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This note reviews the four central parity conditions that underlie most theories regarding the relationship between exchange rates, inflation, and interest rates. The concepts are illustrated through a unified example exploring the relation between the US dollar and the Norwegian krone. The note presents both an intuitive understanding of the relations as well as precise mathematical formulas frequently employed in analysis.ExcerptUVA-F-1572Rev. Oct. 18, 2019Parity Conditions in International MarketsGlobal firms are not the only ones affected by global markets. Even firms with only domestic operations and financing can be dramatically affected by changes in the international landscape associated with, among other things, exchange rate changes, global price changes, and capital market fluctuations.This note presents an overview of the theoretical frameworks that underlie most thinking and discussion about the relations between exchange rates, interest rates, and inflation. All the relations described in this note are based on one premise--that markets will move in response to profit-seeking activities in such a manner as to reach a point where profits are eliminated. When markets are at this zero-profit point and there are no incentives to act, the markets are in equilibrium and deemed to be in "parity." Hence, these basic relations are called parity conditions.Throughout this note, we will consider a single pair of currencies, the US dollar (USD) and the Norwegian krone (NOK). The discussion in this note assumes a familiarity with basic currency terminology and markets; however, a review of these topics is provided in the Appendix. All exchange rates express the relation between two currencies, and both interest and inflation rates are associated with specific currencies. We will introduce notation as concepts are covered. At this point, however, we note that every exchange rate states the value of one currency (we will refer to this as the quoted currency) in terms of another (we will refer to this as the basis currency). We will subscript interest and inflation rates with the letters q and b to indicate whether the rate is for the quoted or basis currencies, respectively.
This book presents an extensive survey of the theory and empirics of international parity conditions which are critical to our understanding of the linkages between world markets and the movement of interest and exchange rates across countries. The book falls into three parts dealing with the theory, methods of econometric testing and existing empirical evidence. Although it is intended to provide a consensus view on the subject, the authors also make some controversial propositions, particularly on the purchasing power parity conditions.
International transactions among nations and multinational corporations are important and growing due to the openness of economies all over the world. In this follow-up title to Exchange Rates and International Financial Economics, Kallianiotis examines the role of the exchange rate and trade policy in improving the trade account. He discusses the international parity conditions extensively, together with the most popular theory in international finance, the interest rate parity (IRP) theory. International Financial Transactions and Exchange Rates describes these theories and gives practical solutions for multinational businesses, individuals, and nations. The increasing internationalization of businesses, openness of economies, integration of nations, change in the exchange rate system, and lastly, the deregulation of the financial market and institutions around the world have made the study of international finance necessary for all business students and professionals.
This note develops the foundations of the ideas underlying much of the theory and practice of International Finance, notably the basic 'parity conditions' linking exchange rates, interest rates, and inflation rates. Specifically, the note develops the ideas of purchasing power parity, speculative efficiency, uncovered interest parity, and the international Fisher effect, and the links among these from a managerial perspective. It includes a brief discussion of the factors driving exchange rate changes in the medium term, and of the three types of exchange rate exposure that cross-border firms face, namely translation exposure, transaction exposure, and economic exposure.
For about three decades until the Global Financial Crisis (GFC), Covered Interest Parity (CIP) appeared to hold quite closely—even as a broad macroeconomic relationship applying to daily or weekly data. Not only have CIP deviations significantly increased since the GFC, but potential macrofinancial drivers of the variation in CIP deviations have also become significant. The variation in CIP deviations seems to be associated with multiple factors, not only regulatory changes. Most of these do not display a uniform importance across currency pairs and time, and some are associated with possible temporary considerations (such as asynchronous monetary policy cycles).
This book extends recent theories of incomplete markets to investigate empirically the appropriate balance between the market and the state in the trade relations between developed and developing countries. The conclusion is that in an ideal world government intervention in foreign exchange and trade is necessary in developing countries in the early stages and inevitably decreases as development occurs. Rationing of foreign exchange prevents a 'soft currency distortion' that commonly afflicts developing countries and can turn comparative advantage trade into competitive devaluation trade, with severe losses of income and welfare. Yotopoulos finds that the level of underdevelopment narrowly circumscribes and conditions the extent to which free-market, free-trade, laissez-faire can be beneficial, contrary to the mainstream policy paradigm as currently applied. The analysis and tests draw on empirical research from seventy countries and four extended country studies to confirm the usefulness and validity of the theoretical framework.
The purpose of this text is to analyze the key financial markets and instruments that facilitate trade and investment activity on a global scale. It spans two key areas: First-the economic determinants of prices, price changes and price relationships in the major financial markets; Second-the policy issues that result from private enterprises and public policymakers.
The book presents all major subjects in international monetary theory, foreign exchange markets, international financial management and investment analysis. The book is relevant to real world problems in the sense that it provides guidance on how to solve policy issues as well as practical management tasks. This in turn helps the reader to gain an understanding of the theory and refines the framework. Various topics are interlinked so the book adopts a systematic treatment of integrated materials relating different theories under various circumstances and combining theory with practice. The text examines issues in international monetary policy and financial management in a practical way, focusing on the identification of the factors and players in foreign exchange markets and the international finance arena. The book can be used in graduate and advanced undergraduate programmes in international or global finance, international monetary economics, and international financial management.
This article conducts empirical research of the state of balance (equal), in regards to simultaneous interest rates across different countries around the globe. It provides a clear insight and reasons for the disagreement between the PPP and IRP. This article also contains the valuation and computation of PPP using the Big Mac index to compare 10 countries' local currency against the dollar (Japan, Thailand, United State, Canada and China etc.). This way we can find out if the currency is overvalued or undervalued. The result from the overall research provides, the connection, disagreement between PPP hypothesis and IRP hypothesis and reasons why international parity holds in some countries plus why it works better with countries with higher inflation rate and underdeveloped capital market, it also discloses the law of one price as an unrealistic theory.