IPRawrgag

8/23/2019 IPRawrgag

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Module : 1

Session 4:

International Parity Relationships amongInflation, Interest Rates and Exchange

Rates

8/23/2019 IPRawrgag


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

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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 ratechanges

C. Compare the PPP theory, the IFE theory, and

the theory of interest rate parity (IRP)

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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

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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

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8.1

Illustration of Purchasing Power Parity

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6. Testing the Purchasing Power ParityTheory

a. Conceptual Tests of PPP

1.) choose two countries (say, the UnitedStates and a foreign country)

2.) compare the differential in their inflation rates to the percentagechange in the foreign currency’s

value during several time periods.

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8.2

Identifying Disparity in Purchasing Power

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b. Statistical Test of PPP

c. Results of Tests of PPP

d. Tests of PPP for Each Currencye. Limitations of PPP Tests

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8.3

Comparison of Annual Inflation Differentials and Exchange Rate MovementsFor Four Major Currencies

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7. Why Purchasing Power Parity Does Not

Occur

a. Confounding Effects

b. No Substitutes for Traded

Goods

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1. Relationship with Purchasing Power

Parity

2. Implications of the IFE for Foreign

Investors

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3. Derivation of the International Fisher

Effect

a. Numerical Example based on

the Derivation of IFE

b. Simplified Relationship

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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

ll f ( h h Ch f l Off

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8.5

Illustration of IFE Line (When Exchange Rate Changes Perfectly Offset InterestRates Differentials)

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5. Test of the International Fisher Effect

a. Results from testing the IFE

b. Statistical Test of the IFE

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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

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1. Concept of Interest Rate Parity

2. Determining the Forward Premiuma. Relationship between Forward

Premium and Interest Rate

Differentialb. Implications

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3. Graphic Analysis of Interest Rate

Parity

a. Points Representing a Discount

b. Points Representing a Premium

c. Points representing IRP

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7.9

Illustration of Interest Rate Parity

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4. How to Test Whether Interest Rate Parity

Exists

5. Interpretation of Interest Rate Parity

6. Does Interest Rate Parity Hold?

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7. Consideration When Assessing Interest

Rate Parity

a. Transaction Costs

b. Political Risk

c. Differential Tax Laws

8. Forward Premiums across MaturityMarkets

9. Changes in Forward Premiums

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D. Comparison of the IRP, PPP, and IFE

Theories

8.7

Documents

IPRawrgag