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CLASS MATERIALS
INTERNATIONAL PARITY CONDITIONS

1.
Key Interest RateExchange Rate Linkages: The Parity Framework
•
Parity conditions are useful when parity holds
•
Parity conditions are useful when parity
does not
hold
2.
Purchasing Power Parity: Theory and Evidence
•
Theory of purchasing power parity
•
PPP and real exchange rates
•
Empirical methods effect our empirical findings about PPP
•
Evidence about PPP in the shortrun
•
Evidence about PPP in the longrun (Is there
mean reversion
?)
3.
Interest Rate Parity: Theory and Evidence
•
Theory of Interest Rate Parity
•
Interest Rate Parity and covered interest arbitrage flows
•
Empirical methods effect our empirical findings about IRP
•
The choice of securities effects our empirical findings about IRP
•
Opportunities for 'oneway' arbitrage even when IRP does not hold
•
Interest Rate Parity for longdated maturities
4.
Uncovered Interest Parity (Fisher International Effect): Theory and Evidence
•
Theory of interest rates and exchange rate changes in the short run
•
Empirical methods effect our empirical findings about UIP
•
Empirical evidence on UIP in the longrun and in emerging markets
5.
Forward Rate Unbiased Property: Theory and Evidence
•
Theory of forward rates and expected future spot rates
•
Empirical evidence on unbiasedness

Richard M. Levich
New York University
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View Full DocumentFIGURE 4.1
PARITY RELATIONSHIPS IN INTERNATIONAL FINANCE
THEORY
IN
WORDS
IN SYMBOLS
DRIVING FORCES
Purchasing Power Parity
Absolute Version
The price of a market basket
P
$
= P
DM
x Spot
Arbitrage in goods
of US goods equals the price of
a market basket of foreign goods
when multiplied by the exchange rate
Relative Version
The percentage change in the exchange
?
Spot =
?
P
$

?
P
DM
Arbitrage in goods
rate equals the percentage change
in US goods prices less the percentage
change in foreign goods prices
Interest Rate Parity
The forward exchange rate premium
(F  S)/S = i
$
 i
DM
Arbitrage between
equals (approximately) the US interest
the spot and forward
rate minus the foreign interest rate
exchange rates
Fisher Parities
Fisher Effect
For a single economy, the nominal
i
$
= r
$
+ E(?P
$
)
Desire to insulate
(Fisher Closed
)
interest rate equals the real interest
the real interest
plus the expected rate of inflation
against expected inflation.
Arbitrage between real
and nominal assets.
International
For two economies, the US interest rate
i
$
 i
DM
= E(
?
Spot)
Arbitrage in bonds
Fisher Effect
minus the foreign interest rate
denominated in two
(Fisher Open)
equals the expected percentage
currencies
change in the exchange rate
Forward Rate Unbiased
Today's forward premium (for
(F
t
 S
t
)/S
t
=
Market players monitor the
delivery in
n
days) equals
(E(S
t+n
)  S
t
)/S
t
difference between today's
the expected percentage
forward rate (for delivery
change in the spot rate (over
in
n
days) and their
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 Fall '10
 Masoudie
 Exchange Rate, Interest, Interest Rate

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