INTERNATIONAL PARITY CONDITION

PRESENTED BY :MANI SHANKAR DWIVEDI

(ENROLL: 16MB05)Gujarat National Law University

Introduction Main determinants of Exchange Rates are :

• Relative Interest Rate • Inflation rate

• Political Stability linkage among these variable cause ‘parity conditions’.

since Arbitrage plays a critical role, we discuss it upfront .

Arbitrage:

• Practice of taking advantages of imbalance between two or more Markets.• Arbitrageur

For example : Suppose iPhone cost in The USA is $800 & Euro 400 in UKAssume , that (2 Dollar = 1 Euro). Since 500 dollar = 1000 euro.Now how mispricing works :1. Buy an iPhone in the US dollar 800.2. Sell it in the UK for Euro 500.3. Convert 500 euro into 1000 dollar. suppose sell 500 iPhone.

Purchasing Power Parity

The interest Rate Parity

International Fisher Effect

Purchasing Power Parity (Law of One price )

• there is no Arbitrage condition• LOP means Identical goods sell foe same price world wide. Assumption that :• Absence of transportation cost • Only tradable goods not to immobile goods such as houses and services etc.• Taxes & other restriction of country . Meanwhile cost of product will be same in every country. PPP is manifestation of LOP applied internationally to a standard commodity basket.

Absolute PPP & Relative PPP

• Absolute PPP :• Price of one good across a different currencies :-

Relative PPP :

• Change in inflation rate governs change in exchange rate :-

Interest Rate Parity or fisher effect :

• In an economy, the relationship between Real Interest Rate , Nominal interest rate , and inflation is known as ‘’ Fisher Effect’’.• Fisher postulate that the nominal interest rate in an economy is equal to

the sum Real rate of return and inflation rate. (1+i)= (1+r) (1+inflation rate) i = nominal interest rate r = real interest rate

Nominal Interest rate = real It+ inflation rate

• So , when nominal interest rate is 12%, expected inflation rate during this period is

8% the real interest rate is 4%, if expected inflation rate is 13%, then real interest rate is -1%. Country specific Fisher effect : (1+ius) = (1+rus ) (1+ inflation rate us) (1+iindia) = (1+rindia) (1+ inflation rate india)

International Fisher Effect (IFE) :

For example :

http://www.economist.com/content/big-mac-index

Thank you.