Question

7.Briefly explain the concepts of interest rate and purchasing power parity?

Answer 1

Concept of interest rate parity:

Interest rate parity is a theory which states that the size of the forward premium (or discount) should be equals to the interest rate differential between the two countries of concern. When interest rate parity exists,covered interest arbitrage (means foreign exchange risk is covered) is not feasible because any interest rate advantage in the foreign country will be offset by the discount on the forward rate. Thus, the act of covered interest arbitrage would generate a return that is no higher than what would be generated by a domestic investment.

Equation for covered interest rate parity:

(1+r0) = F/S*(1+rf)

Where (1+r0) = Amount that an investor would get after a unit period by investing a rupee in the domestic market at r0 rate of interest and F/S*(1+rf) is the amount that an investor by investing in the foreign market at rf that the investment of one rupee yield same return in the domestic as well as in the foreign market.

PURCHASING POWER PARITY(PPP):

Purchasing power parity theory focuses on the 'inflation-exchange rate'relationship. There are two forms of PPP theory:

The ABSOLUTE FORM, also called the 'Law of One Price' suggests that 'prices of similar products of two different countries should be equal when measured in a common currency'. If a discrepancy in prices as measured by a common currency exists, the demand should shift so that these prices should converge.

An alternative version of the ABSOLUTE form that accounts for the possibility of market imperfections such as transportation costs, tariffs and quotas embeds the sectoral constant.It suggests that 'because of these market imperfections, prices of similar products of different countries will not necessarily be same when measured in a common currency. However it states that the rate of change in the prices of products should be somewhat similar when measured in a common currency as long as the transportation costs and trade barriers are unchanged.

Equation for PPP:

E(S1) = S0*(1+id)/(1+if) where

E(S1) = expected spot rate in time period 1

S0 = Current spot rate (Direct quote)

id = inflation in the domestic market (home country)

if = inflation in foreign market

Alpha = Sectorial price and sectorial shares constant