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Law of One Price
"Producers' prices for goods or services of identical quality should be the same in different markets (i.e., countries) (assuming no restrictions on the sale and allowing for transportation costs).
If a country has higher inflation than other countries, its currency should devalue or depreciate so that the real price remains the same as in all countries.
Applications of this law results in the theory of PPP.
Absolute Purchasing Power Parity
If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices.
By comparing the prices of identical products denominated in different currencies, one could determine the "real" or PPP exchange rate which should exist if markets were efficient.
This is the absolute version of the theory of purchasing power parity. Absolute PPP states that the spot exchange rate is determined by the relative prices of similar baskets of goods.
Relative Purchasing Power Parity
PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period.
More specifically, if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate.
Exchange Rate Pass-Through
Incomplete exchange rate pass-through is one reason that a country’s real effective exchange rate index can deviate for lengthy periods from its PPP-equilibrium level of 100.
The degree to which the prices of imported and exported goods change as a result of exchange rate changes is termed pass-through.
Although PPP implies that all exchange rate changes are passed through by equivalent changes in prices to trading partners, empirical research in the 1980s questioned this long-held assumption.
International Fisher Effect
"The spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries."
The real return in different countries should be the same, so that if one country has a higher nominal interest rate, the gain from investing in that currency will be lost by a deterioration of its exchange rate.
The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets
Short-term Forecasts Fixed Exchange Rate
Typically motivated by a desire to hedge a receivable, payable, or dividend, for perhaps a period of three months.
The long-run economic fundamentals may not be as important as technical factors in the marketplace, government intervention, news, and passing whims of traders and investors.
Accuracy of the forecast is critical, since most of the exchange rate changes are relatively small, even though the day-to-day volatility may be high.
Long-term Forecasts Fixed Exchange Rate
May be motivated by a multinational firm's desire to initiate a foreign investment in Japan, or perhaps to raise long-term funds denominated in Japanese yen.
Or a portfolio manager may be considering diversifying for the long term in Japanese securities.
The longer the time horizon of the forecast, the more inaccurate, but also the less critical, the forecast is likely to be.
The forecaster will typically use annual data to display long-run trends in such economic fundamentals as Japanese inflation, growth, and the BOP.
Empirical Tests for PPP
- 1) PPP holds up well over the very
- long run but poorly for shorter time periods and
2) The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets.
Goods and services do not in reality move at zero cost between countries, and in fact many services are not “tradable” (haircuts).
- Many goods and services are not of the same quality across countries, reflecting differences
- in the tastes and resources of the countries of their manufacture and consumption.
< 1 - inelastic (quantity demanded is relatively unresponsive to price changes, often higher pass-through rates)
> 1 - elastic (generally increase price = decrease sales)
Interest Rate Parity (IRP)
- The difference in the national interest
- rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the
- forward rate discount or premium for the foreign currency, except for transaction costs.
Covered Interest Arbitrage (CIA)
The spot and forward exchange markets are not constantly in the state of equilibrium described by interest rate parity. When the market is not in equilibrium, the potential for “riskless” or arbitrage profit exists.
- The arbitrager who recognises such an imbalance will move to take advantage of the disequilibrium by investing in whichever currency offers the higher return
- on a covered basis.
Arbitrage Rule of Thumb
- If the difference in interest rates is greater than the forward premium (or expected change in the spot rate), invest in the higher interest yielding
- currency. If the difference in interest rates is less than the forward premium (or expected
- change in the spot rate), invest in the lower interest yielding currency.
- Nominal interest rates in each country are
- equal to the required real rate of return plus compensation for expected inflation.
Determinants of FX Rates
Balance of Payments
Relative inflation rates
Relative interest rates
Forward exchange rates
Interest rate parity
Balance of Payments
Current account balances
Foreign direct investments
Exchange rate regimes
Official monetary reserves
Asset Market Approach to Forecasting
Relative real interest rates
Prospects for economic growth
Supply and demand for assets
Outlook for political stability
Speculation and liquidity
Political risks and controls
Balance of Payments (Flows) Approaches
The equilibrium exchange rate is found when the net inflow (outflow) of foreign exchange arising from current account activities matches the net outflow (inflow) of foreign exchange arising from financial account activities.
- The exchange rate is determined by the
- supply and demand for national monetary stocks, as well as the expected future levels and rates of growth of monetary stocks.
Asset Market Approach (Relative Price of Bonds)/(Portfolio Balance Approach)
Exchange rates are determined by the supply and demand for financial assets of a wide variety.
Shifts in the supply and demand for financial assets alter exchange rates.
Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter rates.
Exchange Rate Movements
Day-to-day - seemingly random
Short-term - from several days to trends lasting several months
Long-term - characterised by up and down long term trends
(the longer the time horizon, the less accurate the forecast)