International Parity Conditions

"Prices, Interest Rates, and Exchange Rates in Equilibrium" (International Parity Conditions)

Table of Content

Executive Summary………………………………………………………3

1. Introduction………………………………………………………….4

2. Literature Review……………………………………………………6

3. Findings and Analysis: ………………………………………………10

a. PPP………………………………………………..…………10

b. FE……………………………………………..……………..12

c. IFE…………………………………………..……………….14

4. Conclusion & Recommendations …………….……..………………16

Bibliography……………………………………………………………….17

Appendix A. Historical Data………………………………………………18

Table of Figures

"Prices, Interest Rates, and Exchange Rates in Equilibrium" (International Parity Conditions)

Table of Content

Executive Summary………………………………………………………3

1. Introduction………………………………………………………….4

2. Literature Review……………………………………………………6

3. Findings and Analysis: ………………………………………………10

a. PPP………………………………………………..…………10

b. FE……………………………………………..……………..12

c. IFE…………………………………………..……………….14

4. Conclusion & Recommendations …………….……..………………16

Bibliography……………………………………………………………….17

Appendix A. Historical Data………………………………………………18

Table of Figures

Figure 1. International Parity Conditions

Figure 2. Scatter Diagram for PPP

Figure 3. Time-series data for inflation rates differential and exchange rate change

Figure 4. Regression Plot for PPP

Figure 5. Scatter Diagram for FE

Figure 6. Time-series data for inflation and interest rates differentials

Figure 7. Regression Plot for FE

Figure 8. Scatter Diagram for IFE

Figure 9. Time-series data for interest rates differentials and exchange rate change

Figure 10. Regression Plot for IFE

Executive Summary

This assignment is aimed at examining the evidence for three of the relationships that

underpin (explicitly or implicitly) much of international macroeconomics. The first is

purchasing power parity (PPP), or the hypothesis that there exists a constant long-run

equilibrium real exchange rate. The second is Fisher Effect, which tests the relationship

between difference in inflation rates and difference in nominal interest rates. The third

establishes a relationship between real exchange rates and real interest rate

differentials or International Fisher Effect. The tests are conducted on a basis of two

economies: United States and Kazakhstan. The results are obtained using graphs and

regression models, which significantly increase the power of the tests. The empirical

evidence is evaluated on the basis of historical data for the period of 1999-2003.

Figure 2. Scatter Diagram for PPP

Figure 3. Time-series data for inflation rates differential and exchange rate change

Figure 4. Regression Plot for PPP

Figure 5. Scatter Diagram for FE

Figure 6. Time-series data for inflation and interest rates differentials

Figure 7. Regression Plot for FE

Figure 8. Scatter Diagram for IFE

Figure 9. Time-series data for interest rates differentials and exchange rate change

Figure 10. Regression Plot for IFE

Executive Summary

This assignment is aimed at examining the evidence for three of the relationships that

underpin (explicitly or implicitly) much of international macroeconomics. The first is

purchasing power parity (PPP), or the hypothesis that there exists a constant long-run

equilibrium real exchange rate. The second is Fisher Effect, which tests the relationship

between difference in inflation rates and difference in nominal interest rates. The third

establishes a relationship between real exchange rates and real interest rate

differentials or International Fisher Effect. The tests are conducted on a basis of two

economies: United States and Kazakhstan. The results are obtained using graphs and

regression models, which significantly increase the power of the tests. The empirical

evidence is evaluated on the basis of historical data for the period of 1999-2003.

The paper is divided into two main parts. The first part contains analysis of the

historical data about interest rates, exchange rates, and 3-month T-bills (Kazakhstani

name: MEKKAM) in two countries: Kazakhstan and USA. The second part gives implications

based on the results of analysis.

Introduction

The core of international finance theory lies in international parity conditions. They

bring together prices, interest rates, and exchange rates. As expected rate of change in

the spot exchange rate, differential rates of national inflation and interest, forward

discount or premium are all interrelated, a change in one of them leads to a change in all

the rest, so that the first variable changes again.

In our work we test whether International Parity Conditions hold in the context of the Kazakhstani economy.

In our research we intend to examine the theory of Purchasing power parity, Fisher effect,

International Fisher effect, Interest rate parity, and Forward rate as an unbiased

predictor of the future spot rate.

