Chapter 6: International Parity Conditions

Uncovered Interest Arbitrage

A deviation from covered interest arbitrage is uncovered interest arbitrage (UIA), where in 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.

Real Effective Exchange Rate Index

A real effective exchange rate index adjusts the nominal effective exchange rate index to reflect differences in inflation. The adjustment is achieved by multiplying the nominal index by the ratio of domestic costs to foreign costs. The real index measures deviation from purchasing power parity and, consequently, pressures on a country's current account and foreign exchange rate.

The International Fisher Effect

Irving Fisher stated that the spot exchange rate should change in an equal amount but opposite in direction to the difference in nominal interest rates. Stated differently, the real return in different countries should be the same, so that if one country has a higher nominal interest rate, the gain from investing in that currency will be lost by a deterioration of its exchange rate.

Transaction Costs

It would result in large discrepancies between market rates and quotes, as a higher transaction cost would dissuade many arbitragers from making the trades for small amounts

Market Efficiency

Tests of foreign exchange market efficiency conclude that either exchange market efficiency is untestable or, if it is testable, that the market is not efficient. 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 as a forecast at no cost.

Interest Rate Parity

he text demonstrates that parity holds when the discounted value of the difference in interest rates equals the percentage change in the exchange rate. If parity holds no covered interest arbitrage is possible. Hence, the steps of a covered interest arbitrage strategy can be used to explain the parity condition.

Forward Rate Calculation

his is a common misconception. The forward rate is a calculation, using three observable market rates: the spot exchange rate, the domestic interest rate, and the foreign interest rate.It is technically categorized as a foreign currency loan agreement by the financial institution, and the rate makes that evident. There is no "predictive" element in its calculation, although many people in the market commonly use it as a forecast.

The Fisher Effect

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.

Absolute 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(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 which should exist if markets were efficient. This is the absolute version of the theory of purchasing power parity. A

Nominal Effective Exchange Rate Index

An exchange rate index is an index that measures the value of a given country's exchange rate against all other exchange rates in order to determine if that currency is overvalued or undervalued. A nominal effective exchange rate index is based on a weighted average of actual exchange rates over a period of time. It is unrelated to PPP and simply measures changes in the exchange rate (i.e., currency value) relative to some arbitrary base period.It is used in calculating the real effective exchange rate index.

The 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. This is called the law of one price. However, the actions of traders would depress the spot price of the pound and increase the forward price. In both cases, the bank takes losses on its exchange trades.Law of One Price.

Exchange Rate Pass-Through

Incomplete exchange rate pass-through is one reason that a country's real effective exchange rate index can deviate for lengthy periods from its PPP-equilibrium level of 100.The degree to which the prices of imported and exported goods change as a result of exchange rate changes is termed pass-through.

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. Many times an exporter that finds its price has risen in target foreign markets as a result of the exporter's currency appreciating will attempt to keep the price from rising in the target market by as much as the exchange rate change, wishing to not lose sales as a result of the price increase.

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.

Big Mac Index

The Big Mac may be a good candidate for the application of the law of one price andmeasurement of under or overvaluation for a number of reasons. First, the product itself isnearly 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

Carry Trade

The carry trade refers to borrowing in a low interest rate environment, for example Japan, and then investing the proceeds in a higher rate environment, say the Australian dollar, to earn the differential.

Price Elasticity of Demand

The concept of price elasticity of demand is useful when determining the desired level of pass-through. 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:

Purchasing Power Parity

The concept underlying purchasing power parity (PPP) is the law of one price, or the idea that similar traded goods and services that provide similar benefits should have the same price in different countries.

Approximate Form of Fisher Effect

The final compound term, r times π, is frequently dropped from consideration due to its relatively minor value. The Fisher effect then reduces to (approximate form):p= +i r

Covered Interest Arbitrage

The spot and forward exchange markets are not, however, constantly in the state of equilibrium described by interest rate parity. When the market is not in equilibrium, the - 10 -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. This is called covered interest arbitrage (CIA).

Interest Rate Parity

The theory of interest rate parity (IRP) provides the linkage between the foreign exchange markets and the international money markets. The theory states: 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

Undervaluation and Purchasing Power Parity

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

Relative purchasing power parity

that differential rates of inflation between two countries tend to be offset over time by an equal but opposite change in the spot exchange rate. If the assumptions of the absolute version of PPP theory are relaxed a bit more, we observe what is termed relative purchasing power parity. This 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. More specifically, 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

covered interest arbitrage

the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk with a forward contract