INT. FINANCE CHAPTER 6
13) Relative purchasing power parity
A theory that 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.
5) Fisher effect
A theory that nominal interest rates in two or more countries should be equal to the required real rate of return to investors plus compensation for the expected amount of inflation in each country. Named after economist Irving Fisher, states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation.
7) Interest rate parity (IRP)
A theory that the differences in national interest rates for securities of similar risk and maturity should be equal to but opposite in sign (positive or negative) to the forward exchange rate discount or premium for the foreign currency.
8) International Fisher effect
A theory that the spot exchange rate should change by an amount equal to the difference in interest rates between two countries.
11) Nominal effective exchange rate index
Uses actual exchange rates to create an index, on a weighted average basis, of the value of the subject currency over time. It does not really indicate anything about the "true value" of the currency or anything related to PPP. It simply calculates how the currency value relates to some arbitrarily chosen base period, but it is used in the formation of the real effective exchange rate index.
2) Big Mac index
as it has been christened by The Economist and calculated regularly since 1986, is a prime example of the law of one price. Assuming that the Big Mac is indeed identical in all countries listed, it serves as one form of comparison of whether currencies are currently trading at market rates that are close to the exchange rate implied by Big Macs in local currencies.
12) Real effective exchange rate index
indicates how the weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period.
9) International parity conditions
In the context of international finance, a set of basic economic relationships that provide for equilibrium between spot and forward foreign exchange rates, interest rates, and inflation rates.
6) Forward rate as an unbiased predictor of the future spot rate
Some forecasters believe that foreign exchange markets for the major floating currencies are "efficient" and forward exchange rates are unbiased predictors of future spot exchange rates. On page 170 Exhibit 6.10 demonstrates the meaning of "unbiased prediction" in terms of how the forward rate performs in estimating future spot exchange rates. If the forward rate is an unbiased predictor of the future spot rate, the expected value of the future spot rate at time 2 equals the present forward rate for time 2 delivery, available now, E1(S2) = F1,2. Intuitively, this 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. The forward rate may, in fact, never actually equal the future spot rate.
10) Law of one price
The concept that if an identical product or service can be sold in two different markets, and no restrictions exist on the sale or transportation costs of moving the product between markets, the product's price should be the same in both markets.
4) Exchange rate pass-through
The degree to which the prices of imported and exported goods change as a result of exchange rate changes.It is a measure of the response of imported and exported product prices to changes in exchange rates. When that pass-through is partial, meaning the full percentage change in the exchange rate is not reflected in prices, a country's real effective exchange rate index can deviate from its PPP equilibrium level of 100.
14) Uncovered interest arbitrage (UIA)
The process by which 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.
3) Covered interest arbitrage (CIA)
The process whereby an investor earns a risk-free profit by (1) borrowing funds in one currency, (2) exchanging those funds in the spot market for a foreign currency, (3) investing the foreign currency at interest rates in a foreign country, (4) selling forward, at the time of original investment, the investment proceeds to be received at maturity, (5) using the proceeds of the forward sale to repay the original loan, and ( 6) sustaining a remaining profit balance. 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 profit 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.
1) Absolute purchasing power parity
The theory that the exact rate of exchange between two currencies is found by equalizing the purchasing power of the two currencies. It further 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 (PPP) 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 that should exist if markets were efficient.
