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Introduction
Exchange rates are influenced by interest rates and inflation rates and together, they influence markets for exchange rates in the future, known as forward rates. Means that, the main determinants of exchange rates are relative inflation rate, interest rates, national income and political stability. The linkages among these variables are called parity conditions Parity conditions are key relationship used to predict movements in exchange rates. Since arbitrage plays a critical role in this discussion, we should define it upfront.
Objective
What is arbitrage Business operation involving the purchase of foreign exchange gold, financial securities or commodities in one market and their almost simultaneous sale in another market, in order to profit from price differentials existing between the markets. Arbitrage generally tends to eliminate price differentials between markets. So,
the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain profit.
Structure of IPC
Unbiased Forward Rate Forward Rate Premium or Discount Interest Rate Parity
A change in the market interest rate will then, in turn, affect the future spot rate (IFE) and the forward market through IRP. The four main theoretical relationship among the S, F, P (inf), and I are shown in previous graph.
LOP states : identical goods sell for the same price worldwide
Stated that in the absence of transportation cost, taxes and other restrictions, meanwhile the price of a product stated in a common currency such as USD should be the same in every country. This means same product, same price in one common currency. Since the product is sold in different countries, the products price must be stated in different currency terms, but the price of the product should still be the same when expressed in one common currency.
So, PPP states : the exchange rate between two countries currencies should be equal to the ratio of their price levels. PPP is a manifestation of the LOP applied internationally to a standard commodity basket.
where
et e0 ih if t
= = = = =
future spot rate spot rate home inflation foreign inflation the time period
i 1
f
ih 1
t t
Example PPP
US inflation 4% Australia inflation 8% Current spot is USD 0.8034 per AUD Answer : Spot rate
IFE STATES: the spot rate adjusts to the interest rate differential between two countries.
EXAMPLE IFE
Malaysia interest rate for 6-month 4% Australia interest rate for 6 month 8% Current spot rate is MYR2.8735/AUD What is forecast future spot rate of the MYR/AUD if the interest rate in Australia were rise to 10% p.a?
EXAMPLE OF IRP
Example : Assume that American has USD 1 M to invest either in the UK or USA given the following information: Spot rate USD 1.68/GBP Forward rate USD 1.6066/GBP UK interest rate 13 % p.a USA interest rate 8.0625% p.a
Two alternative :
Alternative 1 : invest in USA & get USD 1,080,625 after one year ( 1M X 1.080625)
Alternative 2: Take advantage of the higher interest rate by investing in UK IF INVESTOR CHOOSE AT ALTERNATIVE 2, HE MUST PERFORM THE FOLLOWING STEPS: Step 1: Convert USD 1 Million into pounds at spot rate because bankers only accept pounds. USD 1 Million / 1.68 = GBP 595,238. Step 2 : Invest GBP 595,238 at 13% after one year. GBP 595,238 X 1.13 = GBP 672,619 Step 3 : Sell immediately one year forward at forward rate to get back USD GBP 672,619 X 1.6066 = USD 1,080,630.
Arbitrage profit = USD 1 M USD 1,080,630 = USD 80,630
Why doing covered interest rate because to protect against risk that pound will depreciate in one year.
Example : Suppose that the current one year interest rate in the US is 9.4% and the UK interest rate is 11%. The spot rate is USD1.5 per GBP. What is expected one year forward rate for USD/GBP? [ 1 + 0.094] / [1 + 0.11] = f / s [ 1 + 0.094] / [1 + 0.11] = f / 1.5 So one year USD/GBP = 1.478
seeks to answer the question: is the forward rate an accurate forecast of future spot rate? Actually investor want to know whether the forward rate is an unbiased predictor of the future spot rate. The expectation theory state that forward rate approximately = the expected future spot but does not means they same, because forward rate will, on average, over estimate and under estimate the actual future spot rate. The rationale behind that is the foreign exchange is reasonable efficient.
Conclusion
In this chapter, we learned about five parity conditions or relationship apply to spot rates, inflation rates and interest rates in different currencies: PPP, FE, IFE,IRP and forward rates as an unbiased forecast of the future spot rate or UFR.
International trade or exchange of goods and services across borders gives rise to international settlement with payments being made in different currencies. Discrepancies may arise as a consequences when the settlement is executed in one currency as against the other currency. Moreover, economic conditions and changes in economic conditions in different countries may take effect on the value of goods measured in different currencies and the relative values and opportunity costs of these currencies.
International parities are important since they establish relative currency values and their evolution in terms of economic circumstances and cross broader arbitrage may be possible when they are violated.