Consider two alternative ways of investing your fund: (1) invest 1
Suppose that you have $1 to invest over, say, a one-year period. Interest Rate Parity Interest rate parity (IRP) is an arbitrage condition that must hold when international financial markets are in equilibrium.
Let us begin our discussion with interest rate parity. Such well-known parity relationships as interest rate parity and purchasing power parity, in fact, represent arbitrage equilibrium conditions. The market can be said to be in equilibrium when no profitable arbitrage opportunities exist. As long as there are profitable arbitrage opportunities, the market cannot be in equilibrium. The term arbitrage can be defined as the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits. Since arbitrage plays a critical role in the ensuing discussion, we should define it upfront.
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Some of these are, in fact, manifestations of the law of one price that must hold in arbitrage equilibrium.1 An understanding of these parity relationships provides insights into (1) how foreign exchange rates are determined, and (2) how to forecast foreign exchange rates. To that end, this chapter examines several key international parity relationships, such as interest rate parity and purchasing power parity, that have profound implications for international financial management. Technical Approach Performance of the Forecasters Summary Key Words Questions Problems Internet Exercises MINI CASE: Turkish Lira and Purchasing Power Parity References and Suggested Readings APPENDIX 6A: Purchasing Power Parity and Exchange Rate DeterminationįOR COMPANIES AND investors alike, it is important to have a firm understanding of the forces driving exchange rate changes as these changes would affect investment and financing opportunities. International Parity Relationships and Forecasting Foreign Exchange Rates Interest Rate Parity Covered Interest Arbitrage Interest Rate Parity and Exchange Rate Determination Reasons for Deviations from Interest Rate Parity Purchasing Power Parity PPP Deviations and the Real Exchange Rate Evidence on Purchasing Power Parity Fisher Effects Forecasting Exchange Rates Efficient Market Approach Fundamental Approach International Parity Relationships and Forecasting Foreign Exchange Rates The Foreign Exchange Market, Exchange Rate Determination, and CurrencyĦ. Eun−Resnick: International Financial Management, Fourth Edition