fx2_lecture - Forex 2: Forward rates and parity conditions...

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1 Forex 2: Forward rates and parity conditions Forward rates Interest rate parity Purchasing power parity FNCE102 R. Loh, Week 11 2 Overview: How do exchange rates move? ± Several conditions govern how exchange rates move. We will examine in detail: { Purchasing power parity (PPP) { Fisher effects { Forward rates { Interest rate parity ± Most parity conditions rely on the law of one price, which must hold in an arbitrage equilibrium. ± Arbitrage: simultaneous buying and selling of an asset for the purpose of making a risk-free profit. 3 Absolute Purchasing Power Parity ± PPP states that exchange rates between 2 currencies should be equal to the ratio of the countries’ price levels. ± Formally (note reference currency is foreign currency, i.e. American terms ): { S($/FC) = P $ /P FC , or P $ = S x P FC { The dollar price of a commodity basket in the US should be the same as the dollar price of the same commodity basket in any foreign country. ± E.g.: a Big Mac should cost the same (in US dollars) in France, or the US. Refer to big-mac currencies article. What are the shortcomings of the “big mac” method? 4 Big mac currencies e.g. ± Cost in US: $3.10, China=10.50 Yuan ± Implied PPP exchange rate= 10.5/3.1=3.39Yuan/USD. ± Actual rate is 8.03Yuan/USD ± Yuan is undervalued (-58%). (3.39-8.03)/8.03=-58%. ± i.e., we need the Yuan to appreciate by 58% in order for PPP to hold. ± How would you arbitrage (if possible to trade big macs)?
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5 Relative Purchasing Power Parity ± Relative PPP: { e: { π $ : { π FC : ± If the US inflation rate is higher than the foreign country’s inflation rate, the US$ should _________ against the foreign currency. ± Example: π $ =6%; π £ =4%. e 2%. The US dollar should __________ by about _____% against the British pound. + + = + FC e π 1 1 1 $ 6 Fisher Effect ± FE states that an increase in a country’s inflation rate should be accompanied by a proportionate increase in the interest rate in that country.
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This note was uploaded on 06/06/2009 for the course SOB FNCE102 taught by Professor Rogerloh during the Spring '09 term at Singapore Management.

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fx2_lecture - Forex 2: Forward rates and parity conditions...

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