Finc415 Chapter 6 : international parity relationships

Partial Exchange Rate Pass-Through

Partial pass-through is when prices of imported products rise by less than the full percentage change in the imported product's currency

Real exchange rate =

Sactual / Sppp E =, <, > 1

IRP

is an arbitrage condition that MUST hold when international financial markets are in equilibrium.

When E<1

the foreign currency is overvalued. Foreign products seem expensive relative to the base year. That is, the competitiveness of the domestic country improves.

When E>1

the foreign currency is undervalued. Foreign products seem cheap relative to the base year. That is, the competitiveness of the domestic currency deteriorates.

When E=1

the foreign currency is valued correctly. The competitiveness of the domestic currency is unaltered.

Empirical Tests of the International Fisher Effect

Empirical tests lend some support to the relationship postulated by the international Fisher effect although considerable short-run deviations do occur.

Parity Conditions

Managers of multinational firms and others must deal with these fundamental issues: 1. Are changes in exchange rates predictable? 2. How are exchange rates related to interest rates? 3. What, at least theoretically, is the "proper" exchange rate?

When the under/over valuation against the dollar is "negative"

when it is "positive" it is undervalued.

Empirical Tests of the Forward Exchange Expectations Hypothesis

- A consensus is developing that rejects the efficient market hypothesis. - It appears that the forward rate is not an unbiased predictor of the future spot rate and that it does pay to use resources in an attempt to forecast exchange rates. - The existence and success of foreign exchange forecasting services suggest that managers are willing to pay a price for forecast information even though they can use the forward rate to forecast at no cost. - If professional service more accurate than forward rate in predicting future spot rate, then ratio less than one.

Uncovered Interest "Arbitrage"

- A deviation from CIA is uncovered interest arbitrage, UIA, wherein investors borrow in currencies exhibiting relatively low interest rates and convert the proceeds into currencies which offer higher interest rates. - The transaction is "uncovered" because the investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period. Uncovered interest arbitrage is not truly arbitrage, since it is not a riskless proposition.

What is meant by "unbiased predictor" in terms of how the forward rate performs in estimating future spot exchange rates?

- An "unbiased predictor" means that the distribution of possible actual spot rates in the future is centered on the forward rate. - The fact that it is an unbiased predictor, however, does not mean that the future spot rate will actually be equal to what the forward rate predicts. - Unbiased prediction simply means that the forward rate will, on average, overestimate and underestimate the actual future spot rate in equal frequency and degree.

Applications of Relative PPP:

- Forecasting future spot exchange rates. - Calculating appreciation in "real" exchange rates. This will provide a measure of how expensive a country's goods have become (relative to another country's).

Purchasing Power Parity (Law of One Price)

- If identical products or services can be sold in two different markets, and no restrictions exist on the sale or transportation of product between markets, the product's price should be the same in both markets. - Comparison of prices would only require conversion from one currency to the other: - A primary principle of competitive markets is that prices will equalize across markets if frictions or costs of moving the products or services between markets do not exist. If the two markets are in two different countries, the product's price may be stated in different currency terms, but the price of the product should still be the same.

Relative Purchasing Power Parity

- If the assumptions of the absolute version of PPP are relaxed, - more general idea is that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period - if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate

If the price of the car in the U.S. (in dollars) increases by the same percentage change as the exchange rate, how much does the car cost?

- In the case that the price of the car in dollars increases by the same percentage change as the exchange rate, we say there has been complete pass-through (or 100%) of changes in exchange rates. - However, if Volvo is worried that a price increase of this magnitude in the U.S. market would severely hurt sales volume, it might work to prevent the dollar price of this model from rising the full amount in the U.S. market.

How close does the Big Mac Index conform to the theoretical requirements for a one price measurement of purchasing power parity?

- The Big Mac may be a good candidate for the application of the law of one price and measurement of under or overvaluation for a number of reasons. - First, the product itself is nearly identical in each market. This is the result of product consistency, process excellence, and McDonald's brand image and pride. Second, and just as important, the product is a result of predominantly local materials and input costs. - This means that its price in each country is representative of domestic costs and prices and not imported ones, which would be influenced by exchange rates themselves. - The index, however, still possesses limitations. - Big Macs cannot be traded across borders, and costs and prices are influenced by a variety of other factors in each country market, such as real estate rental rates and taxes.

Foreign Exchange Expectations

- The Forward Rate as an Unbiased Predictor of the Future Spot Rate - Some forecasters believe that for the major floating currencies, foreign exchange markets are "efficient" and forward exchange rates are unbiased predictors of future exchange rates - An unbiased predictor, however, does not mean the future spot rate will actually be equal to what the forward rate predicts. - Unbiased predictor means that the forward rate will, on average, overestimate and underestimate the actual future spot rate in equal frequency and degree.

How is the price elasticity of demand relevant to exchange rate passthrough?

- The concept of price elasticity of demand is useful when determining the desired level of passthrough. Recall that the price elasticity of demand for any good is the percentage change in quantity of the good demanded as a result of the percentage change in the good's price

What is meant by the term exchange rate pass-through?

