# ch04_2 - Chapter 4 The International Parity Conditions...

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4-1 Chapter 4 Chapter 4 The International Parity Conditions The International Parity Conditions Learning objectives The Law of One Price – Exchange rate equilibrium International parity conditions – These relate exchange rates to cross-currency interest rate and inflation differentials Interest rate parity is the most important relation The real exchange rate – Measuring inflation-adjusted currency values Butler / Multinational Finance Chapter 4 The International Parity Conditions

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4-2 Though this be madness, yet there is method in it. William Shakespeare Butler / Multinational Finance Chapter 4 The International Parity Conditions
4-3 Prices Prices appear as Upper Case Symbols P t d = price of an asset at time t in currency d S t d/f = spot exchange rate at time t in currency d F t d/f =forward exchange rate between currencies d and f also E[…] = expectation operator (e.g. E[S t €/\$ ]) The law of one price and interest rate parity Less reliable parity conditions The real exchange rate Appendix: Continuous compounding Notation and definition Parity in the market for gold Cross exchange rate equilibrium Interest rate parity and covered interest arbitrage Butler / Multinational Finance Chapter 4 The International Parity Conditions

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4-4 Returns (rates of change) Changes in a price appear as lower case symbols p t d = inflation in currency d in period t s t d/f = change in the spot rate during period t é t d = real interest rate in currency d in period t r t d = an asset’s return in currency d during period t The law of one price and interest rate parity Less reliable parity conditions The real exchange rate Appendix: Continuous compounding Notation and definition Parity in the market for gold Cross exchange rate equilibrium Interest rate parity and covered interest arbitrage Butler / Multinational Finance Chapter 4 The International Parity Conditions
4-5 The law of one price “Equivalent assets sell for the same price” (also called purchasing power parity , or PPP ) Seldom holds for nontraded assets Can’t compare assets that vary in quality May not hold precisely when there are market frictions The law of one price and interest rate parity Less reliable parity conditions The real exchange rate Appendix: Continuous compounding Notation and definition Parity in the market for gold Cross exchange rate equilibrium Interest rate parity and covered interest arbitrage Butler / Multinational Finance Chapter 4 The International Parity Conditions

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4-6 Price relative P f S f/\$ P \$ to the \$ USA (\$) 3.41 1.00 3.41 1.00 Britain (£) 1.99 0.498 4.00 1.17 Euro-zone (€) 3.06 1.36 2.25 0.66 Hong Kong (HK\$) 12.0 7.82 1.53 0.45 Japan (¥) 280 122 2.30 0.67 S. Korea (Won) 2900 923 3.14 0.92 Switzerland (SFr) 6.30 1.21 5.21 1.53 Purchasing power (dis)parity: The Big Mac Index The law of one price and interest rate parity Less reliable parity conditions The real exchange rate Appendix: Continuous compounding Notation and definition Parity in the market for gold Cross exchange rate equilibrium Interest rate parity and covered interest arbitrage Butler / Multinational Finance Chapter 4 The International Parity Conditions
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