Scope of the study

For the purposes of this study we obtain time series data on the American and Kazakhstani

interest rates, inflation rates, and exchange rate statistics on quarterly basis for five

years (1999-2003).

Limitations

In this paper we consider parity conditions between US and Kazakhstan. Kazakhstani Stock

Exchange doesn't trade forward contracts; therefore we are not able to test such

conditions as forward rate as unbiased predictor of the future spot rate and interest rate

parity. Furthermore, some months T-bills were not issued, that's why we will omit these

months in our analysis.

Significance of the study

The study represents an empirical evidence of international parity conditions. It helps

explain the long run trend in an exchange rate. This study will help to understand how

multinational business is conducted and financed.

Literature review

Alan Shapiro in "Multinational Financial Management" affirms that there are five parity

conditions resulted from arbitrage activities based on law of one price: Purchasing Power

Parity (PPP); The Fisher Effect (FE); The International Fisher Effect (IFE); Interest Rate

Parity (IRP); Unbiased Forward Rate (UFR).

Michael H. Moffet, et al in "Fundamentals of Multinational Finance" say that the PPP is

not particularly helpful in determining what the spot rate is today, but that the relative

change in prices between countries over a period of time determines the change in exchange

rates. Moreover, if the spot rate between 2 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 rate.

months in our analysis.

Significance of the study

The study represents an empirical evidence of international parity conditions. It helps

explain the long run trend in an exchange rate. This study will help to understand how

multinational business is conducted and financed.

Literature review

Alan Shapiro in "Multinational Financial Management" affirms that there are five parity

conditions resulted from arbitrage activities based on law of one price: Purchasing Power

Parity (PPP); The Fisher Effect (FE); The International Fisher Effect (IFE); Interest Rate

Parity (IRP); Unbiased Forward Rate (UFR).

Michael H. Moffet, et al in "Fundamentals of Multinational Finance" say that the PPP is

not particularly helpful in determining what the spot rate is today, but that the relative

change in prices between countries over a period of time determines the change in exchange

rates. Moreover, if the spot rate between 2 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 rate.

As for empirical tests, they say that both relative and absolute purchasing power parity

show that for the most part, PPP tends to not be accurate in predicting future exchange

rates. Two general conclusions can be drawn from the tests:

• PPP holds up well over the very long term but is poor for short term estimates

• The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets.

Georgios E. Chortareas and Rebecca L. Driver in "PPP and the real exchange rate-real

interest rate differential puzzle revisited: evidence from non-stationary panel data"

state that the results show that there is little direct evidence to support PPP, i.e. the

proposition that the real exchange rate is constant, or at least mean-reverting, in the

long run. This evidence is obtained by examining the stationarity of the real exchange

rate. The failure to find PPP contradicts the evidence from recent applications of

non-stationary panel techniques to the real exchange rate. It suggests that, even with the

new more powerful techniques, finding PPP may still be heavily sample-dependent.

The Fisher Effect states that nominal interest rates (r) are a function of the real

interest rate (a) and a premium (i) for inflation expectations: R = a i. Real Rates of

Interest should tend toward equality everywhere through arbitrage; with no government

interference nominal rates vary by inflation differential or rh - rf = ih - if. According

to the Fisher Effect, countries with higher inflation rates have higher interest rates .

Jafar A. Khondaker in "Real Interest Rate Parity and the Modeling of the Real Exchange

Rate" provides a clear understanding of the meaning of real interest rate parity. It then

presented an accounting framework to argue that real interest rates cannot equalize even

in the long run in the presence of country- and currency-premium. He can, however,

conclude that whatever evidence was uncovered using Johansen's maximum likelihood-based

cointegration tests is consistent with the hypothesis that even in the long run real

interest rates between the five industrialized countries in the sample do not become

equal. The evidence is rather consistent with a parity relationship that may include a

risk premium.

Frankel (1993) discusses the relationship between the different theories and assumptions,

while Meese and Rogoff (1988) probably provides the classic derivation of the relationship

between real exchange rates and real interest rates investigated here. However, despite

the theoretical and intuitive appeal both of the real exchange rate real-interest rate

differential relationship and of its underlying components, the empirical evidence for

these propositions (either separately or collectively) has at best been mixed.

