Int. Finance

Discuss the implications of the deviations from the purchasing power parity for countries' competitive positions in the world market

if exchange rate changes satisfy PPP, competitive positions of countries will remain unaffected following exchange rate changes. Otherwise, exchange rate changes will affect relative competitiveness of countries. If a country's currency appreciates (depreciates) by more than is warranted by PPP, that will hurt (strengthen) the country's competitive position in the world market.

International Fisher Effect

can be obtained by combining the fisher effect and the relative version of PPP in its expectational form. assuming that the real interest rate is the same between two countries, (p$=p#), and substituting above results into the PPP E(e)=E(pi$)-E(pi#), we obtain E(e)=i$-i#

Implications of the interest rate parity for the exchange rate determination.

The forward exchange rate is roughly an unbiased predictor of the future spot rate. The exchange rate is thus determined by the relative interest rates, and the expected spot rate, conditional on all the available information, I(t), as of the present time. .One thus can say that expectation is self-fulfilling. Since the information set will be continuously updated as news hits the market, the exchange rate will exhibit a highly dynamic, random behavior.

Absolute PPP

holds that the price level in a country is equal to the price level in another country times the exchange rate between the two countries.

Relative PPP

holds that the rate of exchange rate change between a pair of countries is about equal to the difference in inflation rates of the two countries.

Explain the conditions under which the forward exchange rate will be an unbiased predictor of the future spot exchange rate

1) the forward risk premium is insignificant 2) foreign exchange markets are informationally efficient.

What causes the deviations from the purchasing power parity?

PPP can be violated if there are barriers to international trade or if people in different countries have different consumption taste. PPP is the law of one price applied to a standard consumption basket.

The Law of One Price (ppp)

Refers to the international arbitrage condition for the standard consumption basket. LOP requires that the consumption basket should be selling for the same price in a given currency across countries.

Arbitrage

The act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits.

Derive and explain the monetary approach to exchange rate determination

The monetary approach is associated with the Chicago School of Economics. It is based on two tenets: purchasing power parity and the quantity theory of money. Combing these two theories allows for stating, say, the $/£ spot exchange rate as: S($/£) = (M$/M£)(V$/V£)(y£/y$), where M denotes the money supply, V the velocity of money, and y the national aggregate output. The theory holds that what matters in exchange rate determination are: 1. The relative money supply, 2. The relative velocities of monies, and 3. The relative national outputs.

Explain the random walk model for exchange rate forecasting. Can it be consistent with the technical analysis?

The random walk model predicts that the current exchange rate will be the best predictor of the future exchange rate. An implication of the model is that past history of the exchange rate is of no value in predicting the future, which makes it inconsistent with the technical analysis which tries to utilize past history.

Researchers found that it is very difficult to forecast the future exchange rates more accurately than the forward exchange rate or the current spot exchange rate. How would you interpret this finding?

This implies that exchange markets are informationally efficient. Thus, unless one has private information that is not yet reflected in the current market rates, it would be difficult to beat the market.