Real Interest Parity

12 Key excerpts on "Real Interest Parity"

• 

  eBook - ePub

  International Financial Transactions and Exchange Rates

  Trade, Investment, and Parities

  • I. Kallianiotis(Author)
  • 2013(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The IRP theory provides the link between the international money markets and the foreign exchange markets; it is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available for securities of similar risk and maturity in two countries because the exchange rate (forward discount or forward premium of the currencies) will equalize these two returns (interest rates). The fact that this condition does not always hold allows for potential opportunities to earn riskless profits from covered interest arbitrage. Two important assumptions for the theory of interest rate parity are: (1) capital mobility and (2) perfect substitutability of domestic and foreign assets. Given foreign exchange market equilibrium, the interest rate parity condition implies that the expected return on domestic assets will equal the exchange rate-adjusted expected return on foreign currency assets. Investors cannot then earn arbitrage profits by borrowing in a country with a lower interest rate, exchanging local currency for foreign currency, and investing in a foreign country with a higher interest rate, due to gains or losses from exchanging back to their domestic currency at maturity of the financial asset. In mathematical forms these conditions are:

  For example, the interest rate in the United States is

  it

  = 3.25% per annum, the interest rate in Canada is p.a., the spot exchange rate is

  St

  = 1.0264$/C$, the six-month forward exchange rate is

  Ft+6

  = 1.0277$/C$. We want to see if there is interest rate parity or an arbitrage opportunity between these two economies.

  The interest differential is: .

  The forward discount or premium is

  Comparing the above shows that IRP almost holds because interest differential is approximately equal to the forward discount of the US dollar. Exhibit 2.1 gives a numerical example of an investment of $1,000,000 in the above economies. The results show that IRP holds, so the investor is indifferent as to where to invest.

  The theory of IRP has been developed as follows: We have a MNC, which has the choice to invest in the US money market or in the the Eurozone money market depending on the returns in these two markets. The exchange rate risk can be eliminated by using the forward markets, a “covered investment strategy.” But the present sophistication of high international finance requires taking a hard look at the elements of international investing, due to the idiosyncrasies, unanticipated risks, waste (use) of resources, and complexities of our markets and instruments. If it were to invest in US Treasury bills, it would receive $R US

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  eBook - ePub

  Macroeconomics

  (With Study Guide CD-ROM)

  • Jagdish Handa(Author)
  • 2010(Publication Date)
  • WSPC

    (Publisher)

  The Interest Parity Theory implies that the interest rates should be identical between them. However, as the following graph shows, there is almost always a differential between them. The Canada T-bill rate was higher in Canada from the early 1970s to the mid-1990s; outside this period, the Canadian rate was sometimes higher and sometimes lower than in the USA. Therefore, the value of the interest rate premium/discount α is usually not zero, even for closely integrated economies, and also not constant over time. 3.5.6 The relative importance of PPP and IRP in determining exchange rates International capital flows are nowadays potentially much larger than the value of commodity flows for developed economies with open capital markets, so that anticipated changes in interest rates can set up massive capital flows. These flows — entering on either the demand or supply side of the foreign exchange market of a country — dominate over other flows and determine the exchange rate — unless the governments have fixed the exchange rate or try to manage it through offsetting sales or purchases of foreign exchange from their reserves. 15 Further, since capital is extremely mobile and very large amounts can be transferred among countries with well-developed financial markets at a few minutes’ notice, IRP determines exchange rate changes on a continuous basis in free exchange markets, while, as we have already argued, PPP holds at best in a long-run context. Hence, in well-developed financial markets, IRP provides the short-term determination of the exchange rates while PPP or its relative version at best only provides a long-term tendency, so that exchange rates determined through IRP can deviate from PPP for considerable periods. 3.6 The Balance of Payments The balance of payments can be defined or presented in an economic or accounting form

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  eBook - ePub

  International Money and Finance

  • Michael Melvin, Stefan C. Norrbin, Stefan Norrbin(Authors)
  • 2017(Publication Date)
  • Academic Press

    (Publisher)

  www.deposits.org , Sep. 2015.

  Exchange Rates, Interest Rates, and Inflation

  If we combine the Fisher Eq. (6.5) and the interest parity Eq. (6.3) , we can determine how interest rates, inflation, and exchange rates are all linked. First, consider the Fisher equation for the United States and the United Kingdom:

  i $

  =

  r $

  +

  π $ e

  for the United States ,

  and

  i £

  =

  r £

  +

  π £ e

  for the United States .

