(ΔM s ) > (Δ M D ) PARITY CONDITIONS IN INTERNATIONAL FINANCE AND CURRENCY FORECASTING INFLATION ARBITRAGE AND THE LAW OF ONE PRICE

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1 PARITY CONDITIONS IN INTERNATIONAL FINANCE AND CURRENCY FORECASTING Fv Pay Condons Rsul Fom Abag Acvs 1. Pucasng Pow Pay (PPP). T Fs Ec (FE) 3. T Innaonal Fs Ec (IFE) 4. Ins Ra Pay (IRP) 5. Unbasd Fowad Ra (UFR) 1 Cangs n Excang as PPP Inlaon IFE FE Cangs n Ins as Fv Pay Condons Lnkd by adjusmn o as and pcs o nlaon UFR Cangs n Fowad Ras IRP 3 4 INFLATION (ΔM s ) > (Δ M D ) Inlaon and om cuncy dpcaon a: 1. jonly dmnd by gow o domsc mony supply (M s ) and. lav o gow o domsc mony dmand (M D )

2 PART II. sas a spo xcang as bwn cuncs wll cang o dnal n nlaon as bwn couns. Pucasng Pow Pay: Condons In od o xs PPP w assum: 1. All goods and svcs a adabl. Tanspoaon and o Tadng coss a zo 3. Consums n all couns consum sam popoons o goods and svcs 4. T LAW OF ONE pvals 7 8 PART I. II. THE LAW OF ONE A. Law sas: Idncal goods sll o sam pc woldwd. B. Tocal bass: I pc a xcang-a adjusmn was no qual, abag woldwd nsus a vnually wll. C. Pay Absolu Pucasng Pow III. RELATIVE PURCHASING POWER PARITY A. sas a xcang a o on cuncy agans ano wll adjus o lc cangs n pc lvls o wo couns In mamacal ms: 1 1 w = uu spo a = spo a = om nlaon xpcd = ogn nlaon xp = m pod. I pucasng pow pay s xpcd o old, n bs pdcon o on-pod spo a sould b

3 3. A mo smpld bu lss pcs laonsp s a s, pcnag cang n as sould b appoxmaly qual o nlaon a dnal. 4. PPP says cuncy w g nlaon a s xpcd o dpca lav o cuncy w low a o nlaon Sampl Poblm Pojcd nlaon as o U.S. and Gmany o nx wlv mons a 1% and 4%, spcvly. I cun xcang a s $.5/dm, wa sould uu spo a b a nd o nx wlv mons? (1.577) 1 $.59 PART III. THE FISHER EFFECT I. THE FISHER EFFECT sas a nomnal ns as () a a uncon o al ns a (a) and a pmum () o nlaon xpcaons. R = a PART IV. THE INTERNATIONAL FISHER EFFECT A. Ral Ras o Ins 1. Sould nd owad qualy vyw oug abag.. W no govnmn nnc nomnal as vay by nlaon dnal o - = - THE INTERNATIONAL FISHER EFFECT B. Accodng o IFE, couns w g xpcd nlaon as av g ns as

4 THE INTERNATIONAL FISHER EFFECT II. IFE STATES: A. spo a adjuss o ns a dnal bwn wo couns. B. IFE = PPP + FE 1 1 THE INTERNATIONAL FISHER EFFECT C. Fs posulad 1. T nomnal ns a dnal sould lc nlaon a dnal. 19 THE INTERNATIONAL FISHER EFFECT D. Smpld IFE quaon: THE INTERNATIONAL FISHER EFFECT E. Implcaons IFE s a wok: 1. Cuncy w low ns a xpcd o appca lav o on w a g a. 1 T Innaonal Fs Ec I /$ spo a s 18/$ and ns as n Tokyo and Nw Yok a 6% and 1%, spcvly, wa s uu spo a wo yas om now? /$ 3 PART V. I. INTRODUCTION A. T Toy sas: owad a (F) ds om spo a (S) a qulbum by an amoun qual o ns dnal ( - ) bwn wo couns. 4 4

5 B. T owad pmum o dscoun quals ns a dnal. (F S)/S = ( - ) w = om a = ogn a F = owad a S = spo a C. In qulbum, uns on cuncs wll b sam.. No po wll b alzd and ns a pay xss wc can b wn 1 F S D. Covd Ins Abag 1. Condons qud: ns a dnal dos no qual owad pmum o dscoun.. Funds wll mov o a couny w a mo aacv a. 3. Mak pssus dvlop: a. As on cuncy s mo dmandd spo and sold owad. b. Inlow o unds dpsss ns as. c. Pay vnually acd. 7 8 INTEREST RATE PARITY I Swss anc s $.68/SF on spo mak and annualzd ns as n U.S. and Swzland, spcvly, a 7.94% and %, wa s 18 day owad a und pay condons? $.7/ SF 9 E. Summay: Ins Ra Pay sas 1. Hg ns as on a cuncy os by owad dscouns.. Low ns as a os by owad pmums. 3 5

6 PART VI. THE RELATIONSHIP BETWEEN THE FORWARD AND THE FUTURE SPOT RATE I. THE UNBIASED FORWARD RATE A. Sas a owad a s unbasd, n sould lc xpcd uu spo a. B. Sad as = 31 6

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