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International Parity Relationships and Forecasting Foreign Exchange Rates …
International Parity Relationships and Forecasting Foreign Exchange Rates
Purchasing Power Parity
Purchasing Power Parity and Exchange Rate Determination
The PPP relationship of Equation 6.12 is called the absolute version of PPP. When the PPP relationship is presented in the “rate of change” form
PPP Deviations and the Real Exchange Rate
If there are deviations from PPP, changes in nominal exchange rates cause changes in the real exchange rates, affecting the international competitive positions of countries. This, in turn, would affect countries’ trade balances.
Purchasing Power Parity
Theory of purchasing power parity (PPP): The exchange rate between two currencies should
equal the ratio of the countries’
The exchange rate between two currencies should
equal the ratio of the countries’ price levels:
Interest Rate Parity
Interest Rate Parity (IRP) is an arbitrage condition that must hold when international financial
markets are in equilibrium.
Interest Rate Parity Defined
Covered Interest Arbitrage
When IRP doesn’t hold, the situation also gives rise to covered interest arbitrage
opportunities.
IRP and Exchange Rate
Determination
Being an arbitrage equilibrium condition involving the (spot) exchange rate, IRP has an immediate
implication for exchange rate determination.
Reasons for Deviations from
Interest Rate Parity
Fisher Effects
The Fisher Effects
The Fisher effect holds that an increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country.
International Fisher Effect
which is referred to as forward expectations parity (FEP). FEP states that any forward premium or discount is equal to the expected change in the exchange rate.
When investors are risk-neutral, forward parity will hold as long as the foreign exchange market is informationally efficient.
Exact Equilibrium Exchange Rate
Relationships
Forecasting Exchange Rates
Fundamental Approach
Involves econometrics to develop models that use a variety of explanatory variables.
Technical Approach
Technical analysis first analyzes the past behavior of exchange rates for the purpose of
identifying “patterns” and then projects them into the future to generate forecasts..
Efficient Markets Approach
Financial Markets are efficient if prices reflect all available and relevant information.
Performance of the Forecasters
Forecasting is difficult, especially with regard to the future.
As a whole, forecasters cannot do a better job of forecasting future exchange rates than the
forward rate.