  Global investors now want to have as high as possible real returns from their investments. If global markets allow free flow of capital, one might expect that the real returns across countries equalize. If we assume that the real rate of interest is the same internationally, then r $ =r £ . In this case, the nominal interest rates, i $ and i £ , differ solely by expected inflation, so we can write

  i $

  −

  i £

  =

  π $ e

  −

  π £ e

  (6.6)

  (6.6)

  The interest parity condition of Eq. (6.3) indicates that the interest differential is also equal to the forward premium, or

  i $

  −

  i £

  =

  π $ e

  −

  π £ e

  = ( F − S )   /   E

  (6.7)

  (6.7)

  Eq. (6.7) summarizes the link among interest, inflation, and exchange rates.

  In the real world the interrelationships summarized by Eq. (6.7) are determined simultaneously, because interest rates, inflation expectations, and exchange rates are jointly affected by new events and information. For instance, suppose we begin from a situation of equilibrium, where interest parity holds. Suddenly there is a change in US policy that leads to expectations of a higher US inflation rate. The increase in expected inflation will cause dollar interest rates to rise. At the same time exchange rates will adjust to maintain interest parity. If the expected future spot rate is changed, we would expect F

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  eBook - ePub

  2022 CFA Program Curriculum Level II Box Set

  • (Author)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  The difference in expected inflation rates equals the expected change in the exchange rate. Combining these two expressions, we derive the following:

  The nominal interest rate spread is equal to the difference in expected inflation rates. We can therefore conclude that if uncovered interest rate parity and ex ante PPP hold,

  (rf − rd ) = 0.

  The real yield spread between the domestic and foreign countries (rf − rd ) will be zero, and the level of real interest rates in the domestic country will be identical to the level of real interest rates in the foreign country.

  The proposition that real interest rates will converge to the same level across different markets is known as the real interest rate parity condition.

  Finally, if real interest rates are equal across markets, then it also follows that the foreign–domestic nominal yield spread is determined solely by the foreign–domestic expected inflation differential:

  This is known as the international Fisher effect . The reader should be aware that some authors refer to uncovered interest rate parity as the “international Fisher effect.” We reserve this term for the relationship between nominal interest rate differentials and expected inflation differentials because the original (domestic) Fisher effect is a relationship between interest rates and expected inflation.

  The international Fisher effect and, by extension, real interest rate parity assume that currency risk is the same throughout the world. However, not all currencies carry the same risk. For example, an emerging country may have a high level of indebtedness, which could result in an elevated level of currency risk (i.e., likelihood of currency depreciation). In this case, because the emerging market currency has higher risk, subtracting the expected inflation rate from the nominal interest rate will result in a calculated real interest rate that is higher than in other countries. Economists typically separate the nominal interest rate into the real interest rate, an inflation premium, and a risk premium. The emerging country’s investors will require a risk premium for holding the currency, which will be reflected in nominal and real interest rates that are higher than would be expected under the international Fisher effect and real interest rate parity conditions.

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  eBook - PDF

  International Macroeconomics

  A Modern Approach

  • Stephanie Schmitt-Grohé, Martín Uribe, Michael Woodford(Authors)
  • 2022(Publication Date)
  • Princeton University Press

    (Publisher)

  PART II The Real Exchange Rate CHAPTER 9 The Real Exchange Rate and Purchasing Power Parity You might have noticed that sometimes Europe seems much cheaper than the United States and sometimes it is the other way around. In the first case, Ameri- cans have incentives to visit Europe and to import European goods and services. In the second case, more European tourists should visit America and the United States has an easier time exporting goods and services to Europe. The real exchange rate measures how expensive a foreign country is relative to the home country. It tracks the evolution over time of the price of a basket of goods abroad in terms of baskets of goods at home. When prices expressed in the same currency are equal- ized at home and abroad, the real exchange rate is unity. In this case, the purchasing power of the domestic currency is the same at home and abroad, in the sense that it can buy the same quantity of goods in both countries. When this happens, we say that purchasing power parity holds. An important empirical question in interna- tional macroeconomics is, how large and persistent are deviations from purchasing power parity? Equally important is the question, what factors determine deviations from purchasing power parity? This chapter is devoted to studying these and other related questions. 9.1 The Law of One Price When a good costs the same abroad and at home, we say that the law of one price (LOOP) holds. Let P denote the domestic currency price of a particular good in the domestic country, P ∗ the foreign currency price of the same good in the foreign country, and E the nominal exchange rate, defined as the domestic currency price of one unit of foreign currency. The LOOP holds if P = E P ∗ . The good is more expensive in the foreign economy if E P ∗ > P, and less expensive if E P ∗ < P. Why should the law of one price hold? Imagine that a can of Coke costs $2 in country A and $1 in country B.

