International parity relationship and forecasting

International Parity Relationships & Forecasting Exchange Rates

Chapter Outline Interest Rate Parity –Covered Interest Arbitrage –IRP and Exchange Rate Determination –Reasons for Deviations from IRP Purchasing Power. International Parity Relationships and Forecasting Foreign Exchange Rates 6 Chapter Six Chapter Objective: This chapter examines several key international. CHAPTER 6 INTERNATIONAL PARITY RELATIONSHIPS AND FORECASTING FOREIGN. EXCHANGE RATES. SUGGESTED ANSWERS AND SOLUTIONS.

In contrast, a decrease in the U. In addition to relative interest rates, the forward exchange rate is an important factor in spot exchange rate determination.

Under certain conditions the forward exchange rate can be viewed as the expected future spot exchange rate conditional on all relevant information being available now, that is, F E S t 1 I t 6. First, expectation plays a key role in exchange rate determination.

Specifically, the expected future exchange rate is shown to be a major determinant of the current exchange rate; when people expect the exchange rate to go up in the future, it goes up now. People s expectations thus become self-fulfilling. Second, exchange rate behavior will be driven by news events. People form their expectations based on the set of information I t they possess. As they receive news continuously, they are going to update their expectations continuously.

As a result, the exchange rate will tend to exhibit a dynamic and volatile short-term behavior, responding to various news events. By definition, news events are unpredictable, making forecasting future exchange rates an arduous task. When the forward exchange rate F is replaced by the expected future spot exchange rate, E S t 1 in Equation 6. This relationship is known as the uncovered interest rate parity. Reasons for Deviations from Interest Rate Parity Although IRP tends to hold quite well, it may not hold precisely all the time for at least two reasons: In our previous examples of CIA transactions, we implicitly assumed, among other things, that no transaction costs existed.

Note that the variable S represents the number of U. The interest rate at which the arbitrager borrows, i a, tends to be higher than the rate at which he lends, i b, reflecting the bid-ask spread. Likewise, there exist bid-ask spreads in the foreign exchange market as well. The arbitrager has to buy foreign exchanges at the higher ask price and sell them at the lower bid price. Each of the four variables in Equation 6. Because of spreads, arbitrage profit from each dollar borrowed may become nonpositive: Thus, the IRP line in Exhibit 6.

IRP deviations within the band, such as point D, would not represent profitable arbitrage opportunities. The width of this band will depend on the size of transaction costs. Another major reason for deviations from IRP is capital controls imposed by governments.

Daily data were used in computing the deviations. The zone bounded by and represents the average width of the band around the IRP for the sample period.

International Parity Relationships & Forecasting Exchange Rates

The Japanese Experience,IMF Staff Papers 28pp jawboning, imposing taxes, or even outright bans on cross-border capital movements. These control measures imposed by governments can effectively impair the arbitrage process, and, as a result, deviations from IRP may persist. An interesting historical example is provided by Japan, where capital controls were imposed on and off until Decemberwhen the Japanese government liberalized international capital flows.

Otani and Tiwari investigated the effect of capital controls on IRP deviations during the period They computed deviations from interest rate parity DIRP as follows: Deviations from IRP computed as above are plotted in Exhibit 6. If IRP holds strictly, deviations from it would be randomly distributed, with the expected value of zero.

The deviations were quite significant at times until near the end of They were the greatest during This can be attributed to various measures the Japanese government took 12 Readers can convince themselves that DIRP in Equation 6. While interest rates on Gensaki bonds are determined by market forces, they can still be affected by various market imperfections. As these measures were removed inthe deviations were reduced.

They increased again considerably inhowever, reflecting an introduction of capital control; Japanese financial institutions were asked to discourage foreign currency deposits. Not surprisingly, the deviations hover around zero in the first quarter of The empirical evidence presented in Exhibit 6. This implies that deviations from IRP, especially in anddo not represent unexploited profit opportunities; rather, they reflect the existence of significant barriers to cross-border arbitrage.

When the law of one price is applied internationally to a standard commodity basket, we obtain the theory of purchasing power parity PPP. This theory states that the exchange rate between currencies of two countries should be equal to the ratio of the countries price levels. The basic idea of PPP was initially advanced by classical economists such as David Ricardo in the 19th century.

In those years, many countries, including Germany, Hungary, and the Soviet Union, experienced hyperinflation. As the purchasing power of the currencies in these countries sharply declined, the same currencies also depreciated sharply against stable currencies like the U. The PPP became popular against this historical backdrop.

To give an alternative interpretation to PPP, let us rewrite Equation 6. In other words, PPP requires that the price of the standard commodity basket be the same across countries when measured in a common currency.