- The degree to which the prices of imported and exported goods change as a result of exchange rate changes - Although PPP implies that all exchange rate changes are passed through by equivalent changes in prices to trading partners, empirical research in the 1980s questioned this long-held assumption. - "The old 'rule of thumb' was that 50% of a decline in the dollar would get passed through to consumers within a year. Now it is more like 30%."

Nominal Exchange Rates versus PPP Rates

- The general conclusion from empirical studies of relative PPP is that the theory holds up well in the long run, but not as well over shorter periods. - The difference between short- and long-run effects can be seen in the following graphs, which compare nominal exchange rates with PPP rates. - Despite substantial short-run deviations from PPP, currencies have a distinct tendency to move toward their PPP-predicted rates.

Empirical Tests of PPP

- The strictest version of PPP (the law of one price) is obviously false. - over time, those currencies with the largest relative decline (gain) in purchasing power saw the sharpest erosion (appreciation) in the foreign exchange values. - goods and services do not in reality move at zero cost between countries, and in fact, many services are not "tradable," - Many goods and services are not of the same quality across countries, reflecting differences in the tastes and resources of the countries of their manufacture and consumption. - A common explanation for the failure of PPP to hold is that goods prices are sticky, leading to short-term violations of the law of one price.

Absolute purchasing power parity

- This is the absolute version of the theory of purchasing power parity. Absolute PPP states that the spot exchange rate is determined by the relative prices of similar baskets of goods. -If the law of one price were true for all goods and services, the purchasing power parity exchange rate could be found from any individual set of prices. By comparing the prices of identical products denominated in different currencies, one could determine the "real" or PPP exchange rate which should exist if markets were efficient.

Real Exchange Rate Indexes

- calculates how the weighted average purchasing power of a currency has changed relative to a base period. - If changes in exchange rates just offset differential inflation rates—if purchasing power parity holds—all the real effective exchange rate indices would stay at 100. - If an exchange rate strengthened more than was justified by differential inflation, its index would rise above 100. - If the real effective exchange rate index were above 100, the currency would be considered "overvalued" from a competitive perspective, and vice versa.

Interest Rate Parity

- provides the linkage between the foreign exchange markets and the international money markets: - The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs. - equilibrium condition, it must hold - If Interest Rate for quote is > interest rate of base, then it must be greater than 1 and F > S and the base currency is selling at a premium - If you invest $1 domestically at the U.S. interest rate (i$), the maturity value will be: $1(1+i$)

The Fisher Effect

- states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation - where i is the nominal rate of interest, r is the real rate of interest, and π is the expected rate of inflation - This relation is often presented as a linear approximation stating that the nominal interest rate is equal to a real interest rate plus expected inflation

The Real Exchange Rate

- the real exchange rate measures deviations from PPP. - That is, changes in the spot exchange rate that do not reflect differences in inflation rates between the two currencies in question.

Uncovered Interest "Arbitrage" (UIA): The Yen Carry Trade

- wherein investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. - The transaction is "uncovered," because the investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period

The Theoretical Parity Relations of International Finance

1. The purchasing power parity relation, linking spot exchange rates and inflation. 2. The international Fisher relation, linking interest rates and inflation. 3. The foreign exchange expectations relation, linking forward exchange rates and expected spot exchange rates. 4. The interest rate parity relation, linking spot exchange rates, forward exchange rates, and interest rates.

How long will this arbitrage opportunity last?

As a result of arbitrage opportunities, IRP will be restored quite quickly.

If domestic inflation > foreign inflation, PPP predicts the foreign currency should appreciate

But if domestic inflation < foreign inflation, PPP predicts the foreign currency should depreciate

covered interest arbitrage

The spot and forward exchange markets are not constantly in the state of equilibrium described by interest rate parity. When the market is not in equilibrium, the potential for "riskless" or arbitrage profits exists. The arbitrager who recognizes such an imbalance will move to take advantage of the disequilibrium by investing in whichever currency offers the higher return on a covered basis. - CIA is possible when interest rate parity does not hold. An example of a basic CIA strategy would be to 1) convert dollars at the current spot into a foreign currency, 2) invest the foreign currency in a risk-free investment in the foreign country, 3) simultaneously sell the future proceeds of the foreign risk-free investment in the forward market, and finally 4) calculate the opportunity cost of the funds at the U.S. risk-free interest rate. - When done correctly, the difference between the revenue in step 2 should exceed the cash-outflows in steps 3 and 4.

According to the theory of purchasing power parity, what should happen to a currency which is undervalued?

Theoretically, if the currency is undervalued then market participants, in search of potential profits, will continue to purchase the currency until they drive its price up eliminating the undervaluation.

forward exchange hypothesis

states that the forward exchange rate, quoted today for delivery at time 1, is equal to the expected value of the spot exchange rate at time 1.

International Fisher Effect

states that the spot exchange rate should change to adjust for differences in interest rates between two countries