f55 ER Ch06 IRP PPP and IFE

# f55 ER Ch06 IRP PPP and IFE - International Parity...

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1 6 Chapter Six International Parity Relationships and Forecasting Foreign Exchange Rates Chapter Objective: This chapter examines several key international parity relationships, such as interest rate parity and purchasing power parity. 6-0 Chapter Outline Interest Rate Parity The Fisher Effect Purchasing Power Parity Fisher Effects International Fisher Effects The Fisher Effects Forecasting Exchange Rates Forecasting Exchange Rates Fundamental Approach Technical Approach Performance of the Forecasters 6-1

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2 Interest Rate Parity Interest Rate Parity Defined Covered Interest Arbitrage Interest Rate Parity & Exchange Rate Determination Reasons for Deviations from Interest Rate Parity 6-2 Interest Rate Parity Defined IRP is an “ no arbitrage” condition. If IRP did not hold, then it would be possible for a trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we don’t typically observe persistent arbitrage conditions we can safely assume that …almost all of the time! arbitrage conditions, we can safely assume that IRP holds. 6-3
3 Variable Definitions i H : Interest Rate in the home country i F : Interest Rate in the foreign country S = Current spot rate for the foreign currency (in direct quote S = Current spot rate for the foreign currency (in direct quote) F = 1 year forward rate for the foreign currency (in direct quote) FP H = one year forward premium from the home country’s viewpoint = (F-S) / S FP F = one year forward premium from the foreign country’s viewpoint (S- F) / F or (1/ FP H 1) i CH : Covered rate of interest, from the home country’s viewpoint i CF : Covered rate of interest, from the foreign country’s viewpoint 6-4 Interest Rate Parity Carefully Defined Consider two alternative one-year investments for \$1 1. You could invest in the US at i H . Future value of this investment in \$ will be: \$1 × (1 + i H ) 2. Or you could convert 1\$ into the foreign currency at the going spot rate (S) and invest \$1/S in the foreign country at i F whose future value will be: \$1/S × (1 + i H ). In order to eliminate any exchange rate risk, you will have to sell this amount at forward rate to get you money back in \$: \$1/S × (1 + i H ) x F S F (1 + i F ) × = (1 + i H ) Since these investments have the same risk, they must have the same future value (otherwise an arbitrage would exist) 6-5

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4 Interest Rate Parity Defined Formally, 1 + F IRP is sometimes approximated as + i H 1 + i F S = Or FP 1 + i H 1 + i F -1 = F – S S = IRP is sometimes as i H i F S F – S 6-6 Interest Rate Parity Carefully Defined Depending upon how you quote the exchange rates, direct (S, F) or indirect (S I , F I ), we have: 1 + i H 1 + i F S I F I = 1 + i H 1 + i F S F = or so be a bit caref l abo t that …so be a bit careful about that.
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## This note was uploaded on 04/15/2011 for the course FINA 5500 taught by Professor Staff during the Spring '08 term at North Texas.

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f55 ER Ch06 IRP PPP and IFE - International Parity...

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