CHAPTER 6 - INTERNATIONAL PARITY RELATIONSHIPS
We now look at Int'l. Parity Relationships, starting with the
Law of One Price (LOP),
extended to:
Purchasing Power Parity (PPP) and Interest Rate Parity (IRP).
These parity relationships help us
to understand: 1) how ex-rates are determined, and 2) how to forecast ex-rates.
Int'l. Parity is based on
EMH
(Efficient Market Hypothesis). FX/securities markets are efficient when:
1) securities/FX are priced efficiently reflecting all currently available information, and 2) no arbitrage
opportunities exist.
Arbitrage
: Riskless, certain profit opportunities by exploiting price discrepancies. Simultaneously
buying and selling mispriced securities/FX to make a guaranteed, riskless profit
without
any
investment. "Picking up dimes with a bulldozer."
Example:
triangular arbitrage.
Int'l. parity conditions exist when there are no arbitrage opportunities and markets are in equilibrium.
"No $100 bills lying on the sidewalk."
Law of One Price (LOP)
: P
D
= S ($/£) P
F
, where
P
D
= Domestic Price ($)
P
F
= Foreign Price (£)
S ($/£) = spot ex-rate.
Example:
Gold in U.S. is $1,200/oz., gold in U.K. = £750 and S= $1.600/£
In USD:
£750 x $1.6000/£ = $1,200, Gold is selling in both countries for the same price in USD
In BP:
$1,200/oz. ÷ $1.6000/£ = £750/oz, Gold is selling in both countries for the same price in BP
If Law of One Price (Price Equalization Principle) did not hold, arbitrage would be possible, and would
quickly restore parity.
For example, what if gold in U.K. was $1,250?
What if gold in U.S. was £775?
INTEREST RATE PARITY (IRP)
IRP:
“No Arbitrage condition” when int'l. financial markets (FX and money markets) are in
equilibrium. Assuming free movement of capital, int'l. financial markets should be efficient. "Smell of
profits" eliminates any discrepancies.
Covered Interest Rate Parity
= Parity conditions in fin. mkts.,
when forward markets are used to eliminate or "cover" any FX risk.
Example:
U.S. investor has $1 to invest for one year. You consider two strategies: 1) Invest in U.S.
treasury securities at
i
$
,
the domestic interest rate, for one year; or 2) Invest in foreign U.K. treasury
securities at
i
£
,
and hedge FX risk by selling maturity value of £s forward one year.
In U.S., your payoff (maturity value) in one year will be: $1(1 +
i
$
)
In equilibrium this should be the same as your payoff in U.K.
MGT 566: International Finance – CH 6
Professor Mark J. Perry
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