CFA® Level II Economics - International Parity Conditions

Summary

This video script explores international parity relationships, focusing on how forward exchange rates are determined by interest rate differentials and arbitrage. It explains the concepts of covered interest rate parity, uncovered interest rate parity, and purchasing power parity (PPP). The script also covers the Fisher effect and international Fisher effect, illustrating how inflation and interest rates influence currency values. These theories are used to predict future exchange rates and understand currency movements, though they hold more true in the long term.

Takeaways

• 📈 Forward rates are used to predict future exchange rates; a higher forward rate than the spot rate indicates a forward premium, while a lower rate indicates a forward discount.
• 💹 The forward premium or discount is determined by the arbitrage relationship between spot rates, forward rates, and interest rates in different countries.
• 🌐 Covered interest rate parity is the relationship between the interest rate differentials and the forward premium or discount, which is maintained by arbitrageurs to prevent arbitrage opportunities.
• 💼 Arbitrageurs can earn riskless profit by borrowing in a low-interest-rate currency, exchanging for a high-interest-rate currency, investing there, and using a forward contract to sell back at a future date.
• 📉 If the forward rate is at a discount, it is expected that the currency with the lower interest rate will appreciate against the higher interest rate currency.
• ⏳ The no-arbitrage relationship between forward rates, spot rates, and interest rates is adjusted for the number of days to maturity when calculating for periods less than a year.
• 🌐 Uncovered interest rate parity is based on investor preference and risk neutrality, assuming that investors will be indifferent to investing in different currencies if the expected change in exchange rates offsets the interest rate differential.
• 📊 Forward rate parity suggests that the forward exchange rate is an unbiased forecast of the future spot exchange rate, which is more evident in the long term than the short term.
• 💰 Purchasing power parity (PPP) is based on the law of one price, stating that identical goods should have the same price in all locations when adjusted for exchange rates.
• 📊 Relative PPP and ex-ante relative PPP relate exchange rate changes to inflation differentials, with the latter being a forward-looking version that uses expected inflation rates.
• 🔄 The international Fisher effect combines the Fisher relation and real interest rate parity, suggesting that nominal interest rate differentials should equal expected inflation rate differentials between two countries.

Q & A

What is a forward premium in the context of foreign exchange?

A forward premium occurs when the forward rate is higher than the spot rate, indicating that one unit of a foreign currency can buy more of another currency in the future, suggesting an expectation that the first currency will appreciate against the second.

What is a forward discount and how does it relate to currency appreciation?

A forward discount happens when the forward rate is lower than the spot rate. It implies that one unit of a foreign currency will buy less of another currency in the future, suggesting that the first currency is expected to depreciate against the second.

How does the arbitrage relationship between spot rate, forward rate, and interest rates work?

The arbitrage relationship ensures that the forward rate is set at a level where no riskless profit can be earned. This is achieved by borrowing in a low-interest-rate currency, converting it to a high-interest-rate currency, investing it there, and simultaneously entering a forward contract to sell it back at the future date at the forward rate.

What is the covered interest rate parity and why is it significant?

Covered interest rate parity is the relationship between the interest rate differentials of two countries and the forward premium or discount on their exchange rates. It's significant because it defines the equilibrium level for the forward exchange rate where no arbitrage opportunities exist.

How do you calculate the no arbitrage forward exchange rate?

The no arbitrage forward exchange rate is calculated by adjusting the spot rate by the interest rate differential between two currencies, taking into account the time to maturity. This ensures that the forward rate reflects the cost of carry between the two currencies.

What is the difference between uncovered and covered interest rate parity?

Covered interest rate parity is based on the arbitrage condition, whereas uncovered interest rate parity is based on investor expectations and risk neutrality. Covered interest rate parity involves hedging currency risk, while uncovered does not.

How does the expected change in exchange rates relate to interest rate differentials?

According to uncovered interest rate parity, the expected change in the exchange rate is the difference between the interest rates of the foreign and domestic currencies. This reflects the idea that investors will move funds to the currency with the higher interest rate, adjusting the exchange rate accordingly.

What is the forward rate parity and how does it relate to future spot rates?

Forward rate parity suggests that the forward exchange rate is an unbiased predictor of the future spot rate. If both covered and uncovered interest rate parity hold, the forward rate should reflect all available information about the future spot rate.

How does purchasing power parity (PPP) relate to exchange rates?

Purchasing power parity (PPP) is based on the law of one price, which states that identical goods should have the same price in all locations after adjusting for exchange rates. PPP suggests that exchange rates will adjust to offset differences in price levels between countries.

What is the difference between absolute and relative PPP?

Absolute PPP requires that the law of one price holds true for all goods and services, implying that exchange rates are determined by the ratio of national price levels. Relative PPP focuses on changes in exchange rates being equal to the difference in inflation rates between countries.

How does the Fisher effect connect nominal interest rates and expected inflation?

The Fisher effect states that the nominal interest rate in a country is approximately the sum of the real interest rate and the expected inflation rate. This relationship suggests that differences in nominal interest rates between countries should reflect differences in their expected inflation rates.