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AG313 > International parity relationships > Flashcards

International parity relationships Flashcards

1
Q

What is covered interest arbitrage

A

This is the process of capitalizing on the interest rate differential between 2 countries, while covering for exchange rate risk (Spot and Forward is fixed today)

Interest arbitrage - process of capitalizing on interest rate difference

Covered - uses a forward contract to cover the transaction in future

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2
Q

What is the impact of covered interest arbitrage

A

-An efficient market does not allow profit to be made without taking risk
-The normal assumption is that the forward rate will adjust to other variables (Spot rate, UK interest and EU interest rate)
-In practice, future expectation drives all 4 variables at

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3
Q

What 2 investment options do you have with this if you have £10k to invest

A

1) Deposit your money in a UK bank for a year
2)Convert your money to euros today and deposit them at the eurozone rate for one year, and convert back into pounds

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4
Q

Is it better to do option 1 or 2 ??

A
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5
Q

What is the interest rate parity ??

A

Is a “no arbitrage” condition which suggests that forward exchange rates are defined by todays spot exchange rates grossed up and down by the future value interest factors

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6
Q

What does the interest rate parity result in ?

A

A country with a higher interest rate will NOT offer a higher return to the foreign investor because the forward rate offsets the gain in interest rates

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7
Q

Why does the the market reach the equilibrium state ??

A

Market forces will cause the interest rates to adjust such that covered interest arbitrage is no longer feasible, this is the IRP

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8
Q

What is the no arbitrage condition within IRP

A

Where option 1 is equal to option 2

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9
Q

What is the generic equation for the forward rate ?

A
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10
Q

How to you derivate from forward rate to get the equation for the forward premium ??

A
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11
Q

What is the forward premium denoted by ??

A

Denoted by p

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12
Q

How does the forward premium relate to forward and spot rates ?

A

The forward rate is = to the spot rate multiplied by 1 + the forward premium

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13
Q

What can we approximate about the forward premium if both foreign and home interest rates are low ??

A

That the forward premium is approx the home interest - foreign interest

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14
Q

Now looking at the example from before what return are we given for option 1 and 2

A
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15
Q

What does LOOP state about identical goods or financial assets ??

A

That identical goods or financial assets with identical risks traded in 2 different markets must have the same price in both markets

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16
Q

What are the 2 kinds of purchasing power parity (PPP)

A

1) Absolute PPP
2) Relative PPP

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17
Q

What is absolute PPP ?

A

Extends the law of one price (LOOP) to bundles of identical goods
-In the absence of barriers to trade and transportation

Implication: Prices of the same basket of products in two different countries should be equal when measure in a common currency, the problem is finding identical goods

Solution: The big Mac index

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18
Q

What is relative PPP ?

A

Accepts deviations from absolute PPP, focuses on changes in exchange rates and prices (inflation)

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19
Q

How can absolute PPP be expressed ?

A
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20
Q

Based of this, what is the equation for the spot rate ?

A
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21
Q

What does this mean

A

-A bundle of products costs £100 in the UK
-The same bundle costs 900YEN in china
-Then the PPP spot exchange should be £0.1111/YEN

22
Q

What happens if the good is cheaper in china than in the UK ?

A

-UK consumers will now import that good from China, meaning the demand will shift from the UK to china

23
Q

What does higher demand in China relative to in the UK means what ?

A

Prices in China must increase for UK consumers until the discrepency disappears and the following relationship holds again

24
Q

you are given this, for absolute PPP to hold what does the spot FX rate need to be ??

A
25
Q

If this is the spot rate for absolute PPP to hold, but you observe a spot FX rate of £0.6579/$ than what needs to be done for absolute PPP to hold again

A
26
Q

Provide the 3 main points about PPP

A

-It implies exchange rates will adjust to equalize the purchasing powers of same bundle of products
-The key is that the differences in prices across countries should be reflected in the relative price of the currencies i.e. the exchange rate
-If it is not reflected than there is arbitrage opportunity, i.e. you can buy cheap and sell high

27
Q

What does relative PPP account for that absolute does not ??

A

It accounts for market imperfections such as transportation costs, tariffs and quotas

-This is why the spot FX may not satisfy the absolute PPP

28
Q

What happens to the price of the iphone in the UK

A

-The price of Iphone in the UK now increases £1050 and not £1000 so the absolute PPP is violated

29
Q

What does relative PPP state about the difference in prices in percentage terms ??

A

That they should be constant
- If iPhone is %5 more expensive in UK than in US today
-Than in 1 years time the iPhone should still be 5% more expensive in the UK than US

30
Q

Whats the difference between todays price and 1 year time ???

A

INFLATION

31
Q

What does relative PPP say about movements in the exchange rate

A

That it moves in such a way that it compensates the inflation differentials in the 2 countries, and such that price differentials are kept constant

32
Q

What will the expected price indexes be ??

A
33
Q

What happens if Ih > If and the FX rate does not change ??

A

For a home country’s customers, the purchasing power will be greater when buying foreign goods (Higher external purchasing power) than home goods (Foreign goods are cheaper)

34
Q

What happens if Ih < If and the FX rate does not change ??

A

For home country’s customers, the purchasing power will be greater when buying home goods (Higher internal purchasing power) than foreign goods (Home goods are cheaper)

35
Q

What does the PPP suggest about exchange rate ??

A

That the exchange rate will adjust in such a way that maintains the parity (equality) in purchasing power

36
Q

What does ef denote in the foreign price index ??

A

Let it denote the percentage change in the value of foreign currency for the consumers in home country

37
Q

What does the foreign price index become from the home consumers perspective if inflation occurs and the exchange rate of the foreign currency changes ??

A
38
Q

What is the formula for relative PPP

A

We assume that Ph = Pf

39
Q

What is the formula for the change in the value of currency ??

A
40
Q

What happens if Ih > If

A
41
Q

When would foreign currency appreciate ?

A

If home countries inflation is grater than foreign countries inflation and vice versa

42
Q
A
43
Q

What is real change in income ??

A
44
Q

What is the International Fisher Effect ??

A

According to Fisher, the nominal or monetary interest rate is approximately equal to real interest rate and inflation

45
Q

If real return is constant, than the differences in expected nominal interest rates should be equal to differences in expected inflation, what is this called ??

A

This is the International Fisher Effect

46
Q

What does the IFE link international differences in nominal interest rates to ??

A

Links to changes in the direct spot exchange rate

47
Q

IFE example

A
48
Q

IRP based on arbitrage, what is the forward premium rate

A
49
Q

What is the absolute form of PPP

A
49
Q

What is the relative form of PPP

A
49
Q

What is the equation for IFE

A
50
Q
A

AG313 (12 decks)

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