irp ppp ife

34
Interest rate parity is a relation between Interest Rate differential and Forward Rate discount and premium Interest Rate Parity

Upload: anand-verma

Post on 09-Aug-2015

39 views

Category:

Business


1 download

TRANSCRIPT

Interest rate parity is a relation between Interest Rate differential and Forward Rate discount and premium

Interest Rate Parity

Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries.

A theory in which the interest rate differential between two countries is equal to the differential between the forward

exchange rate and the spot exchange rate. Interest rate parity plays an essential role in foreign exchange markets,

connecting interest rates, spot exchange rates and foreign exchange rates.

Covered Interest Arbitrage

A strategy in which an investor uses a forward contract to hedge against exchange rate risk. Covered interest rate arbitrage is the practice of using favorable interest rate differentials to invest in a higher-yielding currency, and hedging the exchange risk through a forward currency contract.

Covered interest arbitrage is only possible if the cost of hedging the exchange risk is less than the additional return generated by investing in a higher-yielding currency. 

Such arbitrage opportunities are uncommon, since market participants will rush in to exploit an arbitrage opportunity if one exists, and the resultant demand will quickly redress the imbalance.

An investor undertaking this strategy is making simultaneous spot and forward market transactions, with an overall goal of obtaining riskless profit through the combination of currency pairs.

Covered interest arbitrage is not without its risks, which include differing tax treatment in various jurisdictions, foreign exchange or capital controls, transaction costs and bid-ask spreads.

A savvy investor could therefore exploit this arbitrage opportunity as follows -

Borrow 500,000 of currency X @ 2% per annum, which means that the total loan repayment obligation after a year would be 510,000 X.

Convert the 500,000 X into Y (because it offers a higher one-year interest rate) at the spot rate of 1.00.

Lock in the 4% rate on the deposit amount of 500,000 Y, and simultaneously enter into a forward contract that converts the full maturity amount of the deposit (which works out to

520,000 Y) into currency X at the one-year forward rate of X = 1.0125 Y.

After one year, settle the forward contract at the contracted rate of 1.0125, which would give the

investor 513,580 X.

Repay the loan amount of 510,000 X and pocket the difference of 3,580 X.

As with the other forms of arbitrage, market forces resulting from covered arbitrage will cause a market realignment. As many investors capitalize on covered interest arbitrage, there is upward pressure on the spot rate and downward pressure on the forward rate. Once the forward rate has a discount from the spot rate that is about equal to the interest rate advantage, covered interest arbitrage will no longer be feasible.

Realignment due to Covered Interest Arbitrage

Once market forces cause interest rates and exchange rates to adjust such that covered

interest arbitrage is no longer feasible, there is an equilibrium state referred to as

Interest Rate Parity (IRP)

Graphical Analysis Of IRP

Zone of potential Covered Interest Arbitrage by Home

Country Investors

Zone of potential Covered Interest Arbitrage by Foreign

Investors

IRP Line

Interest Rate Differential

Forward Premium

Forward Discount

X

Y

1

2

3

-1

-2

-3

1 2 3 4 5

-4

-1-2-3-4-5

D

C

A

B

Y

Z

Purchasing Power Parity

Purchasing Power Parity is a relation between Inflation and Exchange Rates.

The PPP principle, which was popularized by Gustav Cassell in the 1920s, is most easily explained if we begin by considering the connection between exchange rates and the local currency price of an individual commodity in different countries.

This connection between exchange rates and commodity prices is known as the Law of One Price.

The law of One Price states that in the absence of friction such as differential shipping costs and tariffs, the price of a product when converted into a common currency such as US dollar, using the spot exchange rate, is the same in every country.

The law of one price exists due to arbitrage opportunities. If the price of a security, commodity or asset is different in two different markets, then an arbitrageur will purchase the asset in the cheaper market and sell it where prices are higher.

Law of One Price

Although it may seem as if PPPs and the law of one price are the same, there is a difference, the law of one price applies to individual commodities whereas PPP applies to the general price level.

If the law of one price is true for all commodities then PPP is also therefore true; however, when discussing the validity of PPP, some argue that the law of one price does not need to be true exactly for PPP to be valid.

