Chapter 4

Chapter 4

International Financial Markets Prices and Policies Second Edition 2001 Richard M. Levich 4 McGraw Hill / Irwin International Parity Conditions: Purchasing Power Parity 4-2 Overview The Usefulness of Parity Conditions in International Financial Markets An Overview of International Parity Conditions in a Perfect Capital Market

Purchasing Power Parity in a Perfect Capital Market The Law of One Price Absolute Purchasing Power Parity Relative Purchasing Power Parity The Real Exchange Rate and Purchasing Power Parity McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 4-3 Overview Relaxing the Perfect Capital Market Assumptions Transaction Costs Taxes Uncertainty McGraw Hill / Irwin

2001 by The McGraw-Hill Companies, Inc. All rights reserved. 4-4 Overview Empirical Evidence on Prices and Exchange Rates Empirical Methods, or How to Test a Parity Condition Evidence on the Law of One Price Relative PPP: Evidence from Recent Quarterly Data Relative PPP: Evidence from Hyperinflationary Economies Relative PPP: Evidence from Long-Run Data Empirical Tests of PPP: Is the Real Exchange Rate Constant? Empirical Tests of PPP: The Final Word McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 4-5

Overview Policy Matters - Private Enterprises The Role of Parity Conditions for Management Decisions Purchasing Power Parity and Managerial Decisions Purchasing Power Parity and Product Pricing Decisions Policy Matters - Public Policymakers McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions 4-6 in International Financial Markets Parity conditions can be thought of as international

financial benchmarks or break-even values. They are the defining points where the decision-maker is indifferent between the two strategies summarized by the two halves of the parity relation. Because parity conditions rely heavily on arbitrage, a violation of parity often implies that a profit opportunity or cost advantage is available to the decision-maker. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions 4-7 in International Financial Markets We begin our analysis of international parity conditions by assuming a perfect capital market

(PCM) setting: no transaction costs no taxes complete certainty Based on the PCM assumptions, there are four principle parity conditions in international finance, of which only three are independent. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions 4-8 in International Financial Markets 1a. Purchasing Power Parity Absolute Version The price of a market basket of U.S. goods equals the price of a market basket of foreign goods when

multiplied by the exchange rate. PUS PUK Spot Driven by arbitrage in goods. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions 4-9 in International Financial Markets 1b. Purchasing Power Parity Relative Version The percentage change in the exchange rate equals the percentage change in U.S. goods prices less the percentage change in foreign goods prices. Spot PUS PUK Driven by arbitrage in goods. McGraw Hill / Irwin

2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions 4 - 10 in International Financial Markets 2. Interest Rate Parity The forward exchange rate premium equals (approximately) the U.S. interest rate minus the foreign interest rate. F S S i$ i Driven by arbitrage between the spot and forward exchange rates, and money market interest rates. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

The Usefulness of Parity Conditions 4 - 11 in International Financial Markets 3a. Fisher Parities Fisher Effect (Fisher Closed) For a single economy, the nominal interest rate equals the real interest rate plus the expected rate of inflation. ~ i$ r$ E PUS Driven by desire to insulate the real interest against expected inflation, and arbitrage between real and nominal assets. McGraw Hill / Irwin

2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions 4 - 12 in International Financial Markets 3b. Fisher Parities International Fisher Effect (Fisher Open) For two economies, the U.S. interest rate minus the foreign interest rate equals the expected percentage change in the exchange rate. ~ i$ i E Spot Driven by arbitrage in bonds denominated

in two currencies. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions 4 - 13 in International Financial Markets 4. Forward Rate Unbiased Todays forward premium (for delivery in n days) equals the expected percentage change in the spot rate (over the next n days). Ft St ~ St E St n St St

Driving force: Market players monitor the difference between todays forward rate (for delivery in n days) and their expectation of the future spot rate (n days from today). McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity 4 - 14 in a Perfect Capital Market Purchasing power parity (PPP) is built on the notion of arbitrage across goods markets and the Law of One Price. The Law of One Price is the principle that in a PCM setting, homogeneous goods will sell for the same price in two markets, taking into account the exchange rate.

PUS, wheat PUK,wheat S$ / McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity 4 - 15 in a Perfect Capital Market Let PUS and PUK represent the weighted average price level for goods in the U.S. and U.K. market baskets respectively. Absolute PPP predicts that these two price measures will be equal after adjusting for the exchange rate: PUS = S$/ PUK Absolute PPP requires that the consumption baskets are identical across the two countries. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

4 - 16 Purchasing Power Parity in a Perfect Capital Market Suppose absolute PPP is violated. Introduce K so that: PUS, t +1 = K S$/, t +1 PUK, t +1 PUS, t = K S$/, t PUK, t where s (a) (b) pUS = s + pUK + s pUK S$/, t 1 S$/, t S$/, t , pUS PUS, t 1 PUS, t

