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    This document provides an overview of international parity relationships among inflation, interest rates, and exchange rates. Specifically, it covers: 1. Purchasing power parity (PPP) theory and how it implies that exchange rate changes should offset inflation rate differentials between countries. 2. International Fisher effect (IFE) theory and how it similarly implies that exchange rate changes should perfectly offset interest rate differentials. 3. Interest rate parity (IRP) theory and how it states that expected exchange rate changes should offset interest rate differentials between countries. The document then goes on to explain each theory in further detail and compare their implications.

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    Lecture Class_4_International Parity Relationships

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    This document provides an overview of international parity relationships among inflation, interest rates, and exchange rates. Specifically, it covers: 1. Purchasing power parity (PPP) theory and how it implies that exchange rate changes should offset inflation rate differentials between countries. 2. International Fisher effect (IFE) theory and how it similarly implies that exchange rate changes should perfectly offset interest rate differentials. 3. Interest rate parity (IRP) theory and how it states that expected exchange rate changes should offset interest rate differentials between countries. The document then goes on to explain each theory in further detail and compare their implications.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Flag for inappropriate content
    2K views23 pages

    Lecture Class - 4 - International Parity Relationships

    Uploaded by

    api-19974928
    This document provides an overview of international parity relationships among inflation, interest rates, and exchange rates. Specifically, it covers: 1. Purchasing power parity (PPP) theory and how it implies that exchange rate changes should offset inflation rate differentials between countries. 2. International Fisher effect (IFE) theory and how it similarly implies that exchange rate changes should perfectly offset interest rate differentials. 3. Interest rate parity (IRP) theory and how it states that expected exchange rate changes should offset interest rate differentials between countries. The document then goes on to explain each theory in further detail and compare their implications.

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    of 23

    Module : 1

    Session 4:
    International Parity Relationships among
    Inflation, Interest Rates and Exchange
    Rates
    Session Overview

    A. Purchasing Power Parity (PPP)

    B. International Fisher Effect (IFE)

    C. Interest Rate Parity (IRP)

    D. Comparison of the IRP, PPP, and


    IFE Theories
    Session Objectives

    A. Explain the purchasing power parity (PPP)


    theory and its implications for exchange rate
    changes
    B. Explain the International Fisher effect (IFE)
    theory and its implications for exchange rate
    changes
    C. Compare the PPP theory, the IFE theory, and
    the theory of interest rate parity (IRP)
    A. Purchasing Power Parity (PPP)

    1. Interpretations of Purchasing Power


    Parity
    a. Absolute Form of PPP
    b. Relative Form of PPP
    2. Rationale behind Purchasing Power
    Parity Theory
    3. Derivation of Purchasing Power Parity
    A. Purchasing Power Parity (PPP)

    4. Using PPP to Estimate Exchange Rate


    Effects
    a. Using a Simplified PPP Relationship

    5. Graphic Analysis of Purchasing Power Parity


    a. PPP Line
    b. Purchasing Power Disparity
    Illustration of Purchasing Power Parity

    8.1
    A. Purchasing Power Parity (PPP)

    6. Testing the Purchasing Power Parity


    Theory
    a. Conceptual Tests of PPP
    1.) choose two countries (say, the United States and a
    foreign country)

    2.) compare the differential in their inflation rates to the


    percentage change in the foreign currency’s
    value during several time periods.
    Identifying Disparity in Purchasing Power

    8.2
    A. Purchasing Power Parity (PPP)

    b. Statistical Test of PPP


    c. Results of Tests of PPP
    d. Tests of PPP for Each Currency
    e. Limitations of PPP Tests
    Comparison of Annual Inflation Differentials and Exchange Rate Movements
    For Four Major Currencies

    8.3
    A. Purchasing Power Parity (PPP)

    7. Why Purchasing Power Parity Does Not


    Occur
    a. Confounding Effects
    b. No Substitutes for Traded
    Goods
    B. International Fisher Effect (IFE)

    1. Relationship with Purchasing Power


    Parity

    2. Implications of the IFE for Foreign


    Investors
    B. International Fisher Effect (IFE)

    3. Derivation of the International Fisher


    Effect
    a. Numerical Example based on
    the Derivation of IFE
    b. Simplified Relationship
    B. International Fisher Effect (IFE)

    4. Graphic Analysis of the International


    Fisher Effect
    a. Points on the IFE Line
    b. Points below the IFE Line
    c. Points above the IFE Line
    Illustration of IFE Line (When Exchange Rate Changes Perfectly Offset Interest
    Rates Differentials)

    8.5
    B. International Fisher Effect (IFE)

    5. Test of the International Fisher Effect


    a. Results from testing the IFE
    b. Statistical Test of the IFE
    B. International Fisher Effect (IFE)

    6. Why the international Fisher Effect Does


    Not Occur
    a. PPP does not hold in certain times
    b. Since IFE based on PPP, it does
    not hold consistently either
    C. Interest Rate Parity (IRP)

    1. Concept of Interest Rate Parity

    2. Determining the Forward Premium


    a. Relationship between Forward
    Premium and Interest Rate
    Differential
    b. Implications
    C. Interest Rate Parity (IRP)

    3. Graphic Analysis of Interest Rate


    Parity
    a. Points Representing a Discount
    b. Points Representing a Premium
    c. Points representing IRP
    Illustration of Interest Rate Parity

    7.9
    C. Interest Rate Parity (IRP)

    4. How to Test Whether Interest Rate


    Parity Exists

    5. Interpretation of Interest Rate Parity

    6. Does Interest Rate Parity Hold?


    C. Interest Rate Parity (IRP)

    7. Consideration When Assessing Interest


    Rate Parity
    a. Transaction Costs
    b. Political Risk
    c. Differential Tax Laws
    8. Forward Premiums across Maturity
    Markets
    9. Changes in Forward Premiums
    D. Comparison of the IRP, PPP, and IFE
    Theories

    8.7

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