International Parity Conditions

International Finance and Investment Topic 4 Ali Emami Department of Finance Lundquist College of Business University of Oregon
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International Parity Conditions

Definition: The parity conditions are equilibrium conditions that establish linkage between financial prices (P, i, S, F) in the absence of arbitrage. Implications: 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 (RHS and LHS) of parity condition.
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ImplicationsContinued
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, etc. 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.

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Implications..Continued
The empirical evidence and tests on validity (invalidity) of parity conditions provide useful signals regarding the opportunity for making profits for private enterprise. When parity conditions hold, it implies that its almost impossible to make profit from arbitrage in goods, services, capital, etc. When parity conditions do not hold, it often implies the possibility of making profits doing arbitrage in goods, capital, etc.
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Parity Conditions in Perfect Capital Markets

Perfect Capital Markets Assumptions:
 No transaction costs (price differentials only provokes arbitrage)  No taxes, tariff or trade barriers  Complete certainty (no risk)

Given these assumption, profit-maximizing enterprise will act to capitalize on arbitrage opportunities in trade of goods and services between countries, between spot and forward exchange rates, and between real and financial assets to the extent that eliminates any further arbitrage activity.
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Purchasing Power Parity (PPP) Doctrine

Purchasing power party doctrine was introduced by the Swedish economist Gustav Cassel in 1918 (Gustav Cassel, Abnormal Deviations in International Exchanges, Economic Journal, December 1918, pp.413-415). He proposed the PPP doctrine after WWI as a new method for measuring exchange rates among countries.
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PPP Definition
Definition: Purchasing power parity focuses on the parity condition at a specific time that links the price of a specific product in a country in terms of its currency (P$) to: a) the price of the same product in another country denominated in its currency (P ), and b) the spot exchange rate between the two currencies (S($/)) . $ P$ ! S v P (1)
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Types of PPP
The PPP doctrine has two forms:

a) The absolute PPP (APPP) and, a) the relative PPP (RPPP).

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Absolute PPP (APPP)

The APPP relies on perfect capital market (PCM) assumptions and the Law of One Price (LOOP). The Law of One Price states that under PCM assumptions, there are no opportunities for arbitrage based on the prices of a similar (homogenous) good in two countries. Hence, prices of the same good in two trading partner countries will become identical (after adjustments in the exchange rate). Thus, $ P$ ! S P (1) University of Oregon, Ali Emami 9

APPP Continued
APPP and Exchange Rate Substituting general price levels (a weighted price for all products) for each country in equation (1), yields a measurement for exchange rate between Dollar and Euro currencies:
$ St
$,t

P,t

(2)
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APPP & Exchange rate: Example

Exchange Rate Gold Standard (18761913): One ounce of gold in the United States was priced at $20.67 while in U.K., one ounce of gold was priced at 4.247. According to APPP, what would be the S($/)?
$ P$ $20.67 $4.86695 S ! ! ! P 4.247
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The Big Mac Index

Definition: The APPP measure of the true equilibrium value of a currency based on one product, a MacDonalds Big Mac.

Big Mac APPP

P P

Big Mac FC Big Mac $

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The Big Mac Index: Example

Country United States Brazil China Germany Japan Mexico Switzerland Big Mac Prices (Local Currency) 2.51 2.95 9.90 4.99 294 20.9 5.90 Implied PPP 1.18 3.94 1.99 117 8.33 2.35 Actual Spot Rate, 4/25/00 1.79 8.28 2.11 106 9.41 1.70 Overvaluation(+) Or Undervaluation(-) Of local currency - 34% - 52 -6 +10 - 11 + 38

Source: Big Mac Currencies The Economist, April 12, 1977, p. 71; Big Mac Currencies, The Economist, April 29, 2000, p. 75.

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Relative Purchasing Power Parity (RPPP) Doctrine

Relative purchasing power parity (RPPP) is concerned with the changes in spot rate over time. That is RPPP estimates percentage changes in the exchange rates over a given time period. Rewriting equation (2) for time period P (t+1) yields: S $ ! P (3) Dividing (3) by (2) gives the dynamics behavior of exchange rate:
t 1 $,t 1 ,t+1

& & P$  P & S! & 1+ P

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Implications of RPPP

& & P$  P & & & & S $ ! S  $ ! P$  P & 1  P

& $ $ 1  P$,1 St ! S 0 & 1  P,1

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Example: Consider the following information on U.S. and Japanese CPIs. What was the PPP implied exchange rate between the and the $ in 1989? Was the overvalued or under valued against the $? By how much?

