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• Economic theories which explain the relationships between exchange rates, inflation, interest rates, and price levels across different countries are called international parity conditions.
• These conditions aid understanding of financial market behavior under ideal economic circumstances, with no market imperfections like capital controls or transaction costs.

Concerns in International Trade

• Discrepancies can occur if settlement is executed in one currency against another.
• Economic conditions and changes in economic conditions are also concerns.

Parities

• Generally refer to the conditions of equality or equivalence between two economic variables, particularly in international finance and economics.
• Used to describe relationships between exchange rates, interest rates, and purchasing power that should theoretically hold between different economies.
• Value of one currency in terms of another at an established exchange rate.

International Parity Conditions

• Describe the expected equilibrum relationships between exchange rates, interest rates; inflation and interest rates and Real interest rates across countries.

International Parities

• Relationships between the values of two or more currencies and the economic conditions in those countries.
• Show how these relationships respond to changing economic conditions.

Importance of International Parities

• Establish relative currency values.
• Show evolution in terms of economic circumstances.
• Enable cross-border arbitrage when violated.

Three International Parities

• Purchasing power parity (PPP)
• Covered interest rate parity (CIRP)
• Uncovered interest rate parity (UIRP) or the international Fisher effect (IFE).

Purchasing Power Parity

• Concerned with the relative values or the exchange rate of two currencies and the prices in the two countries.
• Based on the idea that currencies have the same purchasing power for the same good sold in both countries.
• Law of one good, one price.

Versions of PPP

• Absolute PPP studies the exchange rate for two currencies with absolute prices for the same basket of goods.
• Relative PPP examines how the exchange rate changes over time in response to changes in the price levels in the two countries.

Absolute Purchasing Power

• Best described by the "law of one good, one price."
• Ph = S x Pf, where:
  • Ph is the price for a good or basket of goods in the domestic or home country.
  • Pf is the price for the same good or basket of goods in the foreign country.
  • S is the exchange rate expressed as the units of the home currency per foreign currency unit.
• S = Ph/Pf

Foreign Currency Derivatives

• Financial derivatives whose payoff depends on the foreign exchange rates of two or more currencies.
• Derivatives are used for hedging foreign exchange risk or for currency speculation and arbitrage.

Examples of Foreign Exchange Derivatives

• Foreign currency forward contracts
• Foreign currency futures
• Foreign currency swaps
• Currency options
• Foreign exchange binary options

Derivatives

• Value is derived from an underlying asset, in this case, a foreign currency.

Foreign Currency Forward and Futures Contracts

• Forward contract is a non-standardized agreement to buy or sell an asset (foreign currency) at a specified future time at a price agreed upon today.
• Spot contract is an agreement to buy or sell a foreign currency today.
• Delivery price (exchange rate) is the price agreed upon, equal to the forward exchange rate when the contract is entered into.
• Forwards are private and customizable.
• Forwards are traded OTC (Over-the-Counter)

Currency Future

• A futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date.
• These are standardized contracts that trade on stock exchanges, with fixed maturity dates and uniform terms.
• Payments are guaranteed on the agreed-upon date.
• Regulated by the Commodity Futures Trading Commission (CFTC).

Foreign Currency Forward Contracts

• An agreement between an MNC and a bank (foreign currency dealer) that specifies the currencies to be exchanged, the exchange rate (forward rate), and the date at which the transaction will occur.

Foreign Exchange Rate Determination

• The exchange rate (ER) represents the number of units of one currency that exchanges for a unit of another.

Currency Value

• Currency value is always given in terms of another currency.
• The value of a U.S. dollar in terms of British pounds is the £/$ exchange rate.
• The value of the Japanese yen in terms of dollars is the $/\ exchange rate.

Currency Appreciation

• A currency appreciates with respect to another when its value rises in terms of the other.
• For example, the dollar appreciates with respect to the yen if the ¥/$ exchange rate rises.

Currency Depreciation

• A currency depreciates with respect to another when its value decreases in terms of the other.
• For example, if the ¥/$ exchange rate falls, the dollar depreciates with respect to the yen.
• Note that if the ¥/$ rate rises, then its reciprocal, the $/\ rate decreases.

Example:

• On January 6, 2010, EC$/US$ = 1.03
• On January 6, 2009, EC$/US$ = 1.19
• % change = (new value - old value)/old value = (1.03 - 1.19)/1.19 = -0.16/1.19 = -0.134
• Multiply by 100 to write as a percentage change = -0.134 × 100 = -13.4%
• The dollar depreciated by 13.4 % with respect to the C$ during the previous year.

Arbitrage

• Buying a product when its price is low and reselling it after its price rises to make a profit.
• Currency arbitrage means buying a currency in one market (e.g., New York) at a low price and reselling it shortly later in another market (e.g., London) at a higher price.

Spot Exchange Rate

• The exchange rate that prevails for trades that take place immediately.

Forward Exchange Rate

• The rate that appears on a contract to exchange currencies at a specified time in the future.