The American Graduate School of International Management "Thunderbird" (2003) states that

there is also an effective exchange rate, which is a multilateral rate that measures the

overall nominal value of the currency in the foreign exchange market. For example, the

effective U.S. dollar exchange rate combines many bilateral exchange rates using a

weighting scheme that reflects the importance of each country's trade with the United

Rate" provides a clear understanding of the meaning of real interest rate parity. It then

presented an accounting framework to argue that real interest rates cannot equalize even

in the long run in the presence of country- and currency-premium. He can, however,

conclude that whatever evidence was uncovered using Johansen's maximum likelihood-based

cointegration tests is consistent with the hypothesis that even in the long run real

interest rates between the five industrialized countries in the sample do not become

equal. The evidence is rather consistent with a parity relationship that may include a

risk premium.

Frankel (1993) discusses the relationship between the different theories and assumptions,

while Meese and Rogoff (1988) probably provides the classic derivation of the relationship

between real exchange rates and real interest rates investigated here. However, despite

the theoretical and intuitive appeal both of the real exchange rate real-interest rate

differential relationship and of its underlying components, the empirical evidence for

these propositions (either separately or collectively) has at best been mixed.

The American Graduate School of International Management "Thunderbird" (2003) states that

there is also an effective exchange rate, which is a multilateral rate that measures the

overall nominal value of the currency in the foreign exchange market. For example, the

effective U.S. dollar exchange rate combines many bilateral exchange rates using a

weighting scheme that reflects the importance of each country's trade with the United

States. Several institutions (for example, the International Monetary Fund, the Federal

Reserve Board) regularly calculate and report the effective exchange rates. There is also

a real effective exchange rate, adjusting for multilateral PPP relationships.

The relationship between exchange rates and nominal interest rates is captured in two

simple propositions: (1) the covered interest parity theorem (CIP) which deals with a

no-arbitrage equilibrium in international financial markets, and (2) the speculative

efficiency hypothesis and the resulting uncovered parity theorem (UIP) which deals with a

speculative equilibrium in international financial markets.

Covered interest parity is the mechanism through which an equilibrium relationship is

established between spot and forward exchange rates, and risk-equivalent domestic and

foreign nominal interest rates. This relationship is also sometimes referred to as the

interest rate parity theorem or the covered interest arbitrage condition.

Empirical tests generally show that the forward rate is not a very good predictor of the

level of the future spot rate (it explains about 10% of the change in the actual future

exchange rates). However, evidence is strong that the forward rate does a better job of

predicting at least the direction of changes to future spot rates than do about two-thirds

of the better known foreign exchange forecasting services, making it one of the better

predictors around .

Reserve Board) regularly calculate and report the effective exchange rates. There is also

a real effective exchange rate, adjusting for multilateral PPP relationships.

The relationship between exchange rates and nominal interest rates is captured in two

simple propositions: (1) the covered interest parity theorem (CIP) which deals with a

no-arbitrage equilibrium in international financial markets, and (2) the speculative

efficiency hypothesis and the resulting uncovered parity theorem (UIP) which deals with a

speculative equilibrium in international financial markets.

Covered interest parity is the mechanism through which an equilibrium relationship is

established between spot and forward exchange rates, and risk-equivalent domestic and

foreign nominal interest rates. This relationship is also sometimes referred to as the

interest rate parity theorem or the covered interest arbitrage condition.

Empirical tests generally show that the forward rate is not a very good predictor of the

level of the future spot rate (it explains about 10% of the change in the actual future

exchange rates). However, evidence is strong that the forward rate does a better job of

predicting at least the direction of changes to future spot rates than do about two-thirds

of the better known foreign exchange forecasting services, making it one of the better

predictors around .

The market for foreign exchange is the largest market in the world. Transactions in the

foreign exchange market well exceed $1 trillion daily. The market operates almost

twenty-four hours a day, so that somewhere in the world, at any given time, there is a

market open in which you can trade foreign exchange.

Nearly nine-tenths of the trades across the world involve the U.S. dollar. The reasons for

this are three-fold. One, the U.S. dollar is still the most heavily traded currency

worldwide and is the reference currency for denominating the prices of a number of

globally traded products such as oil, aircraft, gold, and so forth. Two, triangular

arbitrage opportunities are rarely present in the foreign exchange markets for the heavily

traded currencies. In other words, if the price of currency A is known with respect to B

and C, the price of B in terms of C is automatically determined, otherwise there would be

a costless arbitrage opportunity—traders quote prices as though such arbitrage

opportunities are not present and thus, the arbitrage opportunity is non-existent in the

first place. Three, the dollar-based quotation dramatically reduces information

complexity. It is far easier for a trader to remember, say, eight currency quotes against

the U.S. dollar and derive the rest by assuming absence of triangular arbitrage

opportunities, rather than remember the 9*8/2 = 36 pairwise currency quotes (including

those for the U.S. dollar) that actually prevail.