6 International Parity Relationships and Forecasting Foreign Exchange Rates

Clearly, PPP is the manifestation of the law of one price applied to the standard consumption basket. As a light-hearted guide to the correct level of exchange rate, The Economist each year compiles local prices of Big Macs around the world and computes the so-called Big Mac PPP, the exchange rate that would equalize the hamburger prices between America and elsewhere.

To compare this PPP and the actual exchange rate, a currency may be judged to be either undervalued or overvalued. The actual exchange rate, however, is 3. Most expected the euro to rise after its launch inyet it fell. When America went into recession last year, the dollar was tipped to decline; it rose.

So to help forecasters really get their teeth into exchange rates, The Economist has updated its Big Mac index. Devised 16 years ago as a light-hearted guide to whether currencies are at their correct level, the index is based on the theory of purchasing-power parity PPP. In the long run, countries exchange rates should move towards rates that would equalise the prices of an identical basket of goods and services.

Our basket is a McDonald s Big Mac, produced in countries. Comparing these with actual rates signals if a currency is under- or overvalued. The first column of the table shows the local-currency prices of a Big Mac. The second converts these into dollars. More countries are listed on our website. By this measure, the Argentina peso is the most undervalued currency and the Swiss franc the most overvalued. Dividing the Japanese price by the American price, for instance, gives a dollar PPP ofagainst an actual exchange rate of The euro area may have a single currency, but the price of a Big Mac varies widely, from 2.

However, that range has narrowed from a year ago. And prices vary just as much within America, which is why we use the average price in four cities. No wonder the Australian economy was so strong last year. Overall, the dollar now looks more overvalued against the average of the other big currencies than at any time in the life of the Big Mac index.

Most emerging-market currencies also look cheap against the dollar. That implies that any currency close to McParity e. Adjustment back towards PPP does not always come through a shift in exchange rates. It can also come about partly through price changes. Every time we update our Big Mac index, readers complain that burgernomics does not cut the mustard. The Big Mac is an imperfect basket. Hamburgers cannot be traded across borders; prices may be distorted by taxes, different profit margins or differences in the cost of non-tradable goods and services, such as rents.

Yet it seems to pay to follow burgernomics. Infor instance, the Big Mac index suggested that the euro was already overvalued at its launch, when nearly every economist predicted it would rise. Several studies confirm that, over the long run, purchasingpower parity including the Big Mac PPP is a fairly good guide to exchange-rate movements. Still, currencies can deviate from PPP for long periods. In the early s the Big Mac index repeatedly signaled that the dollar was undervalued, yet it continued to slide for several years until it flipped around.

Our latest figures suggest that, sooner or later, the mighty dollar will tumble; relish for fans of burgernomics. This implies that the Swiss franc is very much overvalued. The PPP relationship of Equation 6. When the PPP relationship is presented in the rate of change form, we obtain the relative version: McDonald s; The Economist.

If PPP holds and thus the differential inflation rates between countries are exactly offset by exchange rate changes, countries competitive positions in world export markets will 14 From Equation 6. However, if there are deviations from PPP, changes in nominal exchange rates cause changes in the real exchange rates, affecting the international competitive positions of countries. This, in turn, would affect countries trade balances.

The real exchange rate, q, which measures deviations from PPP, can be defined as follows: When PPP is violated, however, the real exchange rate will deviate from unity. Suppose, for example, the annual inflation rate is 5 percent in the United States and 3. Then the real exchange rate is. If the dollar depreciates by less than the inflation rate differential, the real exchange rate will be greater than unity, weakening the competitiveness of U.

To summarize, q 1: Competitiveness of the domestic country unaltered. Competitiveness of the domestic country improves. Competitiveness of the domestic country deteriorates. The real effective exchange rate rises if domestic inflation exceeds inflation abroad and the nominal exchange rate fails to depreciate to compensate for the higher domestic inflation rate.

Thus, if the real effective exchange rate rises fallsthe domestic country s competitiveness declines improves. It is noted that the real effective exchange rate of the Chinese yuan has fallen sharply in the first half of the s and stayed at a low level since then.

Evidence on Purchasing Power Parity As is clear from the above discussions, whether PPP holds in reality is a question of considerable importance. In view of the fact that PPP is the manifestation of the law of one price applied to a standard commodity basket, it will hold only if the prices of constituent commodities are equalized across countries in a given currency and if the composition of the consumption basket is the same across countries.

The PPP has been the subject of a series of tests, yielding generally negative results. For example, in his study of disaggregated commodity arbitrage between the United States and Canada, Richardson was unable to detect commodity arbitrage for a majority of commodity classes. The presence of commodity arbitrage could be rejected with 95 percent confidence for at least 13 out of the 22 commodity groups p.

