price between two regions by more than the transport and transaction costs (otherwise arbitrage). Allows us to determine how integrated /segmented the world capital market is (barriers to flow of goods/money prevent this law from holding) (2) Purchasing power Parity (PPP) applies the law to a basket of goods. PPP states that, under ideal conditions, exchange rates instantaneously respond to local price level changes. There are three primary applications that apply the Law of One Price to exchange rates, inflation rates, and interest rates; thus creating the following parity theorems. 1. Expected changes in exchange rates = expected differences in inflation rates 2. Differences in interest rates between 2 countries will reflect the differences in expected inflation 3. As a result of 1 & 2: Expected exchange rates = the interest rate difference between 2 countries (therefore dollar adjusted interest rates should be the same in every country. High inflation = poor exchange rates)
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4 | P a g e Economic relationships: Equity Expectations Parity (theorem) The Equity Expectations Parity proposes that: If stock prices are set in a world CAPM framework, the beta-adjusted expected returns on stocks will be the same in every country. Aim: whether a country experienced below average beta-adjusted returns. Compare correlations of each USD-adjusted equity returns with dollar-adjusted bond returns and local inflation rates Results: high correlation between equity and bond returns = same exchange rate adjustment Negative correlation between equity returns & inflation = inflation hurts stock markets GENERALLY Ibbotson, Carr and Robinson find barriers to international trade and the flow of capital defect relationships found in party theorems Advantages of international diversification If asset returns are imperfectly correlated: •Risk is reduced at a given level of return •Segmentation in world market may produce bargains oLow US investment in foreign markets = under-pricing = excess returns for investors •Size of Non-US market: international investment = broadening horizon Assumption of exchange adjustments may be delayed rather than instantaneous (according to international parity theorems) but exchange risk can be diversified or hedged in forward markets, incurring some transaction costs.