If the law of one price is not true for a certain commodity, the price levels will not differ enough from the level predicted by PPP

The absolute form of PPP is based on a notion that without international barriers, consumers shift their demand to wherever prices are lower. It suggests that prices of the same basket of products in two different countries should be equal when measured in a common currency. If a discrepancy in prices as measured by a common currency exists, the demand should shift so that these prices converge.

Absolute PPP

However, it is difficult to test the validity of PPP in its absolute form, because different baskets of goods are used in different countries for computing prices indexes. Different baskets are used because of taste and needs differ between countries, affecting what people buy.

For example, people in cold, northern countries consume more heating oil and less olive oil than people in more temperate countries. This means that even if the law of one price holds for each individual good, price indexes, which depend on the weights attached to each good will not conform to the law of one price.

For example, if heating oil prices increased more than olive oil prices, the country with a bigger weight in tis price index for heating oil would have a larger price index increase than the olive oil consuming countries. Even though heating oil and olive oil prices increased the same amount in both countries.

Partly for this reason an alternative form of PPP condition which is stated in terms of rates of inflation can be useful. This form is called the Relative form of PPP.

The relative form of PPP accounts for the possibility of market imperfections such as transportation costs, tariffs, and quotas.

This version acknowledges that because of these market imperfections, prices of the same basket of products in different countries will not necessarily be the same when measured in a common currency.

It does state, however, that the rate of change in the prices in the prices of the baskets should be somewhat similar when measured in a common currency, as long as the transportation costs and trade barriers are unchanged.

Relative PPP

For Example, Assume the US and UK trade extensively with each other and initially have zero inflation. Now assume that the US experiences a 9% inflation rate, while the UK experiences a 5% inflation rate.

Under these conditions, PPP theory suggests that the British pound should appreciate by approximately 4%, the differential in inflation rates. Thus, the exchange rate should adjust to offset the differential in the inflation rates of the two countries.

If this occurs, the prices of the goods in the two countries should appear similar to consumers. That is, the relative purchasing power when buying products in one country is similar to when buying products in the other country.

Derivation of PPP

Price Indexes at home country (h)

Inflation rate in home country Ih

Inflation rate in foreign country If

Price Indexes in foreign country (f)

Ph (1+Ih)

Due to inflation, the price index of goods in the consumer’s home country becomes

The price index of foreign country will also change due to inflation in that country

Pf (1+If)

The consumer’s purchasing power is greater on foreign

goods than on home goods. In this case PPP does not exist.

The Ex. Rate between the

currencies of the two countries

does not change

If Ih > If

The consumer’s purchasing power is

greater on home goods than on

foreign goods. In this case PPP does not

exist.

The Ex. Rate between the

currencies of the two countries

does not change

If Ih < If

The PPP theory suggests that the exchange rate will not remain constant but will adjust to maintain the parity in purchasing power. If inflation occurs and the exchange rate of the foreign currency changes, the foreign price index from the home consumer’s perspective becomes

ph (1+Ih ) (1+ef)ef

represents the %

change in the value of the foreign currency

Pf(1+If)(1+ef) =Ph(1+Ih)

1+ef = Ph (1+Ih) Pf (1+If)

ef = Ph (1+Ih) -1 Pf (1+If)

Since Ph equals Pf ( because prices indexes were initially assumed equal in both countries), they

cancel, leaving

ef = 1+Ih -1 1+If

If Ih > Ifef

Foreign Currenc

y

If Ih < If-ef

Foreign Currenc

y

International Fisher Effect is a relation between Interest Rate Differential and Expected Exchange Rate

International Fisher Effect

International fisher effect uses Interest Rate rather than inflation rate differentials to explain why exchange rates change over time but it is closely related to PPP theory because interest rates are often highly correlated with inflation rates. According to IFE, nominal risk-free interest rates contain a real rate of return and anticipated inflation. If investments of all countries require the same real return, interest rate differential between countries may be the result of differentials in expected inflation.

The International Fisher Effect (IFE) is an exchange-rate model designed by the economist Irving Fisher in the 1930s. It is based on present and future risk-free nominal interest rates rather than pure inflation, and it is used to predict and understand present and future spot currency price movements.

Anand VermaRohit KumarMahesh GuptaMadan MaviSagar Parmar