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Consider alternative one year investments for $100,000:
1. Invest in the U.S. at i$. Future value = $100,000 × (1 + i$)
2. Trade your $ for £ at the spot rate, invest $100,000/S$/£ in Britain at i£ while eliminating any exchange rate risk by selling the future value of the British investment forward.
S$/£
F$/£Future value = $100,000(1 + i£)×
S$/£
F$/£(1 + i£) × = (1 + i$)
Since these investments have the same risk, they must have the same future value (otherwise an arbitrage would exist)
Where do the numbers come from? We owe our supplier £100 million in one year—so we know that we need to have an investment with a future value of £100 million. Since i£ = 11.56% we need to invest £89.64 million at the start of the year.
How many dollars will it take to acquire £89.64 million at the start of the year if S($/£) = $1.25/£?
Parity condition stating that the difference in interest rates between two countries is equal to the expected change in exchange rates between the countries’ currencies. If this parity does not exist, there is an opportunity to make a profit."i1" represents the interest rate of country 1"i2" represents the interest rate of country 2"E(e)" represents the expected rate of change in the exchange rate
E.g. assume that the interest rate in America is 10% and the interest rate in Canada is 15%. According to the uncovered interest rate parity, the Canadian dollar is expected to depreciate against the American dollar by approximately 5%. Put another way, to convince an investor to invest in Canada when its currency depreciates, the Canadian dollar interest rate would have to be about 5% higher than the American dollar interest rate.
PPP suggests that the purchasing power of a consumer will be similar when purchasing goods in a foreign country or in the home country. If inflation in a foreign country differs from inflation in the home country, the exchange rate will adjust to maintain equal purchasing power.
Currencies in countries with high inflation will be weak according to PPP, causing the purchasing power of goods in the home country versus these countries to be similar.
Inflation differentials are offset by exchange rate changes.
This concept posits that the exchange rate between two countries will be identical to the ratio of the price levels for those two countries. This concept is derived from a basic idea known as the law of one price, which states that the real price of a good must be the same across all countries
The Economist, which compares the prices of a Big Mac burger in McDonald's restaurants in different countries. The Big Mac Index is presumably useful because although it is based on a single consumer product that may not be typical, it is a relatively standardized product that includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc.
Relative purchasing power parity relates the change in two countries' expected inflation rates to the change in their exchange rates. Inflation reduces the real purchasing power of a nation's currency. If a country has an annual inflation rate of 10%, that country's currency will be able to purchase 10% less real goods at the end of one year
Where,S0 is the spot exchange rate at the beginning of the time period (measured as the "y" country price of one unit of currency x)S1 is the spot exchange rate at the end of the time period.Iy is the expected annualized inflation rate for country y, which is considered to be the foreign country.Ix is the expected annualized inflation rate for country x, which is considered to be the domestic country.
Japan has typically had lower inflation than the United States. How would one expect this to affect the Japanese yen’s value? Why does this expected relationship not always occur?
Japan’s low inflation should place upward pressure on the yen’s value. Yet, other factors can sometimes offset this pressure. For example, Japan heavily invests in U.S. securities, which places downward pressure on the yen’s value.
Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in the United States is 8 percent for one‑year securities that are free from default risk. Describe the expected nominal return to U.S. investors who invest in Mexico.
According to PPP, the Mexican peso should depreciate by the amount of the differential between U.S. and Mexican inflation rates. Using a 40 percent differential, the Mexican peso should depreciate by about 40 percent. Given a 48 percent nominal interest rate in Mexico and expected depreci ation of the peso of 40 percent, U.S. investors will earn about 8 percent.
PPP probably doesn’t hold precisely in the real world for a variety of reasons. Haircuts cost 10 times as much in the developed world as in the
developing world. Film, on the other hand, is a highly standardized commodity that is
actively traded across borders. Shipping costs, as well as tariffs and quotas can lead to deviations from
PPP. There may not be substitutes for traded goods. Therefore, even when a
country’s inflation increases, the foreign demand for its products will not necessarily decrease (in the manner sug gested by PPP) if substitutes are not available.
PPP-determined exchange rates still provide a valuable benchmark.