PPP n IRP

Fundamental Equilibrium Relationships : 

Fundamental Equilibrium Relationships

Topics covered : 

Topics covered Purchasing Power Parity (PPP) Interest Rate Parity (IRP) Fisher Open Theorem (FOT) International Fisher Effect (IFE)

Purchasing power parity : 

Purchasing power parity Gustav Cassel (Swedish Economist) What is purchasing power? The idea of PPP The law of one price Absolute PPP Relative PPP

Purchasing power : 

Purchasing power Purchasing power of a currency is determined by the amount of goods and services that can be purchased with one unit of currency.

Idea of PPP : 

Idea of PPP PPP states that if arbitrage across national borders is unhindered, the price of a good or service in one nation should be the same as the exchange rate adjusted price of the same good or service in another nation.

Law of one price : 

Law of one price Identical goods should trade at the same relative prices regardless of where they are sold. Assumption : consumers in all countries have the same consumption basket and that all goods are equally tradable.

Criticism : 

Criticism Transportation costs Tax provisions in different countries Government intervention Speculation in exchange market Discrepancy in rate of inflation and price level indices When a currency is used as an instrument for international payments

Absolute PPP : 

Absolute PPP Absolute PPP states that the domestic price level should equal the foreign price level times the spot exchange rate. P = EP* P = price of a G/S in domestic country E = Exchange rate P* = Price of G/S in foreign country

Relative PPP : 

Relative PPP Relative PPP states that the change in an exchange rate is equal to the difference in the inflation rates between two economies. % change in ER = Inflation rate differential Et = (1+Ih)t Eo (1+If)t Et: Forward rate, Eo: Spot rate Ih: Inflation rate of home country Ih: Inflation rate of foreign country t: time period

Exercises : 

Exercises Prb 1: calculate the expected spot rate in 2 years. US Inflation rate 5% Indian inflation rate 12% Spot rate (Eo) Rs.43.0060/$

Slide 11: 

Prb 2: US inflation rate 4% Indian inflation rate 12% Spot rate $/Rs 0.0285 Calculate expected spot rate on 2 years.

Slide 12: 

Prb 3 : Calculate 1 year forward rate Spot rate Rs./Lira 10.00 Inflation rate India : 10% Italy :1%

Slide 13: 

Prb 4: Inflation rate India : 7% Europe: 5% Spot rate 1 euro = Rs. 52.30 What should be the value of the euro in one year?

Interest Rate Parity : 

Interest Rate Parity Relationship between the interest rates and exchange rates of 2 countries. Uncovered interest rate parity Covered interest rate parity

Uncovered Interest Rate Parity : 

Uncovered Interest Rate Parity Results when the expectation of future spot rate does not match with the forward rate. Relates interest differentials of 2 countries to the expected change in the spot exchange rate between those countries.

Covered Interest Parity : 

Covered Interest Parity Relates the difference between the interest rate domestically and abroad to the forward premium or discount. Country with lower interest rate is at forward premium in terms of the currency of the country with higher rate.

Covered interest arbitrage : 

Covered interest arbitrage No arbitrage condition: 1+Rh = F1 1+Rf Eo Rh: Interest rate in home country Rf: Interest rate in foreign country F1: Forward Rate Eo: spot rate

Arbitrage : 

Arbitrage Funds flow from HC (home country) to FC (foreign country) if: 1+Rh < (1+Rf)F1 Eo Funds flow from FC to HC if: 1+Rh > (1+Rf)F1 Eo

Exercises : 

Exercises Prb 1: Spot rate FFr 5.0150/$ Interest rate: France 8.5% US 7% Find one year forward.

Slide 20: 

Prb 2 Spot rate Yen 110/$ Interest rate : Tokyo 3% New York 4.5% Find one year forward.

Slide 21: 

Prb 3 : Calculate 90 day forward rate Interest rate US 10% Switzerland 4% Spot rate 1 SFr = $0.3864

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Prb 4 Spot rate Rs. 45.0020/$ Interest rate India :12% US 7% Calculate 6 months forward rate.

Slide 23: 

Prb 5: Given Can$ 1.317/$ - spot rate Can$ 1.2950/$ - 6 months forward rate Interest rate: US 10% Canada 6% Is arbitrage possible? If so calculate the arbitrage gain.

Slide 24: 

Prb 6: Given Spot rate : $0.60/DM 1 year forward rate : $0.63/DM Interest rate Germany 6.5% US 8.5% Calculate the arbitrage gain.