International Parity Conditions - Research Proposal Example

Research proposal for Topics in International Business Finance Quantitative and Qualitative Analysis Study of International Parity Conditions 2 Study of International Parity Conditions Introduction The spotlight of this research is to observe real interest parity, uncovered interest parity, and purchasing power parity. The three parity terms describe the crucial links between markets and they are considered to be the cornerstones of representation in international finance. These models are routinely utilised to measure the degree of integration in capital, financial, and goods markets. Key literature and its limitations The real interest parity is a condition which pivots on capital mobility. The study can also give information as to whether capital flow equalizes real interest rates across economies. Also, the degree of real interest rate parity depends on the scope of uncovered interest parity and relative purchasing power parity. Actually, uncovered interest parity denotes financial investment between money and foreign exchange markets. The relative purchasing power parity means investment in goods and services. Thus the real interest parity condition embraces components of both real and financial integration. According to Roll (1979), under the efficient market assumption, ex ante deviations from purchasing power parity are unpredictable. (Frankel, 1991), for instance, proposes that breach of ex ante relative purchasing power parity is linked with uncompleted combination of goods markets. The situation under which real interest rate parity holds is sometimes known as real capital mobility. This reveals that the real interest rates are equalled when “real” 3 capital is open to shift. For example, an optimal firm fixes its marginal product of capital equal to the consumer cost of capital. The consumer cost of capital is nominal interest rate (without considering taxes and depreciation) attuned to the rate of inflation of its output. Thus the real interest parity is a signal to the equalization of the marginal product of capital. A refinement is drawn in using parity conditions to assess integration. That is, if a parity condition is discarded, then expansions and reductions of differences may happen as a result of either more economic integration or greater union of economic policies, or both. Real Interest Parity Regression modes are applied to decide the strength of real interest parity (Cumby and Obsfeld, 1984). For instance, interest rate derivatives are returned on inflation differentials and the coefficient figures are applied to evaluate whether the real interest rate parity condition holds. There is an extensive literature on testing real interest parity according to (Mishkin (1984), Mark (1985), and Cumby and Mishkin (1986)). Interest Rate Parity (IRP) Example: U.S. investor has $1 to invest, say for one year.  Here, two strategies are to be considered: 1) Investment in U.S. treasury securities at i$, at domestic interest rate, or 2) Invest U.K. treasury securities at i£, and hedge FX risk by selling maturity value of £s forward one year. In U.S., the maturity value in one year will be: $1(1 +  i$) In U.K., the investment strategy will be: 4 1. Sell $1 for £s to get $1 ÷ S($/£) pounds.  (assumption that S = S($/£)). 2. Invest £s at U.K. int. rate ( i£) with payoff = $1/S x (1 +  i£ ) 3. Sell £s forward at F360 ($/£) for the maturity value of the UK investment, to get a guaranteed amount of $s. The IRP condition for the above example will be: (1 +  i$) = (F / S) (1 +  i£) Limitation of Interest Rate Parity: Even though Interest Rate Parity (IRP) hold most of the time, but still IRP does not always hold exactly as it has to be. IRP depends on:   Transaction costs:  The borrowing and lending interest rate cannot be assumed to be the same. Interest rates are normally higher for borrowing than for lending. Therefore, higher interest rates for borrowing may do away with or surpass any possible arbitrage profits. Also, there are transaction costs like commissions, bid-ask spreads, fees, etc., when currencies are bought/sold, and forward contracts and securities may also decrease or eliminate arbitrage profits. Purchasing Power Parity (PPP) PPP is the Law of One Price (LOP) which can be applied to a standard commodity, priced the same in all countries when it is evaluated in a common currency. Thus: P$ =  S  x  P£ 5 where P$ is the domestic price level (CPI), P£ is the foreign price level (CPI), and S = $/£ ex-rate.  Under such circumstances PPP says that the dollar price of the commodity in the U.S. should be equal to the dollar price of the same commodity in U.K. But what if prices were higher on average in U.S. than in the U.K.? P$  >  S  x  P£ or S = P$ P£ where the spot rate (S) is the ratio between the price level of the two countries.  If domestic U.S. prices rise (P$ goes up), S should also automatically increase. Absolute PPP links ex-rates to the relative price levels (P) in two countries Relative PPP looks at Relative Inflation Rates (%): e =  %INFus -  %INFF , where e is the % change in the ex-rate. If   INFus >  INFF , then the dollar will depreciate and the pound will appreciate (S will get bigger and e will be positive). If   INFus Read More