International Parity Conditions
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1 International Parity Conditions Fall 2013 Stephen Sapp
2 Introduction The costs should be the same for buying and selling goods, services and financial assets in different countries when converted to a common currency. For example, the price of an orange in Detroit should be the same as in Windsor when quoted in either US or Canadian dollars. This forms the basis for the fundamental parity conditions used to link financial markets.
3 Parity Conditions We will build on this intuition to develop the following international parity conditions: (1) Purchasing Power Parity (PPP) (2) Uncovered Interest Rate Parity (UIP) (3) Covered Interest Rate Parity (CIP) (4) Expectations Theory The most intuitive and frequently talked about is Purchasing Power Parity.
4 Purchasing Power Parity (PPP) It is based on the Law of One Price : in the long run the exchange rate should move to equalize the price of an identical basket of goods and services across countries. Price Domestic = Exchange Rate Dom Cur /For Cur Price Foreign Or Price Canadian dollars = Exchange Rate CAD/MXN Price Mexican Pesos
5 MacParity: Price of a Big Mac (in US dollars) Local Currency US dollars Switzerland SFr Sweden SKr Canada C$ Euro area Australia A$ United States New Zealand NZ$ Britain South Korea Won 3, Japan Mexico Peso Poland Zloty Russia Rouble China RMB Hong Kong HK$ Source: The Economist July 2013
6 MacGDParity? Source: The Economist July 28, 2011
7 MacParity: Minutes to Earn a Big Mac Source: The Economist August 20, 2009
8 MacParity:Over time Source: The Economist August 20, 2009
9
10 Coffee with that Burger?
11 Relative PPP In terms of changes in prices, we would expect the law of one price to continue to hold. Any change in the inflation rates between countries will be offset, over the long run, by an equal and opposite change in the spot exchange rate. Formally: % change in = % change in - % change in exchange rate domestic prices foreign prices Does this make sense?
12 The Verdict on PPP PPP is a poor guide to estimating the short run behaviour of exchange rates, but it has some usefulness for predicting where exchange rates should be in the long run. Why? What does this mean for managers? In the short-run? In the long-run?
13 Financial Assets: Where Would You Invest? In London (UK) you are quoted: One year Euro-dollar Interest Rate: 6% One year Euro-Yen Interest Rate: 3%
14 Where Would You Invest? (cont d) If investors are rational, it should not matter! (Why?) Assume the current spot exchange rate is 102 Yen/USD. The 6% Eurodollar rate means $1US today is worth $1.06US in a year. If we wanted to invest in Yen today, $1 US could be converted to 102 Yen. Investing at the Euro-yen interest rate this would be worth Yen in one year. For these investments to be equal, it must be that we are expecting the exchange rate in one year to be such that Yen = $1.06US, so the Yen/USD exchange rate should be 99.1 Yen/USD in one year.
15 Uncovered Interest Rate Parity Formally, this is: (1+R CAD, t ) E t [S CAD/USD, T ] (1+R US, t ) = S CAD/USD, t This is called Uncovered Interest Parity. We can use this relationship to determine where we expect exchange rates to be in the future: E t [S CAD/USD,T ] = S CAD/USD,t [(1+R CAD, t )/(1+R US, t )]
16 Where Would You Invest: Part II What if you could lock in the exchange rate you would be facing in one year? Would this change anything? Investing one Canadian dollar in Canada or in the U.S. should yield the 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 These should be worth the same amount in 1 year (why?)
17 Where Would You Invest: Part II If you can lock in an exchange rate for 1 year it should be: 89.25USD/104.25CAD = USD/CAD. This relationship is called Covered Interest Rate Parity. F USD/CAD, t = S USD/CAD, t (1+R US, t ) (1+R CAD, t ) This is how the forward rate is determined.
18 Covered Interest Rate Parity: Example
19 Expectations Theory F S CAD / USD E[ SCAD / USD] CAD / USD S CAD / USD forward rates are unbiased expectations of future spot rates note this implies that: E[S CAD/USD ] = F CAD/USD Note this is because both are equal to: (1 R (1 R USD CAD ) )
20 Predicting Future Spot Exchange Rates What would we do if we wanted to estimate the exchange rate in 60 days? What does PPP tell us? What does Uncovered Interest Rate Parity tell us? What does Covered Interest Rate Parity tell us? A natural forecast is the 60 day forward rate.
International Parity Conditions
International Parity Conditions Spring 2013 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.
International Parity Conditions. Introduction. Parity Conditions. Fall Stephen Sapp
International Parity Conditions Fall 2010 Introduction Te costs sould be te same for buying and selling goods, services and financial assets in different countries, in a common currency. For example, te
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