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    Cfi 1101-Lecture 13

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    Cfi 1101-Lecture 13

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    mpofumunyaradzi6
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    CFI_1101-LECTURE_13 - Copy

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    2 views14 pages

    Cfi 1101-Lecture 13

    Uploaded by

    mpofumunyaradzi6

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 14

    CHAPTER NINE

    EXCHANGE RATE PARITY


    CONDITIONS
    SESSION TWO
    What are Exchange Rate Parity Conditions?
    Equilibrium relations between exchange rates
    (spot, forward, and expected future spot rates)
    and economic fundamentals such as interest
    rates and inflation rates.
    Used in forecasting exchange rates and
    identifying arbitrage opportunities in the FX
    market.
    Assume freely floating exchange rates and free
    flow of trade and capital.
    Also simplify by assuming no transaction costs
    Absolute Purchasing Power Parity
    Based on law of one price
    Holds that the equilibrium exchange rate is one
    that equalizes the internal and external
    purchasing power of a currency
    Assumes all goods are tradable
    Based on goods market arbitrage
    Affected by non-tradable goods and costs
    Replaced by Relative Purchasing Power Parity
    Relative Purchasing Power Parity (RPPP)
    Holds that the exchange rate changes to reflect
    changes in the internal purchasing power of
    currencies, so as to keep the external purchasing
    power of currencies constant
    Based on inflation differentials as opposed to
    price indexes
    Imply that changes in inflation rates do not affect
    the international competitiveness of a country’s
    exports
    The exchange rate adjusts to fully offset the
    effect of inflation
    Countries with relatively higher expected
    Relative Purchasing Power Parity

    Relative Purchasing Power Parity

    Evidence on the RPPP
    Research shows that the RPPP holds in the long-run

    RPPP holds better for countries that are


    geographically proximal to each other and have
    trade ties

    RPPP does not hold for countries with significant


    trade restrictions

    RPPP holds better for countries with less developed


    financial markets
    Interest Rate Parity

    Interest Rate Parity
    Covered Interest Arbitrage
    Example 11.3
    Assume that the quoted 3-months forward
    ZAR/USD rate is 10.5245 instead. How will an
    arbitrager exploit the misalignment in FX market?
    Solution
    Since the quoted rate < the IRP rate, the discount
    on the ZAR falls short of the required discount.
    Funds should flow to South Africa.
    Covered Interest Arbitrage
    Now:
    Step 1- Borrow USD at 4.8% p.a. for 3 months
    Step 2- Convert to ZAR at spot rate of 10.5000
    Step 3- Invest in South Africa at 6.6% p.a. for 3 months
    Step 4- Simultaneously sell ZAR forward @ 10.5245

    3 months later:
    Step1- Liquidate ZAR investment
    Step2- Deliver ZAR @10.5245
    Step3-Repay USD loan with Interest
    Step 4-Pocket the difference
    Covered Interest Arbitrage
    Based on USD1 million:
    Now:
    Step 1- Borrow USD at 4.8% p.a. for 3 months (+USD1000000)
    Step 2- Convert to ZAR at spot rate of 10.5000 (-
    USD1000000+ZAR10500000)
    Step 3- Invest in South Africa at 6.6% p.a. for 3 months (-
    ZAR10500000)
    Step 4- Simultaneously sell ZAR forward @ 10.5245

    3 months later:
    Step1- Liquidate ZAR investment (+ZAR10673250)
    Step2- Deliver ZAR @10.5245 (- ZAR10673250 + USD
    1014133.69)
    Step3-Repay USD loan with Interest (-USD1012000)
    Step 4-Pocket the difference (+USD2133.69)
    International Fisher Effect (IFE)
    Holds that spot exchange rates adjust to equalize
    real interest rates across countries
    May be taken as a combination of the RPPP and
    the Generalized Fisher Effect
    Alternatively, it is a combination of the IRP and
    the Rational Expectations Hypothesis.
    Based on uncovered interest arbitrage
    International Fisher Effect (IFE)

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