Question

Which of the following parity conditions holds best (closest)? Select one: a. International Fischer Effect b. Relative Purchasing Power Parity c. Purchasing Power Parity d. Covered interest rate parity

Answer 1

The objective of International Finance theories is to understand how and why, in a system of free markets and flexible exchange rates, currencies strive to move toward equilibrium. These theories define the relationship between exchange rates (current spot, future spot, and forward), inflation, and nominal interest rate movements.

1. International Fisher Effect

The International Fisher Effect (IFE) is an economic theory stating that the expected disparity between the exchange rate of two currencies is approximately equal to the difference between their countries' nominal interest rates. The IFE is based on the analysis of interest rates associated with present and future risk-free investments, such as Treasuries, and is used to help predict currency movements. This is in contrast to other methods that solely use inflation rates in the prediction of exchange rate shifts, instead functioning as a combined view relating inflation and interest rates to a currency's appreciation or depreciation.

The theory stems from the concept that real interest rates are independent of other monetary variables, such as changes in a nation's monetary policy, and provide a better indication of the health of a particular currency within a global market. The IFE provides for the assumption that countries with lower interest rates will likely also experience lower levels of inflation, which can result in increases in the real value of the associated currency when compared to other nations. By contrast, nations with higher interest rates will experience depreciation in the value of their currency.The Fisher Effect and the IFE are related models but are not interchangeable. The Fisher Effect claims that the combination of the anticipated rate of inflation and the real rate of return are represented in the nominal interest rates. The IFE expands on the Fisher Effect, suggesting that because nominal interest rates reflect anticipated inflation rates and currency exchange rate changes are driven by inflation rates, then currency changes are proportionate to the difference between the two nations' nominal interest rates.

Empirical research testing the IFE has shown mixed results, and it is likely that other factors also influence movements in currency exchange rates. Historically, in times when interest rates were adjusted by more significant magnitudes, the IFE held more validity. However, in recent years inflation expectations and nominal interest rates around the world are generally low, and the size of interest rate changes is correspondingly relatively small. Direct indications of inflation rates, such as consumer price indexes (CPI), are more often used to estimate expected changes in currency exchange rates.

2. Relative Purchasing Power Parity (RPPP) is an expansion of the traditional purchasing power parity (PPP) theory to include changes in inflation over time. Purchasing power is the power of money expressed by the number of goods or services that one unit can buy, and which can be reduced by inflation. RPPP suggests that countries with higher rates of inflation will have a devalued currency.

According to relative purchasing power parity (RPPP), the difference between the two countries’ rates of inflation and the cost of commodities will drive changes in the exchange rate between the two countries. RPPP expands on the idea of purchasing power parity and complements the theory of absolute purchasing power parity (APPP). The APPP concept declares that the exchange rate between the two nations will be equal to the ratio of the price levels for those two countries.

RPPP is essentially a dynamic form of PPP, as it relates the change in two countries’ inflation rates to the change in their exchange rate. The theory holds that inflation will reduce the real purchasing power of a nation's currency. Thus if a country has an annual inflation rate of 10%, that country's currency will be able to purchase 10% less real goods at the end of one year.

RPPP also complements the theory of absolute purchasing power parity (APPP), which maintains that the exchange rate between two countries will be identical to the ratio of the price levels for those two countries. This concept comes from a basic idea known as the law of one price. This theory states that the real cost of a good must be the same across all countries after the consideration of the exchange rate.

2. ABSOLUTE Purchasing Power Parity (PPP)

Note the difference between the absolute and relative PPP. The absolute PPP indicates that the exchange rate has to reflect the ratio of two countries' price levels.All the relative PPP requires is the changes in the exchange rate equal the changes in the ratio of the price level. The Purchasing Power Parity (PPP) implies that the changes in two countries’ price levels affect the exchange rate. According to the PPP, when a country’s inflation rate rises relative to that of the other country, the former’s currency is expected to depreciate. In terms of the different PPP concepts, such as absolute and relative PPP, the nature of the change in the exchange rate is different.

Note the difference between the absolute and relative PPP. The absolute PPP indicates that the exchange rate has to reflect the ratio of two countries’ price levels. However, this is not easy.

In reality, there are market imperfections such as nontransferable inputs, transportation costs, tariffs, quotas, and so forth. Therefore, the relative PPP takes these market imperfections in consideration and relaxes the relationship between the exchange rate and the price levels of two countries. It does so by considering the relationship between the changes in the exchange rate and the changes in the ratio of the price levels.

All the relative PPP requires is the changes in the exchange rate equal the changes in the ratio of the price level.

4. INTEREST RATE PARITY

According to IRP, at equilibrium, the forward rate of a foreign currency will differ (in %) from the current spot rate by an amount that will equal the interest rate differential (in%) between the home and foreign country. As a result of market forces, the forward rate differs from the spot rate by an amount that sufficiently offsets the interest rate differential between two currencies. Then, covered interest arbitrage is no longer feasible, and the equilibrium state achieved is referred to as interest rate parity (IRP).

When IRP exists, the rate of return achieved from covered interest arbitrage should equal the rate of return available in the home country.To test whether IRP exists, collect actual interest rate differentials (assets of similar risk and maturity) and forward premiums/discounts for various currencies, and plot them on a graph. IRP holds when covered interest arbitrage is not possible or worthwhile.When IRP exists, it does not mean that both local and foreign investors will earn the same returns. What it means is that investors cannot use covered interest arbitrage to achieve higher returns than those achievable in their respective home countries.
In its absolute version, purchasing power parity states that price levels should be equal worldwide when expressed in a common currency. In other words, a unit of home currency (HC) should have the same purchasing power around the world. The relative version of purchasing power parity, which is used more commonly now, states that the exchange rate between the home currency and any foreign currency will adjust to reflect changes in the price levels of the two countries. For example, if inflation is 5% in the United States and 1% in Japan, then the dollar value of the Japanese yen must rise by about 4% to equalize the dollar price of goods in the two countries.