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  eBook - PDF

  International Macroeconomics

  • Harms, Philipp(Authors)
  • 2016(Publication Date)
  • Mohr Siebeck

    (Publisher)

  In fact, the presentation in Section VII.4 has demonstrated that a variation in economic fundamentals – a change of market structure, preferences, or productivity – may result in a variation of relative prices which, in turn, gives rise to a movement of the real exchange rate. Such movements should not be interpreted as over- or undervaluations, but as the outcome of market equilibria. The formidable challenge faced by both research-ers and policymakers consists in empirically distinguishing (temporary) devia-tions from a long-run equilibrium value and variations of the equilibrium value itself. In this section, we will present some approaches that have been developed to meet this challenge. 30 When it comes to identifying deviations from the equilibrium real exchange rate, practical feasibility may be as important as conceptual accuracy. This is why, in the following subsection, we will return to the theory of purchasing power parity as the simplest possible theory of the equilibrium real exchange rate and discuss how it can be put to use. Subsection VII.6.3 will introduce an approach that explicitly accounts for the various exogenous variables that may influence the equilibrium real exchange rate. The third approach, presented in Subsection VII.6.4, will relate the equilibrium real exchange rate to the current account and will thus establish a link between our analysis of exchange rates and the earlier chapters of this book. VII.6.2 Putting Purchasing Power Parity to Use The theory of absolute purchasing power parity postulates that the real ex-change rate equals one. As we have detailed above, this claim is very likely to fail if real exchange rates are computed on the basis of national consumer price indices, since the composition of these CPIs differs across countries. To solve this problem, one can use internationally standardized goods baskets to compute national price levels.

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  eBook - ePub

  Introduction to Foreign Exchange Rates

  • Thomas J. O'Brien(Author)
  • 2013(Publication Date)
  • Business Expert Press

    (Publisher)

  CHAPTER 6 Topics in Uncovered Interest Rate Parity This chapter covers some applications and issues related to the uncovered interest rate parity (UIRP) condition. We first show the simple expected rate of change of the short-run intrinsic foreign exchange (FX) rate, given the UIRP condition. This concept has important implications in international finance, including converting an asset's cost of capital from one currency into another. The chapter also analyzes the impact on the spot FX rate if a currency's interest rate abruptly changes. This exercise is intended to help us see the dynamic forces that affect FX rates. We shall also describe Siegel's paradox, which is a minor mathematical problem for the UIRP theory. Finally, we shall cover the idea of how real interest rates connect the short-run intrinsic FX rate (consistent with financial market conditions and the UIRP condition) with the long-run intrinsic FX rate (consistent with goods market conditions and the absolute purchasing power parity (APPP) condition.) Expected Rate of Short-Run Intrinsic FX Change If the spot FX rate is correctly valued relative to financial market conditions, the expected rate of FX change is the expected rate of short-run intrinsic FX change. The notation E* (x Sf/$) denotes the expected annualized percentage change in the short-run intrinsic spot FX price of the U.S. dollar (relative to the Swiss franc), where the asterisk conveys the notion of short-run intrinsic FX valuation consistent with financial market conditions

