Parity Conditions in International Finance - Finance and Accounting - Lecture Slides, Slides of Financial Accounting

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Parity Conditions in International

Finance and Currency Forecasting

PURCHASING POWER PARITY

• I. THE THEORY OF PURCHASING

• POWER PARITY

• states that spot exchange rates between currencies will change to the differential in inflation rates between
• countries.

Purchasing Power Parity:

Conditions

• In order to exist PPP we assume:
• 1. All goods and services are tradable
• 2. Transportation and other Trading costs are zero
• 3. Consumers in all countries consume the same proportions of goods and services
• 4. The LAW OF ONE PRICE prevails

Rationale behind PPP Theory

• Suppose Indian inflation > U.K. inflation.

↑ Indian. imports from U.K. and

↓ Indian. exports to U.K.

Upward pressure is placed on the £ against INR.

This shift in consumption and the £’s appreciation

will continue until

• in the Indian priceU.K. goods ≥ price (^) Indian. goods
• in the U.K.: price (^) Indian. goods ≤ priceU.K. goods

PURCHASING POWER PARITY

• III. RELATIVE PURCHASING POWER

PARITY

• A. states that the exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries.

PURCHASING POWER PARITY

• 1. In mathematical terms:
• et = (1 + ih ) t
• e 0 (1 + i (^) f ) t
• where et = future spot rate
• e 0 = spot rate
• i (^) h = home inflation
• i (^) f = foreign inflation
• t = time period

PURCHASING POWER PARITY

• 3. A more simplified but less precise
• relationship is
• et - e 0 = i (^) h - if
• e (^0)
• that is, the percentage change should be approximately equal to
• the inflation rate differential.

Why PPP Does Not Occur

• PPP does not occur consistently due to:
• confounding effects
  • Exchange rates are also affected by differences in inflation, interest rates, income levels, government controls and expectations of future rates.
• a lack of substitutes for some traded goods

THE FISHER EFFECT

• I. THE FISHER EFFECT
• states that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations.
• R = a + i
• If all investors require the same real return, differentials in interest rates may be due to differentials in expected inflation

PART IV. THE INTERNATIONAL

FISHER EFFECT

• A. Real Rates of Interest
• 1. Should tend toward equality
• everywhere through arbitrage.
• 2. With no government interference
• nominal rates vary by inflation
• differential or
• rh - r (^) f = i (^) h - i (^) f

THE INTERNATIONAL FISHER

EFFECT

• II. IFE STATES:
• A. the spot rate adjusts to the

interest rate differential between

two countries.

• B. IFE = PPP + FE
• et = (1 + r (^) h) t
• e 0 (1 + r (^) f ) t

THE INTERNATIONAL FISHER

EFFECT

• E. Implications if IFE is at work:
• 1. Currency with the lower interest rate expected to appreciate relative to one
• with a higher rate.