PUS, t , pUK PUK, t 1 PUK, t PUK, t For small % changes, or when continuous rates are used, the cross-product term s pUK can be ignored. % exchange rate = % U.S.prices % U.K.prices McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity 4 - 17 in a Perfect Capital Market Often, we are interested in the level of the exchange rate that satisfies PPP. The PPP spot rate reestablishes PPP relative to

a base period. It is the exchange rate that would just offset the relative inflation between a pair of countries since the base period. (a) (b) McGraw Hill / Irwin S PPP ,t 1 S$ / , t PUS, t 1 PUS, t PUK, t 1 PUK, t 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity 4 - 18 in a Perfect Capital Market Example

Base period nominal exchange rate = $1.50/ Prices of U.S. goods had risen by 8% Prices of U.K. goods had risen by 4% PPP spot rate = $1.50/ 1.08/1.04 = $1.5577/ A nominal exchange rate of $1.5577/ would reestablish PPP in comparison to the base period. Nominal exchange rates greater than $1.5577/ represent overvaluation ($ undervaluation), while rates less than $1.5577/ represent $ overvaluation ( undervaluation). McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity 4 - 19 in a Perfect Capital Market PPP conditions do not imply anything about causal linkages between prices and exchange rates or vice versa.

Both prices and exchange rates are jointly determined by other variables in the economy. PPP is an equilibrium condition that must be satisfied when the economy is at its long-term equilibrium. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity 4 - 20 in a Perfect Capital Market Real magnitudes are constructed from nominal magnitudes by adjusting for the appropriate price levels or inflation rates. Example Nominal income in 2000 (base year) = $55,000/year Real = $55,000/year = 220 market baskets/year income $250/market basket Nominal income in 2001 = $60,500/year

Real = $60,500/year = 224.07 mkt baskets/year income $270/market basket Index (2001) = 224.07/220 = 1.0185 McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity 4 - 21 in a Perfect Capital Market The real exchange rate is calculated by correcting the nominal exchange rate for the price levels in the two countries. When absolute PPP holds: $1.50/ = $1,500/US good 1,000/British good .

LHS = 1 US good / British good RHS When PPP holds, the real exchange rate is constant. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity 4 - 22 in a Perfect Capital Market An index of the real exchange rate is defined as: Spot (Real, t) = Spot (Nominal, t) Spot (PPP, t) .

Example Todays spot exchange rate is $1.80/ PPP spot rate is $1.50/ Real exchange rate index = 1.80/1.50 = 1.20 At 1.20, the is overvalued on a PPP basis. 1.0 British good can be exchanged for 1.2 U.S. goods. So, sellers of British goods have lost competitiveness on international markets. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Relaxing the 4 - 23 Perfect Capital Market Assumptions Transaction Costs Transport and menu costs lead to a neutral band

around the PPP line, within which it is not profitable to execute arbitrage transactions. Taxes Tariffs have an effect similar to transaction costs. Uncertainty Arbitrageurs will seek a greater profit to compensate for risks, thus leading to a wider band around the PPP line before arbitrage becomes profitable. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on 4 - 24

Prices and Exchange Rates A parity condition can be viewed as a 45 line passing through the origin with the LHS and RHS variables plotted on the x and y axes. Thus, parity conditions can be tested by running the simple linear regression: LHSt = + RHSt + t Parity holds when the data cannot reject a null hypothesis where = 0, = 1, and the error terms have classical properties. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on 4 - 25 Prices and Exchange Rates In reality, seemingly homogeneous goods may differ in a number of important respects which undermine tests of the Law of One Price. One test of the Law of One Price is the Big Mac

index, which has been published annually in The Economist since 1986. It was devised as a light-hearted guide to whether currencies are at their correct level, based on PPP. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on 4 - 26 Prices and Exchange Rates 1.60 1.40 Ratio of Big Mac Prices in US$ Relative to U.S. Price U.S. Price is $2.51/Big Mac

1.20 1.00 0.80 0.60 0.40 0.20 Israel Switzerland Denmark Britain Japan South Korea Sweden France United States Argentina Chile Euro Area Germany Taiwan Mexico Italy Spain

Canada Singapore Indonesia New Zealand Brazil Australia Thailand Czech Rep Russia South Africa Hong Kong Poland Hungary China Malaysia 0.00 McGraw / Irwin Source: TheHill Economist,

April 29, 2000 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on 4 - 27 Prices and Exchange Rates With the rise of e-commerce, investigating the Law of One Price becomes easier and violations more puzzling. A recent Wall Street Journal article highlighted the case of a popular book that sold for $16.20 at Amazon.com (U.S.), for $13.52 at Amazon.co.uk (Britain), and for $27.00 at Amazon.de (Germany). McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Empirical Evidence on 4 - 28 Prices and Exchange Rates To examine the relative PPP condition, we can compare the exchange rate change to the contemporaneous inflation differential: st = + (p$ pDM)t + t It seems that PPP is a poor explanation of exchange-rate changes on a period-by-period basis. However, there is a tendency for PPP to reassert itself as time passes (mean reversion). McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Quarterly Deviations from Relative PPP 4 - 29 CPI: Germany and the United States, 1973-1999