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  eBook - PDF

  Exchange Rates and Macroeconomic Dynamics

  • P. Karadeloglou, V. Terraza, P. Karadeloglou, V. Terraza(Authors)
  • 2008(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Rogoff, K. (1996), 'The Purchasing Power Parity Puzzle', Journal of Economic Literature, XXXIV, 647-668. Roll, Richard, (1979), 'Violations of Purchasing Power Parity and their Implications for Efficient International Commodity Markets', in International Finance and Trade, Vol. 1, ed. by Marshall Sarnat and Giorgio P. Szego (Cambridge, Massachusetts: Ballinger), pp. 133-76. Sercu, P. Uppal and Van Hulle (1995), 'The Exchange Rate in the Presence of Transaction Costs: Implications for Tests of Purchasing Power Parity', Journal of Finance, 50,1309-1319. Tsay, R.S. (1989), 'Testing and Modeling Threshold Autoregressive Processes', Journal of the American Statistical Association, 84, 231-240. Wei, S-]. and D. Parsley (1995), 'Purchasing Power Disparity during the Recent Floating Rate Period: Exchange Rate Volatility, Trade Barriers and Other Culprits', Quarterly Journal of Economics. Wolff, C. (1987), 'Time-Varying Parameters and the Out-of Sample Forecasting Performance of Structural Exchange Rate Models', Journal of Business and Economics Statistics,S: 87-97. 2 The Real Exchange Rate Misalignment in the Five Central European Countries - Single Equation Approach Jan Frait, Lubos Komarek and Martin Melecky 2.1 Introduction Both policy makers and market participants have a strong interest in appropriate estimates of equilibrium real exchange rates and their prospective movements. They have also a keen interest in understanding determinants of the equilibrium real exchange rate and the factors behind implied misalignments of the actual rate from its equilibrium level. The real exchange rate is viewed as a key indicator of external competitiveness. Hence, a real appreciation of the exchange rate is often interpreted as a loss of price competi- tiveness. Nevertheless, this applies only if the real exchange rate becomes overvalued in relation to the equilibrium one.

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  eBook - ePub

  Purchasing Power Parity and Real Exchange Rates

  • Mark P. Taylor(Author)
  • 2013(Publication Date)
  • Routledge

    (Publisher)

  Real exchange rates and Purchasing Power Parity: mean-reversion in economic thought Mark P. Taylor

  Department of Economics, University of Warwick, Coventry, CV4 7AL, UK

  This study provides a critical review of the research literature on long-run Purchasing Power Parity and the stability of real exchange rates.

  I.  Introduction

  During the past three decades – notably since the breakdown of the Bretton Woods system of fixed exchange rates – an ongoing and lively debate has been conducted among international economists concerning purchasing power parity (PPP) and the stability of real exchange rates. Professional confidence in the validity of PPP even as a long-run equilibrium condition has waxed and waned considerably over this period, from a consensus belief in the very early 1970s, to outright rejection in the late 1980s, to guarded confidence in long-run PPP in the late 1990s and early 2000s. Indeed, economic thought in this area might itself be seen to have displayed a measure of the mean reversion that has so often been tested for in real exchange rates.

  This study provides a selective overview of this research, with an emphasis on recent developments and contributions.1 It begins, however, with an outline of the conceptual origins of purchasing power parity.

  II.  Purchasing Power Parity: Conceptual Origins

  The concept of PPP and discussions relating to the relationship between the exchange rate and prices more generally have a very long history in economics, dating back as far as the writings of the scholars of the University of Salamanca in the sixteenth century. The development of the concept of purchasing power at this time appears to have been due to the confluence of three major influences. First, the University of Salamanca was at that time one of the world’s leading seats of learning; second, this was the period of Spain’s ‘Great Inflation’; third, the Catholic Church at that time prohibited usury – i.e. the charging of interest on loans.

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  eBook - ePub

  Introduction to Foreign Exchange Rates, Second Edition

  • Thomas J. O'Brien(Author)
  • 2016(Publication Date)
  • Business Expert Press

    (Publisher)

  CHAPTER 6 Topics in Uncovered Interest Rate Parity

  This chapter covers some applications and issues related to the uncovered interest rate parity (UIRP) condition. We first show the expected rate of change of the short-run intrinsic foreign exchange (FX) rate, given the UIRP condition. This concept has important implications in international finance, including converting an asset’s cost of capital from one currency into another.

  The chapter also analyzes the impact on the spot FX rate if a currency’s interest rate abruptly changes. This exercise is intended to help us see the dynamic forces that affect FX rates. The chapter also describes Siegel’s paradox, which is a minor mathematical problem for the UIRP theory.

  Finally, we cover the idea of how real interest rates connect the short-run intrinsic FX rate that is consistent with financial market conditions and the UIRP condition, with the long-run intrinsic FX rate that is consistent with goods market conditions and the absolute purchasing power parity (APPP) condition.

