ARBC 106b Chapter Notes - Chapter 1: Interest Rate Parity, Fisher Hypothesis, Spot Contract

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12 Dec 2019
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FIN 439 Final Exam
Chapter 8 |Relationships among Inflation, Interest Rates and Exchange Rates
Purchasing power parity (PPP) theory specifies a precise relationship between relative inflation rates of two countries
and their exchange rate.
Forms of PPP:
Absolute Form of PPP: Without international barriers, consumers shift their demand to wherever prices are lower.
Prices of the same basket of products in two different countries should be equal when currency measured in
common.
Relative Form of PPP: Due to market imperfections, prices of the same basket of products in different countries will
not necessarily be the same, but the rate of change in prices should be similar when currency measured in common.
In inexact terms, PPP theory suggests that the equilibrium exchange rate will adjust by the same magnitude as the
differential in inflation rates between two countries. Though PPP continues to be a valuable concept, there is evidence
of sizable deviations from the theory in the real world.
Limitations of PPP
Confounding effects
A change in a country’s spot rate is driven by more than the inflation differential between two countries:
Since the exchange rate movement is not driven solely by ΔINF, the relationship between the inflation differential
and exchange rate movement cannot be as simple as the PPP theory suggests.
No Substitutes for Traded Goods: If substitute goods are not available domestically, consumers may not stop buying
imported goods.
The international Fisher effect (IFE) specifies a precise relationship between relative interest rates of two countries and
their exchange rates. Implications of the International Fisher Effect: The international Fisher effect (IFE) theory suggests
that currencies with high interest rates will have high expected inflation (due to the Fisher effect) and the relatively high
inflation will cause the currencies to depreciate (due to the PPP effect).
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It suggests that an investor who periodically invests in foreign interest-bearing securities will, on average, achieve a
return similar to what is possible domestically. This implies that the exchange rate of the country with high interest rates
will depreciate to offset the interest rate advantage achieved by foreign investments. However, there is evidence that
during some periods the IFE does not hold. Thus, investment in foreign short-term securities may achieve a higher
return than what is possible domestically. If a firm attempts to achieve this higher return, however, it does incur the risk
that the currency denominating the foreign security might depreciate against the investor’s home currency during the
investment period. In this case, the foreign security could generate a lower return than a domestic security, even though
it exhibits a higher interest rate.
Limitations of the IFE
The IFE theory relies on the Fisher effect and PPP
Limitation of the Fisher Effect: The difference between the nominal interest rate and actual inflation rate is not
consistent. Thus, while the Fisher effect can effectively use nominal interest rates to estimate the market’s expected
inflation over a particular period, the market may be wrong.
Limitation of PPP
Other country characteristics besides inflation (income levels, government controls) can affect exchange rate
movements. Even if the expected inflation derived from the Fisher effect properly reflects the actual inflation rate
over the period, relying solely on inflation to forecast the future exchange rate is subject to error.
The PPP theory focuses on the relationship between the inflation rate differential and future exchange rate movements.
The IFE focuses on the interest rate differential and future exchange rate movements. The theory of interest rate parity
(IRP) focuses on the relationship between the interest rate differential and the forward rate premium (or discount) at a
given point in time.
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