Parity Conditions

Parity Conditions - Parity Conditions Click to edit Master...

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Click to edit Master subtitle style Parity Conditions and Links 1. Interest rate parity 2. Purchasing power parity 1. Expectation Theory of Forward Rates 2. International Fisher Effect Parity Conditions Links
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What determines currency values? n Exchange rates are market prices, and like all market prices, they are determined by the interaction of buyers and sellers. n How is “equilibrium” reached? q Exchange rates or prices that move too far from equilibrium will tend to move back as economic agents try to exploit pricing differences across countries q Concept of international arbitrage n Capitalizing on a discrepancy in quoted prices by making a riskless profit. n The strategy does not require funds to be tied up for a length of time. n The strategy does not involve any risk. q Types of international arbitrage: n Locational/Triangular/Covered interest arbitrage
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International arbitrage: LOCATIONAL n Locational : buying a currency at the location where it is priced cheap and immediately selling it at the location where it is priced higher. q Gains: depend on the amount of money that you use to capitalize on the exchange rate discrepancy along with the size of the discrepancy q Realignment: as the currency prices are adjusted, gains from locational arbitrage are reduced. q Prices usually adjust in a matter of seconds. q Explains why exchange rate quotations among banks at different locations normally will not differ by a significant amount.
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International arbitrage: TRIANGULAR n Cross-exchange rates q represent the relationship between two currencies that are different from one’s base currency n Triangular arbitrage q currency transactions are conducted in the spot market to capitalize on a discrepancy in the cross exchange rate between two currencies. q Re-alignment is almost instantaneous q Ensures cross-exchange rates are aligned correctly
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COVERED INTEREST arbitrage n Covered interest arbitrage : q process of capitalizing on the interest rate differential b/w two countries while covering your exchange rate risk with a forward contract q “covered” = hedging your position against exchange rate risk n Suppose foreign interest rate > domestic (i*>i), but the spot and forward direct rates are the same. q There will be a downward pressure on the forward rate. Once the forward rate has a discount from the spot rate that is about equal to the interest rate advantage, covered interest arbitrage will no longer be feasible. q Re-alignment is fast: within minutes q Re-alignment is focused on the forward rate: the forward rate is likely to experience most or all of the necessary adjustment q Ensures forward rates are properly set
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Interest Rate Parity n Once market forces cause interest rates and exchange rates to adjust such that covered interest arbitrage is no longer feasible, there is an equilibrium state, called Interest Rate Parity q IRP: the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies.
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This note was uploaded on 10/21/2010 for the course ECON 1530 taught by Professor Ohly during the Spring '10 term at Dartmouth.

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Parity Conditions - Parity Conditions Click to edit Master...

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