Money and Banking
Money and Banking FIN 3233
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This 2 page Study Guide was uploaded by Jamie Frami on Wednesday September 23, 2015. The Study Guide belongs to FIN 3233 at University of South Florida taught by Ziwei Xu in Fall. Since its upload, it has received 61 views. For similar materials see /class/212610/fin-3233-university-of-south-florida in Finance at University of South Florida.
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Date Created: 09/23/15
A Review for Various Parities Relations of Foreign Exchange Rate 1 Absolute Purchasing Power Parity This parity requires that the level of foreign exchange rate only re ects the price level difference between the two countries Eg if an apple is sold for 1 in US but for 100 Yen in Japan then the exchange rate should be 100 Yen Mathematically it requires Exchange rate in terms of Currency NCurrency B remember this is a measure of the value of Currency B Price level in Country A Price level in Country B 2 Relative Purchasing Power Parity This parity requires that the change in foreign exchange rate only re ects the in ation difference between the two countries Eg ifthe apple price will increase by 10 in Us or US in ation rate is 10 and by 20 in Japan in the future 3 years then Japanese Yen should depreciate by 10 relative to dollar in the future 3 years since the purchasing power of Yen is decreasing at a higher rate than the dollar Mathematically it requires Change in Exchange rate in terms of Currency N Currency B or appreciationdepreciation in Currency B in ation rate in Country A 7 in ation rate in Country B 3 Uncovered Interest Rate Parity This parity requires that the change in foreign exchange rate only re ects the interest rate difference between the two countries E g if the oneyear interest rate is 5 in the Us and 10 in Japan then Japanese Yen should depreciate by 5 relative to dollar in the future one year to eliminate its interest rate advantage If there is no change in the interest rate there is an arbitrage opportunity Eg everybody will borrow US dollars from the Us Bank paying 5 interest rate convert the money into Yen and save the money in Japanese Banks earning 10 interest rate Later on investors will pay the 5 interests and principal back to Us Banks and keep the extra 5 interests earned in their own pocket Sooner or later nobody will want to hold US dollars and everybody is enjoying the 5 free lunch One way to prevent this situation from happening is to let Yen depreciate relative to by 5 So when the people needs to convert the Yen back to to payolT the US bank debt at the end of the year they won t be able to make a pro t Mathematically it requires Change in Exchange rate in terms of Currency N Currency B or appreciationdepreciation in Currency B interest rate in Country A 7 interest rate in Country B This parity also makes sense from the Relative Purchasing Parity perspective since the country paying higher interest rate tend to have higher in ations than other countries notice the nominal interest rate real in ation so their currency should depreciate relative to others currencies 4 Covered Interest Rate Parity This parity requires that the Forward PremiumDiscount only re ects the interest rate difference between the two countries Forward PremiumDiscount can be thought as the expected change in foreign exchange rate re ected by Forward market traders E g if traders expect the currency B to appreciate relative to currency A then forward contract of buying Currency B using Currency A denominated as Currency NCurrency B should be sold at a premium So this parity is essentially the same as Uncovered Interest Rate Parity as long as the forward market is efficient which means that Forward exchange rate equals to the people s expected future exchange rate It is easier to arbitrage on this parity than on uncovered interest rate parity because the market expected change in exchange rate is unobservable So it is hard to tell whether the uncovered parity relation is violated or not However the forward exchange rate is known today from the forward market So it is readily observable that whether the relation is violated or not Also the arbitrage profit on this parity is guaranteed since the exchange rate in the future is guaranteed by the forward contract Mathematically it requires Forward PremiumDiscount in terms of Currency NCurrency B interest rate in Country A 7 interest rate in Country B
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