Foreign Exchange Rate Parity

Summaries

The followings are the international parity relationships:

Absolute Purchasing Power Parity – Use the average of the absolute prices of goods

Relative PPP – User the change of CPI or GDP deflator

Future rate_t = spot rate (direct quote) X (1+ inflation in DC)^t/ (1+ inflation in FC)^t

Since there is no arbitrage possibility, this equation does not have to be satisfied in short long (usually true in long run)

Since it does not hold in short run (under valued or over valued), we can still use it to determine the long term value of the currency.

International Fisher Relation

Nominal interest rate (DC) – Nominal interest rate (FC) = DC inflation – FC inflation

Exact: (1+r_dc)/(1+r_fc) = (1+inflation_dc)/(1+inflation_fc)

Assume the real rates of both countries are the same.

Uncovered Interest rate parity (direct quote)

Future exchange rate/ Spot exchange rate = (1+r_DC)/(1+r_FC)

This is the same as covered interest rate parity except that future rate is used instead of forward rate

Foreign Exchange Expectation Relation

Forward rate = expected future rate

Asset Market Approach

Find the future rate using relative PPP – this is the equilibrium value of exchange rate

Then find the new spot rate using the future rate calculated with uncovered IRP