Both direct and indirect quotes (against the U.S. dollar) are simultaneously used in

foreign exchange markets, depending on the currency involved. For instance, the Euro and

foreign exchange market well exceed $1 trillion daily. The market operates almost

twenty-four hours a day, so that somewhere in the world, at any given time, there is a

market open in which you can trade foreign exchange.

Nearly nine-tenths of the trades across the world involve the U.S. dollar. The reasons for

this are three-fold. One, the U.S. dollar is still the most heavily traded currency

worldwide and is the reference currency for denominating the prices of a number of

globally traded products such as oil, aircraft, gold, and so forth. Two, triangular

arbitrage opportunities are rarely present in the foreign exchange markets for the heavily

traded currencies. In other words, if the price of currency A is known with respect to B

and C, the price of B in terms of C is automatically determined, otherwise there would be

a costless arbitrage opportunity—traders quote prices as though such arbitrage

opportunities are not present and thus, the arbitrage opportunity is non-existent in the

first place. Three, the dollar-based quotation dramatically reduces information

complexity. It is far easier for a trader to remember, say, eight currency quotes against

the U.S. dollar and derive the rest by assuming absence of triangular arbitrage

opportunities, rather than remember the 9*8/2 = 36 pairwise currency quotes (including

those for the U.S. dollar) that actually prevail.

Both direct and indirect quotes (against the U.S. dollar) are simultaneously used in

foreign exchange markets, depending on the currency involved. For instance, the Euro and

the British pound are quoted in direct terms (number of dollars per currency unit), while

the Kazakhstani Tenge is quoted indirectly (the number of tenge per dollar).

There is a large volume of research on the underlying fundamentals that determine currency

values. In the short run (hour to hour, or even over days), such fundamentals do not seem

to matter much, since currency trading and speculation are driven almost entirely by

technical considerations. This is consistent with the fact that direct deals account for a

large proportion of foreign exchange transactions.

It is for these reasons that currency forecasting is an exercise that is, at best, tenuous

and, at worst, somewhat pointless. Therefore, the list of variables and the effects

indicated above should be used with a fair amount of caution. The role of an MNE manager

is not to forecast exchange rates; rather, it is (a) to appreciate the fact that the

uncertainty induced by this aspect of the international environment is real and

ubiquitous, and (b) to manage and plan for the effects of this uncertainty on the

operations and performance of the firm. This in turn requires us to understand the

different ways in which MNEs are exposed to exchange rates.

If we combine the insights from RPPP and UIP, we obtain another interesting implication,

known as the international Fisher effect. It says that real interest rates, i.e., the

nominal interest rates adjusted for inflation expectations, must be the same both at home

and abroad. In other words, it implies the following: when goods markets are in

the Kazakhstani Tenge is quoted indirectly (the number of tenge per dollar).

There is a large volume of research on the underlying fundamentals that determine currency

values. In the short run (hour to hour, or even over days), such fundamentals do not seem

to matter much, since currency trading and speculation are driven almost entirely by

technical considerations. This is consistent with the fact that direct deals account for a

large proportion of foreign exchange transactions.

It is for these reasons that currency forecasting is an exercise that is, at best, tenuous

and, at worst, somewhat pointless. Therefore, the list of variables and the effects

indicated above should be used with a fair amount of caution. The role of an MNE manager

is not to forecast exchange rates; rather, it is (a) to appreciate the fact that the

uncertainty induced by this aspect of the international environment is real and

ubiquitous, and (b) to manage and plan for the effects of this uncertainty on the

operations and performance of the firm. This in turn requires us to understand the

different ways in which MNEs are exposed to exchange rates.

If we combine the insights from RPPP and UIP, we obtain another interesting implication,

known as the international Fisher effect. It says that real interest rates, i.e., the

nominal interest rates adjusted for inflation expectations, must be the same both at home

and abroad. In other words, it implies the following: when goods markets are in