  Expected Rate of Short-Run Intrinsic FX Change

  If the spot FX rate is correctly valued relative to financial market conditions, the expected rate of FX change is the expected rate of short-run intrinsic FX change. Let denote the expected percentage change in the short-run intrinsic spot FX price of the U.S. dollar (relative to the Swiss franc), where the asterisk conveys the notion of short-run intrinsic FX valuation consistent with financial market conditions. If the UIRP condition is the correct model of short-run intrinsic FX value, then is given as a linear approximation in Equation 6.1 .

  Expected Rate of Short-Run Intrinsic FX Change

  Linear Approximation UIRP Condition

  (6.1)

  In Equation 6.1 , the interest rate for the “denominator currency” is subtracted from the interest rate of the “numerator currency.” Let us do a numerical example. Assume , and . The linear approximation in Equation 6.1 says that −0.02, or −2 percent. By way of comparison with the UIRP condition in Equation 5.1 , assume . Thus the UIRP condition in Equation 5.1 says that today’s spot FX rate should be , and the expected rate of intrinsic spot FX change, given that the UIRP condition holds, is (1.57 Sf/$)/(1.60 Sf/$) − 1 = −0.019, or −1.9 percent, So the linear approximation in Equation 6.1 is close.1

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  The Big Mac Index

  Applications of Purchasing Power Parity

  • L. Ong(Author)
  • 2003(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  We then discuss the productivity bias hypothesis, which is generally accepted as the most important reason for depar- tures from PPP, and other limitations of PPP. This is followed by a summary. Absolute and relative parities PPP required that the price level in two countries be equal when converted to a common currency to ensure that the real exchange rate is equal to unity. Consequently, any change in the nominal exchange rate would be determined by a change in the price level. Thus, it could be said that the PPP theory of exchange rates looks at the relationship between a country’s foreign exchange rate and its price level, as well as the relationship between the changes in those variables. 2 The Big Mac Index PPP may be expressed in either absolute or relative terms. Absolute PPP is the ratio of price levels which are measured as the number of units of currency per unit of physical quantity. Since absolute PPP of the foreign currency is the ratio of the domestic price level to the for- eign price level, it has as its dimension the number of units of domes- tic currency per unit of foreign currency. In turn, relative PPP is based on price movements which are measured by price indices relative to a designated base period. The basic concept here is that the change in the exchange rate should equal the inflation differential. It can either be defined as the ratio of the domestic to the foreign price index, or the product of this ratio and the base-period exchange rate. Relative PPP implies that the real exchange rate is constant, although it need not be unity. This means that movements in the real exchange rate are synonymous with deviations from PPP.

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  International Financial Markets And Agricultural Trade

  • Thomas Grennes(Author)
  • 2019(Publication Date)
  • CRC Press

    (Publisher)

  By partially delinking the current from the capital account, all the dual rates system can hope to do is delay the eventual crisis. A system that is particularly relevant for the developing countries consists of the coexistence of a fixed rate for commercial transactions with a floating parallel (either black or grey) market rate governing the financial transactions. 9 3. MEASURING REAL EXCHANGE RATES From an empirical point of view, the first question that should be addressed is: How should the real exchange rate be measured? From equation (9), which defines the real exchange rate as the relative price of tradables and nontradables, it is apparent that the main measurement problems are those related to the selection of the real-world counterparts of P; and P N In reality, it is extremely difficult, if not impossible, to define which goods are actually tradables and which are nontradables. A second measurement problem is related to the definition of E. Should the nominal exchange rate with respect to the U.S. dollar be considered? Or is the exchange rate with respect to the DM the most appropriate? Or should an average of both rates be used? These and other problems related to the measurement of the real exchange rate will be discussed in this section. The analysis will be restricted to the actual measurement of the RER without entering into the important and difficult question of the empirical definition of the equilibrium level of the real exchange rate. The analysis presented in this section will first discuss briefly the arguments traditionally given favoring alternative measures of the real exchange rate. The discussion will be quite general and will provide a broad cover of the literature. That is, the presentation will also deal, even though briefly, with the PPP real exchange rate. Section 4, on the other hand, deals with the actual behavior of different RER indexes in the developing countries.

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