Key Takeaways

• An exchange rate denominated x/y gives the units of x it takes to purchase 1 unit of y.
• When the exchange rate x/y increases, this means that y has appreciated in value and x has depreciated.
• Spot rates are for trades today.
• Future rates are values on trades that occur in the future per a predetermined agreement.
• Currency arbitrage is when one takes advantage of a price difference in currencies to make a profit.
• Hedging refers to actions taken to reduce the risk associated with currency trades.

Transaction Exposure

• Measures gains or losses that arise from settling existing financial obligations stated in a foreign currency.
• Purchasing or selling on credit and Borrowing or lending funds when repayment is to be made in a foreign currency.

Forex Market

• Acquiring assets or incurring liabilities denominated in foreign currencies also leads to transaction exposure.

Foreign-Exchange Market

• A market where one country's currency can be exchanged for that of another country.
• It is an informal network of telephone, telex, satellite, facsimile, and computer communications between banks, foreign-exchange dealers, arbitrageurs, and speculators.

Tiers of the Forex Market

• Individuals and corporations buy and sell foreign exchange through their commercial banks.
• Commercial banks trade in foreign exchange with other commercial banks in the same financial center.
• Commercial banks trade in foreign exchange with commercial banks in other financial centers.

Major Participants in the Exchange Market

• Commercial banks, central banks

Commercial Banks

• Participate in the foreign exchange market as intermediaries for customers such as MNCs and exporters.
• Maintain an interbank market.
• Accept deposits of foreign banks and maintain deposits in banks abroad.
• Play three key roles in international transactions: operate the payment mechanism, extend credit, help to reduce risk.

Commercial Banking System

• Provides the mechanism for making international payments efficiently.
• It is a collection system through which transfers of money by drafts, notes, and other means are made internationally.
• Banks maintain deposits in banks abroad and accept deposits of foreign banks to operate an international payments mechanism.
• Banks can make international money transfers quickly and efficiently by using telegraph, telephones, and computer services.

Extending Credit

• Commercial banks provide credit for international transactions and for business activity within foreign countries.
• They make loans to those engaged in international trade and foreign investments on either an unsecured or a secured basis.

Reducing Risk

• The letter of credit is used as a major means of reducing risk in international transactions.
• A letter of credit is a document issued by a bank at the request of an importer.
• In the document, the bank agrees to honor a draft drawn on the importer if the draft accompanies specified documents.
• The letter of credit is advantageous to exporters; they can sell their goods abroad against the promise of a bank rather than a commercial firm.

Central Banks

• Act as their governments' banker for domestic and international payments.
• Central bank operations reflect government transactions and transactions with other central banks and various international organizations.
• Central banks intervene to influence exchange rate movements.

Spot Exchange Quotation

• The foreign-exchange market employs both spot and forward exchange rates.
• The spot rate is the rate paid for delivery of a currency within two business days after the day of the trade.

Direct vs. Indirect Quotation

• Direct Quotation is a foreign exchange rate quoted as the domestic currency per unit of the foreign currency.
• Indirect Quotation expresses the amount of foreign currency required to buy or sell one unit of the domestic currency.

The Bid-Ask Spread

• A bank's bid price is the price at which the bank is ready to buy a foreign currency.
• A bank's ask price is the price at which the bank is ready to sell a foreign currency.
• The bid-ask spread represents the spread between the bid and ask rates for a currency.
• The spread represents the bank's fee for executing the foreign-exchange transaction.

International Parity Conditions

• There are five major theories used to assist with exchange rate determination:
  • Purchasing power parity.
  • The Fisher effect.
  • The international Fisher effect.
  • The theory of interest rate parity.
  • The forward rate as an unbiased predictor of the future spot rate.

Efficient Exchange Markets

• Exchange rates reflect all available information and adjust quickly to new information.
• Relies on three hypotheses:
  • Prices should reflect the consensus estimate of the future spot rate.
  • Investors should not earn unusually large profits in forward speculation.
• Impossibility for any market analyst to consistently "beat the market".

Theory of Purchasing Power Parity (PPP)

• It Explains why the parity relationship exists between inflation rates and exchange rates
• Absolute version maintains that the equilibrium equals the ratio between domestic and foreign prices.
• Relative version states that the exchange rate between the home currency and the foreign currency will adjust to changes in the price levels of the two countries.

The Fisher Effect

• Nominal interest rate in each country is equal to a real interest rate plus an expected rate of inflation
• Real interest rate is determined by productivity in an economy and a risk premium commensurate with the risk of a borrower. Nominal interest rate embodies an inflation premium sufficient to compensate lenders or investors for an expected loss of purchasing power.

Theory of Interest Rate Parity

• The movement of short-term funds between two countries to take advantage of interest differentials.
• A major determinant of the spread between forward is the amount the interest rates differ between the countries.
• The spread between a forward rate and a spot rate should be equal but opposite in sign to the difference in interest rates between two countries

Synthesis of International Parity Conditions

• In the absence of predictable exchange market intervention by central banks, an expected rate of change in a spot rate, differential rates of national inflation and interest, and forward premiums or discounts are all directly proportional to each.
• Due to money, capital, and exchange markets being efficient, these variables adjust quickly to changes.

Arbitrages

• The purchase of something in one market and its sale in another market to take advantage of a price differential.
• Professional arbitrageurs can transfer funds from one currency to another to profit from discrepancies between exchange rates in different markets.