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gives the rate of depreciation of the domestic currency relative to the foreign currency (i.e., X 5 10 2 0 5 10 percent in the above example). 4-4a-(iii) Problems with PPP PPP posits that exchange rate changes are explained by relative prices across countries. However, empirical tests of PPP have found mixed results. While PPP appears to hold in the long run for periods exceeding five years, it may not hold in shorter periods. For countries with large price disparities due to inflation or other reasons, PPP is predictive of exchange rate movements. But for other countries with little difference in inflation rates, PPP is less reliable.11 A variety of problems could explain the failure of PPP for shorter durations of time. Earlier in the text, it was noted that transportation costs and trade barriers cause some discrepancies in prices between countries. Other potential problems include government intervention in trade and exchange rates (e.g., trade restrictions and prohibitions on conversions of local currencies for foreign currencies), multinational firms with pricing power on a global basis (e.g., Microsoft sets prices of its software in different countries), and goods that are not traded but affect internal prices in a country (e.g., rental costs of equipment and property). Moreover, the value of a country’s currency is probably attributable to more than differences in price levels between countries. Market expectations about the economic growth, global competitiveness, monetary and fiscal policy, and many other factors could possibly affect a country’s currency value in world forex markets. Indeed, a nation’s currency is a financial asset of its own, with its complex pricing factors, including relative prices.
4-4b Interest Rate Parity Relative interest rates on financial securities are another possible determinant of exchange rate changes. Under the law of one price, if an investor purchases government bonds in the United States and comparable maturity and risk government bonds in Europe, the rates of return on both should be the same for an individual investor.12 For example, assume that the one-year U.S. Treasury bond rate is 4 percent and the similar European government bond rate is 6 percent. It is worth noting that U.S. bonds pay earnings in dollars and European bonds pay in euros. An investor from the United States would view the higher interest rate European bond as attractive. But, to purchase the European bond, the U.S. investor would need to convert dollars to euros, purchase the European bond with the euros, and then later convert euro earnings on the European bond back to dollars. (The investor could, for example, use forward contracts at the time the bond is purchased to lock in the future dollar-to-euro exchange rate.) For comparison purposes, the U.S. investor would compute the dollar interest rate on the European bond. According to interest rate parity (IRP) theory, the dollar interest rate on the U.S. and European bonds should be the same. Otherwise, there would be arbitrage opportunities for investors to purchase the higher interest rate bond and sell the lower interest rate bond to make riskless profits. If covered interest rate parity holds with no arbitrage profits, we have the following IRP equation: (1 1 iUS) 5 (F/S)(1 1 iE),
(4.2)
where iUS 5 interest rate on U.S. bond paid in dollars iE 5 interest rate on European bond paid in euros F 5 forward dollar to euro exchange rate S 5 spot dollar to euro exchange rate. This equation says that a dollar invested in a U.S. bond earns the same dollar return as a dollar converted to euros and invested in European bonds with euro returns later repatriated
interest rate parity (IRP)
theory stating that interest rates on bonds in different countries should be the same, as investors would buy and sell these bonds to make arbitrage profits until this condition holds
covered interest rate parity
principle implying that forward exchange rates and spot exchange rates set interest rates on bonds in different countries equal to one another
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