the following information is available for USand Europe:
Nominal rUSD 0.04Nominal rEUR 0.06
Expected InflationUSD 0.02Expected InflationEUR 0.05
SUSDEUR
1.13
F1USDEUR
1.13
I Does the CIRP hold?
I According to the PPP, what is the expected change inthe spot rate of the Euro in one year?
I According to the UIRP, what is the expected change inthe spot rate of the Euro in one year?
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