International Parity Conditions
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1 International Parity Conditions Spring 2013
2 Introduction Te costs sould be te same for buying and selling goods, services and financial assets in different countries wen converted to a common currency. For example, te price of an orange in Detroit sould be te same as in Windsor wen quoted in eiter US or Canadian dollars. Tis forms te basis for te fundamental parity conditions used to link financial markets.
3 Parity Conditions We will build on tis intuition to develop te following international parity conditions: (1) Purcasing Power Parity (PPP) (2) Uncovered Interest Rate Parity (UIP) (3) Covered Interest Rate Parity (CIP) (4) Expectations Teory Te most intuitive and frequently talked about is Purcasing Power Parity.
4 Purcasing Power Parity (PPP) It is based on te Law of One Price : in te long run te excange rate sould move to equalize te price of an identical basket of goods and services across countries. Price Domestic = Excange Rate Dom Cur /For Cur Price Foreign Or Price Canadian dollars = Excange Rate CAD/MXN Price Mexican Pesos
5 MacParity: Price of a Big Mac (in US dollars) Local Currency US dollars Sweden Skr Switzerland SFr Australia A$ Euro area United States $ Britain Japan New Zealand NZ$ Canada C$ Sout Korea Won3, Mexico Peso Poland Zloty Cina Yuan Russia Rouble Hong Kong HK$ Source: Te Economist July 26, 2012
6 MacGDParity? Source: Te Economist July 28, 2011
7 MacParity: Minutes to Earn a Big Mac Source: Te Economist August 20, 2009
8 MacParity: Over time Source: Te Economist August 20, 2009
9
10 Relative PPP In terms of canges in prices, we would expect te law of one price to continue to old. Any cange in te inflation rates between countries will be offset, over te long run, by an equal and opposite cange in te spot excange rate. Formally: % cange in = % cange in - % cange in excange rate domestic prices foreign prices Does tis make sense?
11 Te Verdict on PPP PPP is a poor guide to understanding/estimating te sort run beaviour of excange rates, but it as some usefulness for predicting were excange rates sould be in te long run. Wy? Wat does tis mean for managers? In te sort-run? In te long-run?
12 Financial Assets: Were Would You Invest? In London (UK) you are quoted: One year Euro-dollar Interest Rate: 6% One year Euro-Yen Interest Rate: 3%
13 Were Would You Invest? (cont d) If investors are rational, it sould not matter! (Wy?) Assume te current spot excange rate is 102 Yen/USD. Te 6% Eurodollar rate means $1US today is wort $1.06US in a year. If we wanted to invest in Yen today, $1 US is wort 102 Yen. Based on te Euro-yen interest rate tis would be wort Yen in one year. For tese investments to be equal, it must be tat we are expecting te excange rate in one year to be suc tat Yen = $1.06US, so te Yen/USD excange rate sould be 99.1 Yen/USD in one year.
14 Uncovered Interest Rate Parity Formally, tis is: (1+R CAD, t ) E t [S CAD/USD, T ] (1+R US, t ) = S CAD/USD, t Tis is called Uncovered Interest Parity. We can use tis relationsip to determine were we expect excange rates to be in te future: E t [S CAD/USD,T ] = S CAD/USD,t [(1+R CAD, t )/(1+R US, t )]
15 Were Would You Invest: Part II Wat if you could lock in te excange rate you would be facing in one year? Would tis cange anyting? Investing one Canadian dollar in Canada or in te U.S. sould yield te same return. Assume: R CDN = 4.25%, R US = 5%, spot rate 0.85 USD/CAD Invest $100CAD in Canada: ( x $100CAD) = $104.25CAD Or, you can invest $100CAD in US dollars: ($100CAD x 0.85USD/CAD) x (1.05) = $89.25US Tese sould be wort te same amount in 1 year (wy?)
16 Were Would You Invest: Part II cont d If you can lock in an excange rate for 1 year it sould be: 89.25USD/104.25CAD = USD/CAD. Tis relationsip is called Covered Interest Rate Parity. F USD/CAD, t = S USD/CAD, t (1+R US, t ) (1+R CAD, t ) Tis is ow te forward rate is determined.
17 Covered Interest Rate Parity: Example
18 Predicting Future Spot Excange Rates How could we estimate te excange rate in 60 days? Wat does PPP tell us? Wat does Uncovered Interest Rate Parity tell us? Wat does Covered Interest Rate Parity tell us? Suppose you make daily forecasts of te value of te excange rates for two monts in te future, E(S t+60 ). A natural forecast is te 60 day forward rate.
19 Expectations Teory F S CAD / USD E[ SCAD / USD] CAD / USD S CAD / USD forward rates are unbiased expectations of future spot rates note tis implies tat: E[S CAD/USD ] = F CAD/USD Note tis is because bot are equal to: (1 R (1 R USD CAD ) )
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