Year 1973 1989

CPI (U.S.) 40.3 117.2

CPI (Japan) 44.0 104.6

Exchange Rate $0.003762/ $0.006971

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Answer: Dividing equation (3) by equation (2) yields:

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Example: Assume that inflation rate in U.S. and euro region are expected to be 6% and 4% respectively each year for the next four years, and the current spot rate is $1.2812 per euro. Calculate the PPP rate for euro in four years.

Answer:

10.06 $1.285454 $1.2812 S2008 ! ! 10.04

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Example: Suppose the base period is year 1990. Assume that currently (in 2004), the U.S. CPI is 102 and the United Kingdoms CPI is at 115 relative to 1990 base period. The exchange rate was $1.5 in 1990. Calculate the PPP exchange rate in 2004.

Answer:

102 $1.330435 $ S2004 ! $1.5v ! 115

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Example: Given the following information, if PPP hold over 1979-1998, what would have been the S(DM/$) rate in 1998?

S(DM/$) 1979 1998 DM2.4/$ DM2.50/$

CPIDM 92.0 120.5

CPI$ 79.2 145.3

Answer:
CPI 98, DM
DM S PPP,98 $ N CPI 79, DM ! S79 CPI 98,$ CPI 79,$

120.5 ! DM 2.4 92 145.3 79.2

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Real Purchasing Power Parity Exchange Rates

The Real Bilateral Exchange Rate Based on Absolute PPP

S RPPP,t
The Real Exchange Rate Based on Relative Purchasing Power Parity

$ !

market ( N ) $ St

CPI$ CPI

$ R S RPPP ,t  n !

Stmarket ( N ) n CPI $,t  n CPI $,t market ( N ) St CPI ,t  n CPI ,t

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Real Exchange Rate Based on the Market Exchange Rate

Formula:
FC S $ FC ! Streal PFC $ P$
nominal t

real t

P$ FC nominal FC ! St v $ $ PFC

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Interest Rate Parity (IRP) Theory and the Fisher Parities

Interest rate parity focuses on the parity condition that links the spot and forward (expected) exchange rates with international money and bond markets. The parity condition implied by this theory establishes the break-even condition where the return on a domestic currency investment is identical with the return on a foreign currency investment covered against exchange rate risk
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CIRP Relations
Invest $1 at Home at the rate of i$ and after one year get: $ 1 1  i$ Invest $1 in euro at the rate of i and after one year get:
$1 v 1  i v S0 $ $ 1 year 0 $
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CIRP Relations.continued
Where to invest (if you got the money)?
$1 $ v F01 year v 1  i $11  i$ S $ 0 $

If (LHS > RHS), then invest in $. If (LHS < RHS), then invest in Euro. If (LHS = RHS), then indifferent.
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CIRP Relations.continued
Where to borrow and invest (if you dont have money)?
$ 1 1  i $
$1 S0 $ v 1  i v
1 year 0

$ $

If (LHS > RHS), then borrow from euro and invest in $. If (LHS < RHS), then borrow from $ and invest in Euro. If (LHS = RHS), then indifferent.
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Variations of Covered and Uncovered IRP Formula

1 2 3 4
$ $ 1  i$ ! S 1  i
$ $ 1  i$ ES ! S 1  i
$ $ F  S ! $ S

i$

 i

1  i

$ $ F S i$  i ! $ 1  i S
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Uncovered IRP: Relationship Between PPP and IRP: Fishers interest-open economy condition

& & P$  P & S! & 1+ P

! 4 6 4 44F7 ES 4 4 8 $ $ & $ S t 1  S  S i$  i ! $ 1  i S

3 4

& $ ! i$  i S 1  i

& & P$  P i$  i ! & 1+ P 1  i

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Fishers interest-open economy condition 1

& & P  P ! i$  i $
i$ 14
&  P$ 2 4 3
i $r e a l

!  i4 1

&  P 2 4 3
i
real

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Market Forces and Covered Interest Parity

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