What's the deal with international parity conditions?

rahul12

hi all, first of all sorry if this question is dumb. i still can't get my head around this nor understand the difference between:

• purchasing power parity
• covered and uncovered interest rate parity
• fischer effect

any help to explain this would be much appreciated.

cfachris

Hey, I remember bitching about this back in L2. I've dug out and copied my notes below, hopefully I got it right....

International parity conditions shows the relationship between expected inflation, interest rate differentials, forward exchange rates, and expected future spot exchange rates, and forms the basis of our understanding of long term equilibrium value of exchange rates.

Covered interest rate parity (CIRP)
CIRP basically states that the interest rate differential between two currencies should equal the differential between the forward and spot exchange rates, so that an investor would earn the same return investing in either currency:

Fwd/Spot = (1 + i FC)/(1 + i DC), where Fwd and Spot exchange rate are expressed as Foreign Currency (FC) per Domestic Currency (DC), i = interest rate.

CIRP holds because if it does not hold, arbitrageurs would capitalize and exploit any arbitrage opportunity and make risk-less profit.

Uncovered interest rate parity (UIRP)

UIRP states that the expected movement in exchange rate should equal the interest rate differential.

E(Spot t=1)/Spot = (1 + i FC)/(1 + i DC), where E(S1) is the expected spot rate.

Key difference between CIRP and UIRP is that UIRP deals with expected future exchange rates, and expectations are not market traded, so it is not bound by arbitrage. UIRP tends to hold over the long-term but not over shorter periods, because it assumes that capital markets are efficient. And this can happen when, e.g.

capital flows are restricted or currency forwards are not available. CIRP on the other hand is based on arbitrage.

Purchasing Power Parity (PPP)

Mind you, there are a few versions of this (absolute, relative, ex-ante), but the main gist of it is that it links changes in exchange rates to changes in inflation rates between countries, based on the law of one price. Relative PPP is based on actual changes in exchange rates and inflation rates, whilst ex-ante PPP is based on expected changes in exchange rates and inflation rates.

rahul12

cfachris, thanks so much for sharing your notes man. it does help reading others' explanation sometimes in hope to understand this. i just have to go through the section and try some end of chapter questions to see the implications of each condition i suppose. and hope something sticks this time! you got any notes on fischer effect?