International parity condition
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International parity condition

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  • Equilibrium condition-

International parity condition International parity condition Presentation Transcript

  • Maica Jimena Batiancela BSBA Financial Management Saint Louise de Marillac College of Sorsogon
  • DEFINITION The parity conditions are equilibrium conditions that establish linkage between financial prices in the absence of arbitrage.
  • IMPLICATION ☺Provide guidelines for financial strategic decisions suggested by each side of parity condition. ☺The parity conditions define international financial break-even points encompassing alternative strategies yielding identical financial outcomes suggested by each side of parity condition.
  • ☺ From private investors point of view, parity conditions help to make optimal (beneficial) financial decisions regarding the choice of currency for borrowing , location of plants in different countries, measuring currency risk exposure.
  • ☺From public policy makers point of view, parity conditions help to evaluate the strength of national currencies, the efficiency of national capital markets , and the effectiveness of fiscal and monetary policies towards achieving macroeconomic policies
  • • Arbitrage can be loosely defined as capitalizing on a discrepancy in quoted prices to make a riskless profit. • The effect of arbitrage on demand and supply is to cause prices to realign, such that no further risk-free profits can be made.
  • • As applied to foreign exchange and international money markets, arbitrage takes three common forms: –locational arbitrage –triangular arbitrage –covered interest arbitrage
  • LOCATIONAL ARBITRAGE • Locational arbitrage is possible when a bank’s buying price (bid price) is higher than another bank’s selling price (ask price) for the same currency. • Example Bank C Bid Ask Bank D Bid Ask NZ$ $.635 $.640 NZ$ $.645 $.650 • Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645. Profit = $.005/NZ$.
  • TRIANGULAR ARBITRAGE • Triangular arbitrage is possible when a cross exchange rate quote differs from the rate calculated from spot rate quotes. • Example Bid Ask British pound (£) $1.60 $1.61 Malaysian ringgit (MYR) $.200 $.202 British pound (£) MYR8.10 MYR8.20 • MYR8.10/£ X $.200/MYR = $1.62/£ • Buy £ @ $1.61, convert @ MYR8.10/£, then sell MYR @ $.200. Profit = $.01/£.
  • COVERED INTEREST ARBITRAGE • Covered interest arbitrage is the process of capitalizing on the interest rate differential between two countries while covering for exchange rate risk. • Covered interest arbitrage tends to force a relationship between forward rate premiums and interest rate differentials.
  • • Example £ spot rate = 90-day forward rate = $1.60 U.S. 90-day interest rate = 2% U.K. 90-day interest rate = 4% Borrow $ at 3%, or use existing funds which are earning interest at 2%. Convert $ to £ at $1.60/£ and engage in a 90-day forward contract to sell £ at $1.60/£. Lend £ at 4%. Note: Profits are not achieved instantaneously.
  • DEFINITION ☺Are standardized contracts, with fixed, standardized contract sizes and fixed expiration dates, that are exchange- traded, i.e., traded as securities on organized exchanges. ☺Futures contracts have secondary markets, can be traded many times during life of contract, like a bond (vs. bank loan).
  • PARTICIPANTS IN FUTURES 1. Speculators Pure speculative bet/investment using futures contracts, with no business interest in the underlying commodity/currency
  • 2. Hedgers Someone with a business/personal interest in the underlying currency, and is using futures trading to minimize, eliminate or control currency risk, e.g., MNCs, banks, exporters, importer s, etc.
  • DEFINITION ☺A contract that grants the holder the right, but not the obligation, to buy or sell currency at a specified exchange rate during a specified period of time. ☺For this right, a premium is paid to the broker, which will vary depending on the number of contracts purchased. ☺Currency options are one of the best ways for corporations or individuals to hedge against adverse movements in exchange rates.
  • ☺Investors can hedge against foreign currency risk by purchasing a currency option put or call. ☺For example, assume that an investor believes that the USD/EUR rate is going to increase from 0.80 to 0.90 (meaning that it will become more expensive for a European investor to buy U.S dollars). In this case, the investor would want to buy a call option on USD/EUR so that he or she could stand to gain from an increase in the exchange rate (or the USD rise).
  • Parity Conditions Resulting Arbitrage Activities: 1. Purchasing Power Parity (PPP) 2. The Fisher Effect (FE) 3. The International Fisher Effect (IFE) 4. Interest Rate Parity (IRP)
  • PURCHASING POWER PARITY (PPP) • states that spot exchange rates between currencies will change to the differential in inflation rates between countries. • Can be: – Absolute Purchasing Power Parity – Relative Purchasing Power Parity
  • ABSOLUTE PURCHASING POWER PARITY • Price levels adjusted for exchange rates should be equal between countries • One unit of currency has same purchasing power globally.
  • RELATIVE PURCHASING POWER PARITY • states that the exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries.
  • In mathematical terms: where et = future spot rate e0 = spot rate ih = home inflation if = foreign inflation t = the time period t f t ht i i e e 1 1 0
  • • If purchasing power parity is expected to hold, then the best prediction for the one-period spot rate should be: t f t h t i i ee 1 1 0
  • THE FISHER EFFECT • states that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations. R = a + I • According to the Fisher Effect , countries with higher inflation rates have higher interest rates.
  • THE INTERNATIONAL FISHER EFFECT (IFE) • the spot rate adjusts to the interest rate differential between two countries. • IFE = PPP + FE • t f t ht r r e e )1( )1( 0
  • Simplified IFE equation: (if rf is relatively small) rh - rf = e1 - e0 e0
  • Interest Rate Parity (IRP) • As a result of market forces, the forward rate differs from the spot rate by an amount that sufficiently offsets the interest rate differential between two currencies. • Then, covered interest arbitrage is no longer feasible, and the equilibrium state achieved is referred to as interest rate parity (IRP).
  • • When IRP exists, the rate of return achieved from covered interest arbitrage should equal the rate of return available in the home country. • End-value of a $1 investment in covered interest arbitrage = (1/S) x (1+iF) x F = (1/S) x (1+iF) x [S x (1+p)] = (1+iF) x (1+p) • where p is the forward premium.
  • • End-value of a $1 investment in the home country = 1 + iH • Equating the two and rearranging terms: p = (1+iH) – 1 (1+iF) i.e. forward = (1 + home interest rate) – 1 premium (1 + foreign interest rate)