FINS3616 Lecture Notes - Lecture 3: Purchasing Power Parity, Arbitrage, Transaction Cost

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6 Sep 2018

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Week 3: parity conditions in international finance and currency forecasting: pri(cid:272)e le(cid:448)el: the (cid:374)o(cid:373)i(cid:374)al pri(cid:272)e le(cid:448)el of a (cid:272)ou(cid:374)tr(cid:455)"s (cid:862)(cid:271)asket of goods(cid:863) ; weighted average of goods and services, calculating inflation, annual inflation, cumulative inflation. Internal purchasing power: the amount of goods and services that can be purchased with in the u. s spending your money in your own country. It is a ratio of a price level denominated in another currency. If it is violated, then arbitrage will occur. Undervalued currency is expected to strengthen (appreciate: big mac index formulas, market and ppp xr. If s > sppp , currency in numerator undervalued, denominator overvalued. If s < sppp , currency in numerator overvalued, denominator undervalued: relative ppp. It takes market imperfections into account: currency over/undervaluation exists for a reason. Cirp (covered interest rate parity): a forward contract can be replicated by combining money market transactions: uncovered interest rate parity; Cirp was built on the no arbitrage principle.

Related Questions

Analyse the current state of the financial markets. An amusing example of purchasing power parity is The Economist's Big Mac index. Under PPP, movements in countries' exchange rates should in the long-term mean that the prices of an identical basket of goods or services are equalised. The McDonalds Big Mac represents this basket. The index compares local Big Mac prices with the price of Big Macs in America. This comparison is used to forecast what exchange rates should be, and this is then compared with the actual exchange rates to decide which currencies are over and under-valued. Required: Select one currency from The Economist's Big Mac index. Conduct a secondary research on this currency and its recent trends. Analyse their historical 5 values and determine whether they have been over or undervalued based on the Big mac index

Short- and Long-Run Exchange Rate Risk Exercise

Worksheet (v1.2)

In this exercise you are asked to choose a currency in which it is assumed you have foreign exchange exposure both in trade (short-run) and investment (long-run). In this exercise you are asked to find both spot and forward exchange rates for a chosen currency and also inflation rates associated with that currency. You are encouraged to read through the exercise first before choosing your currency to ensure the requested data is accessible via the links provided.

Short-Run Exchange Rate Risk

Assume you have a trade receivable denominated in a foreign currency of your choice that is payable to you by your customer in 6 months. At the current spot rate the trade receivable is worth the equivalent of US$5,000,000. To find the current spot rate for the chosen currency pair go to http://www.hsbcnet.com/gbm/fxcalc-disp.[1] Enter 5,000,000 in the âConvertâ box, United States dollar in the âFrom:â box, and your chosen currency in the âTo:â box. Click on âGoâ for the spot rate, which will be expressed in European terms, that is, units of foreign currency per one US dollar. Enter the name of the chosen currency, the date the site is accessed, and the spot rate in European terms in the table below.

To find a 180 day forward rate for the currency pair, go to http://www.hsbcnet.com/gbm/fwcalc-disp#. For âAmountâ you can just enter 1 and enter US dollars in the âBuyâ box and the foreign currency in the âSellâ box. For âValue Dateâ enter â6 Monthsâ and click âGoâ for the forward rate. (Clicking on the Inverse box will switch the rate from European to American terms.) Enter the one-year forward rate in the table below. Make sure the forward rate is expressed in the same way as the forward rate, that is, in European terms.

Foreign Currency	Date	Current Spot Rate in European terms: FX per 1 US dollar	Six -Month Forward Rate in European terms: FX per 1 US dollar

Based on the data above, answer the following questions:

At the current spot rate how much in the foreign currency are you owed in 6 months?

Assuming you fully hedge your FX exposure in the forward market, how many US dollars will you receive in 6 months?

Is the foreign currency selling in the forward market at a premium, i.e. it appreciates relative to the spot rate, or a discount, i.e., it depreciates relative to the spot rate? Provide numbers to support your answer.

Long-Run Exchange Rate Risk

Assume you have undertaken a 3-year investment abroad with expected cash flows denominated in your chosen currency. At the current spot rate those cash flows are expected to provide a positive net present value (NPV) in US dollar terms. Based on relative purchasing power parity you are asked to estimate future spot rates over the next three years based on comparative inflation data.[2] With that data complete the table below.

S₀ = Current Spot Rate in European Terms (Foreign currency per US dollar)	E(S_t) = Expected Exchange Rate Spot Rate in t Years in European Terms (Foreign currency per US dollar)	h_US= Annual Inflation Rate in the United States	h_FC = Annual Foreign Country Inflation Rate

Using the data above and textbook equation (18.3) E(S_t) = S₀ â [1 + (h_FC - h_US)]^t and assuming the estimated inflation rate in Year 1 also holds for Years 2 and 3, please respond to the following:

Based on relative purchasing power parity, estimate S_1.

Based on relative purchasing power parity, estimate S_2.

Based on relative purchasing power parity, estimate S_3.

Based on relative purchasing power parity, has the foreign currency appreciated or depreciated against the US dollar? Explain.

Based on relative purchasing power parity, has the NPV of the investment project increased or decreased in US dollar terms? Explain.

[1] Please note currencies are grouped according to their region: Americas (where the United States dollar may be found), Asia-Pacific, Europe, and MENA. Please advise your instructor should this or any other link in the assignment be broken.

[2] Sources of Inflation data include http://stats.oecd.org/ for OECD countries and http://data.worldbank.org/indicator/FP.CPI.TOTL.ZG at the World Bank site. It is viewed important to be consistent in the definition and source of inflation numbers for the US and the other currency that you use for the relative PPP equation. The most basic definitions of inflation are consumer price index (CPI), producer price index (PPI), and GDP deflator. Estimates of the next yearâs inflation are preferred but it is also common to use the past yearâs inflation as the best estimate of next yearâs and subsequent yearsâ inflation. You are encouraged to share any useful websites for this data you find with the class.

ivorybeetle692

You believe that IRP presently exists. The nominal annual interest rate in Mexico is 13%. The nominal annual interest rate in the U.S. is 4%. You expect that annual inflation will be about 4% in Mexico and 4.5% in the U.S. The spot rate of the Mexican peso is $.10. Put options on pesos are available with a one-year expiration date, an exercise price of $.1008, and a premium of $0.014 per unit.

You will receive 1 million pesos in one year.

a. Determine the amount of dollars that you will receive if you use a forward hedge.

b. Determine the expected amount of dollars that you will receive if you do not hedge and believe in purchasing power parity (PPP).

c. Determine the amount of dollars that you will expect to receive if you use a currency put option hedge. Account for the premium you would pay on the put option.

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FINS3616 Lecture Notes - Lecture 3: Purchasing Power Parity, Arbitrage, Transaction Cost

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