Exchange Rates Flashcards
(13 cards)
Absolute Purchasing Power Parity (Absolute PPP)
Compares the average price of a representative basket of consumption goods between countries
.📌 Key Implication:
Prices of goods should be the same when expressed in a common currency.
Used to determine if a currency is overvalued or undervalued.
The Absolute PPP asserts that the equilibrium exchange rate between two countries is determined
entirely by the ratio of their national price levels.
.
Bf = E x Bd
the Absolute PPP states that the nominal exchange rate will be determined by the ratio of the foreign and domestic broad
price indexes.
However, it is highly unlike that their relationship actually holds because of the transaction costs and the weights (consumption patterns) of the
various goods in the two economies may not be the same (e.g. people eat more potatoes in Russia
and more rice in Japan).
Relative Purchasing Power Parity
Relative Purchasing Power Parity (Relative PPP) states that changes in exchange rates should exactly offset the price effects of any inflation differential between two countries.
E.g. If Country A has a 6% inflation rate and Country B has 4% inflation rate, then Country A’s currency should depreciate by approximately 2% relative to Country B’s currency over the period.
% △ S0 = IA - IB
% △ S0 = Inflation foregin - Iinflation Domestic
If the spot exchange rate ‘S ‘ remained unchanged, the higher foreign inflation rate would erode the competitiveness of foreign companies relative to domestic companies.
The Relative PPP focuses on actual changes in the exchange rates being driven by actual differences in national inflation rates.
Ex-Ante Purchasing Power Parity
Ex-Ante Purchasing Power Parity (Ex-Ante PPP) asserts that the expected changes in the spot exchange rate ‘S ‘ are entirely driven by expected differences in national inflation rates.
Ex-Ante PPP tells us that countries that are expected to run persistently high inflation rates should expect to see their currencies depreciate over time, while countries that are expected to run relatively low inflation rates on a sustainable basis should expect to see their currencies appreciate
over time.
Therefore, while over shorter horizons nominal exchange rate movements may appear random, over long time horizons nominal exchange rates tend to gravitate towards their long-run PPP equilibrium value.
Assumption of Uncovered Interest Rate Parity
UIRP assumes that the country with a higher interest rate will see its currency depreciate.
UIRP
Currency with a lower interest rate will see its currency
Appreciate
UIRP
Currency with a higher interest rate will see its currency
Depreciate
Real Exchange Rate Formula
% Δ Sd/f + foregin CPI - Domestric CPI
or
Spot f/d x (CPI Foreign / CPI Domestic)
If the USD 1 year rate is 1%, and the CAD 1 rate is 2%, and If we have a Hedged Interest Rate Parity HPR.
What would return would the total provide, if we’re a CAD investor investing in a USD bond?
2%.
A fully hedged CAD Investment would provide the same return as the USD.
Formula for UIRP
% Δ Sd/f = If - Id
Forward Rate Parity
Forward Rate Parity is a no-arbitrage condition stating that the forward exchange rate between two currencies should reflect the interest rate differential between those two countries.
It ensures that investors earn the same return whether they invest domestically or in a foreign country and hedge currency risk using a forward contract.
“If interest rates differ between two countries, the forward rate must adjust so there’s no arbitrage profit from borrowing in one currency and investing in another.
Forward = Spot x Rate ratio
Rate ratio = 1+if / 1+id
Explain covered interest rate parity
📌 Concept:
A no-arbitrage condition where the forward exchange rate is set in such a way that prevents arbitrage opportunities between domestic and foreign interest rates.
📌 Key Implication:
Ensures that investors earn the same return whether they invest in domestic or foreign assets when fully hedged.
If CIRP holds, arbitrage is not possible.
.
Given the spot exchange rate and the domestic and foreign yields, the forward exchange rate must equal the rate that gives these two alternative investment strategies—invest either in a domestic money market instrument or in a fully currency-hedged foreign money market instrument—exactly the same holding period return.
If one strategy gave a higher holding period return than the other, then an investor could short-sell the lower-yielding approach and invest the proceeds in the higher-yielding approach, earning riskless arbitrage profits in the process.
Explain forward rate parity
Forward exchange rates will be an unbiased predictor of the future spot exchange rate.
In other words, the forward rate is an unbiased predictor of where the spot rate will be in the future — assuming no arbitrage, efficient markets, and rational expectations
International Fisher Relation
Taking the Fisher Relation and Real Interest Rate Parity together gives us the International Fisher Effect.
This tells us that the difference between two countries’ nominal interest rates should be equal to the difference between their expected inflation rates.
Real interest rates are assumed to be equal across countries in the long run (under perfect capital mobility and no arbitrage).