= 0.003 = 0.15 R2 = 0.003 N = 107 (0.007) (0.83) DW = 1.83 0.20 % Deviations 0.15 Spot Rate Changes 0.10 0.05 0.00 -0.05 Average Inflation Difference -0.10 -0.15

(US-German) Inflation 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on 4 - 30 Prices and Exchange Rates During a hyperinflation period, even the demanding regression-style test tends to support PPP. This is due in some degree to dollarization. Long-run data indicated that the real exchange rate did not evolve as a random walk, but demonstrated a clear tendency to revert back to its central value. McGraw Hill / Irwin

2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on 4 - 31 Prices and Exchange Rates Note that the real exchange rate itself may not be constant. It may change on a permanent basis if a real shock affected one country but not its trading partners. The Balassa-Samuelson hypothesis states that countries that have experienced high productivity gains, higher real income growth and higher real incomes should have appreciating real exchange rates. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Empirical Evidence on 4 - 32 Prices and Exchange Rates Empirical tests confirm that ... PPP is a poor descriptor of exchange rate behavior in the short run, where the rates are quite volatile and domestic prices are somewhat sticky. But in longer-run analysis, it appears that PPP offers a reasonably good guide. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 4 - 33 Policy Matters - Private Enterprises If managers can identify the deviations from parity that are growing larger or likely to persist, then profit-maximizing decisions can be

made. Knowing that deviations from parity occur, managers may adopt strategies that reduce their exposure to the risks of such deviations. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 4 - 34 Policy Matters - Private Enterprises In a number of instances, international price differentials in some commodities have been both large and persistent. More interesting perhaps are the international price differentials across branded goods like McDonalds Big Mac and The Economist, whose prices are set by brand managers rather than by market forces. McGraw Hill / Irwin

2001 by The McGraw-Hill Companies, Inc. All rights reserved. 4 - 35 Policy Matters - Public Policymakers Deviations from PPP, by definition, measure changes in a countrys international competitiveness, and reveal whether a currency is overvalued or undervalued relative to a simple standard. However, there are limitations on the usefulness of PPP in policy decisions, as real macroeconomic disturbances call for a change in the real exchange rate. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Recently Viewed Presentations

  • Spatial Computation

    Spatial Computation

    Ideal Architecture Spatial Computation Thesis committee: Seth Goldstein Peter Lee Todd Mowry Babak Falsafi Nevin Heintze Ph.D. Thesis defense, December 8, 2003 Thesis Statement Application-Specific Hardware (ASH): can be synthesized by adapting software compilation for predicated architectures, provides high-performance for...
  • emésztő - SotePedia

    emésztő - SotePedia

    Egyes fehérjék kis mennyiségben változatlan formában is felszívódhatnak jelentős szerepet játszva az ételallergia kialakulásában emésztő 2 Emésztés, felszívódás, transzport, kiválasztás Mechanikus folyamat: darabolás, keverés, szállítás Emésztőenzimek: fehérjék, szénhidrátok, (epe jelenlétében) zsírok ...
  • Kiwanis Club of Jacksonville Beaches Florida District ...

    Kiwanis Club of Jacksonville Beaches Florida District ...

    Ross Edwards To give primacy to the human & spiritual rather than the material values of life. To encourage the daily living of the Golden Rule in all human relationships. To promote the adoption & the application of higher social,...
  • Chapter 14: Organometallics, structure and nomenclature H CR3

    Chapter 14: Organometallics, structure and nomenclature H CR3

    Yager, Ashley M Cutrona, Amparo Loreta Oliver, Rayshone Moniq . Fairchild, William Manchi, Sarah Elizabet Spirtos, Lewis M Fusselman, Gregory Dan Domer, Brittany Anne Merkel, Shane Darrenle Wharry, William Michae
  • SPARK a Reaction, D A E R !

    SPARK a Reaction, D A E R !

    An international team of scientists has found more evidence that massive black holes are surrounded by a doughnutshaped gas cloud which, depending on our line of sight, blocks the view of the black hole in the center.-nasa.gov, June 20, 2004
  • FIUME E ABBAZIA (1938 - 1944) - Anna Pizzuti

    FIUME E ABBAZIA (1938 - 1944) - Anna Pizzuti

    Fiume: serie di elenchi di ebrei residenti e profughi residenti a Fiume e in altre località della Provincia del Carnaro da sottoporre a provvedimenti di allontanamento o fermo in previsione della dichiarazione dello stato di guerra ACS, MI, Dgps, Dagr,...
  • Market Segmentation, Positioning and the Value Proposition

    Market Segmentation, Positioning and the Value Proposition

    Market Segmentation, Positioning and the Value Proposition with Duane Weaver OUTLINE Marketing Strategies Identifying Target Segments Prioritizing Target Segments - SWOTs Positioning Strategy Value Proposition Seminar Discussion Marketing Strategies Target Segment subgroup chosen as focal point for the marketing program...
  • English Literature Yr 10 End of Year revision

    English Literature Yr 10 End of Year revision

    Explore how Shakespeare presents the relationship between Macbeth and Banquo (extract Act 3 Scene 1). Mention honour between men and how Macbeth has ignored loyalty over ambition - killing his best friend to reach goal of being king. Relationship is...