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What's the deal with international parity conditions?
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.
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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.
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.
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.