If commodity arbitrage is imperfect between neighboring countries like the United States and Canada that have 15 The real exchange rate measures the degree of deviations from PPP over a certain period of time, assuming that PPP held roughly at a starting point. If PPP holds continuously, the real exchange rate will remain unity. It cost 6 times! The price differential, however, is likely to persist because haircuts are simply not tradable.

In comparison, the price disparity for camera film is substantially less. This can be attributable to the fact that camera film is a highly standardized commodity that is actively traded across national borders. Kravis and Lipsey examined the relationship between inflation rates and exchange rates and found that price levels can move far apart without rapid correction via arbitrage, thus rejecting the notion of integrated international commodity price structure.

Frenkel reported that while PPP did very poorly in explaining the behavior of exchange rates between the U. It thus provides a measure of dispersion adjusted for the magnitude of the variable. Even among these European currencies, however, Frenkel found that relative price levels are only one of the many potential factors influencing exchange rates. If PPP holds strictly, relative price levels should be sufficient in explaining the behavior of exchange rates.

Generally unfavorable evidence about PPP suggests that substantial barriers to international commodity arbitrage exist. Obviously, commodity prices can diverge between countries up to the transportation costs without triggering arbitrage. An understandi anding of these parity relationships providess iinsights into l how foreign exchange rates ates are determined, and 2 how to forecast for foreign exchange rates.

The term arbitrage can be defined as the act of simultaneously buying ing and selling the same or equivalent asset sets or commodities for the purpose of m making certain, guaranteed profits. As long ong as there are profitable arbitrage opportuni unities, the market cannot be in equilibrium. The market can be said to be in equilibrium when no profitable arbitrag trage opportunities exist.

Such well-knownn pa parity relationships as interest rate parityy an and purchasing power parity, in fact, represe resent arbitrage equilibrium conditions. Interest rate parity IRP holds forward premium or discount should be equal to the interest rate differential between two countries. IRP represents an arbitrage equilibrium that should hold in the absence of barriers to international capital flows. If IRP is violated, one can make profit by borrowing in one currency and lending in another with exchange risk hedged via forward contract.

IRP implies that in short run, the exchange rate depends on a relative interest rates between two countries b the expected future exchange rate. Clearly, IRP is not holding, implying that a profitable arbitrage opportunity exists. Since the interest rate is lower in the United States, an arbitrage transaction should involve borrowing in the United States and lending in the U. The arbitrager can carry out the following transactions: A simple answer is: As a result of these arbitrage activities, IRP will be restored quite quickly.

Chapter 5 International Parity Relationships & Forecasting Exchange Rates. - ppt download

To see this, let's get back to our numerical example, which induced covered interest arbitrage activities. Since every trader will 1 borrow in the United States as much as possible, 2 lend in the U. The interest rate will fall in the U. The pound will appreciate in the spot market S. The pound will depreciate in the forward market F. The three-month interest rate is 8.

Determine whether the interest rate parity is currently holding. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit. Explain how the IRP will be restored as a result of covered arbitrage activities.

6 International Parity Relationships and Forecasting Foreign Exchange Rates

Followings are the arbitrage transactions described below. The dollar interest rate will rise. The pound interest rate will fall. The spot exchange rate will rise. The forward exchange rate will fall.

What is INTEREST RATE PARITY? What does INTEREST RATE PARITY mean? INTEREST RATE PARITY meaning

These adjustments will continue until IRP holds. An arbitrage in equilibrium condition involves the spot exchange rate. The forward exchange rate is an important factor in spot exchange rate determination. Under certain conditions the forward exchange rate can be viewed as the expected future spot exchange rate.

A popular example of such trade is provided by currency carry trade. Currency carry trade involves buying a high-yielding currency and funding it with a low-yielding currency, without any hedging. This theory states that the exchange rate between currencies of two countries should be equal to the ratio of the countries' price levels.

The purchasing power parity PPP theory attempts to quantify the inflation exchange rate relationship. There are two popular techniques: Absolute PPP that states that similar products in different countries should be priced equally when measured in common currency. Relative PPP that accounts for imperfections like transportation costs, tariffs and quotas. It states that the rate of price changes should be similar. Interpretation The foreign currency should appreciate 1.

Interpretation The foreign currency should depreciate 2. Confounding Effect PPP theory presumes that exchange rates are completely driven by inflation differentials between two countries but there are some other factors, such as: Change in expectation of future exchange ii.

Lack of substitutes for traded goods The idea behind PPP theory is as soon as prices become high in one country. The consumers in another country buying imported goods and shift to domestic goods.