Lecture_FX_Markets_Part 3.pdf - International Finance FINA...

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1 F I N A 4 3 2 9 – F A L L 2 0 1 8 P R O F . A R Z U O Z O G U Z F O R E I G N E X C H A N G E M A R K E T ( 3 ) I N T E R N A T I O N A L P A R I T Y C O N D I T I O N S P U R C H A S I N G P O W E R P A R I T Y International Finance How are exchange rates determined? What describes the behavior of exchange rates? Lots of acronyms! Purchasing power parity (PPP) Interest rate parities Uncovered interest rate parity (UIRP) Covered interest rate parity (CIRP) Unbiasedness hypothesis (UH) Fisher hypothesis
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2 Law of One Price Two securities that have identical cash flows must have the same price. Otherwise, there would be arbitrage opportunities. The holder of the overpriced asset could sell this asset and buy the cheaper asset, and net the price difference without any risk. In equilibrium, no arbitrage argument means that you cannot make money without investing capital and taking on risk. Absolute PPP = Law of One Price A logical starting point based on law of one price: If a bundle of everyday goods costs $25 in the U.S., and a comparable bundle of goods costs 750 rubles in Russia, then we would expect $25 to be roughly 750 rubles (or $1 30 rubles).
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