Description
international finance
Reíatíon of
IRP & PPP
SUMIT KUMAR DAS
Roll- 95/MBA/130020
MBA – Calcutta Unive!it" Ali#u Ca$#u!
I R P & P P P P a g e | 1
I%T&R&ST RAT& 'ARIT(
It’s no-arbítrage condítíon representíng an equíííbríum state under whích
ínvestors wííí be díherent to ínterest rates avaííabíe on deposíts ín two countríes.
The fact that thís condítíon doesn’t aíways hoíd aííows for potentíaí opportunítíes
to earn rísk íess proñts from covered ínterest arbítrage.
Two assumptíons centraí to ínterest paríty are capítaí mobíííty and perfect
sustaínabíííty of domestíc and foreígn assets. Gíven foreígn exchange market
equíííbríum the ínterest rate paríty condítíon ímpííes that the unexpected return
on domestíc assets wííí be equaí to the exchange rate ad|usted expected on
foreígn currency assets. Inventors that can’t earn arbítrage proñts by borrowíng
ín a country wíth a hígher ínterest rate, due to gaín or íosses from exchangíng
back to theír domestíc currency at maturíty.
Interest rate paríty takes 2 dístínctíve forms:-
? Uncovered Interest Rate Paríty (UIRP): ít refers to the paríty condítíon ín
whích exposure to foreígn exchange rísk(unantícípated change ín
exchange rates) ís unhabítuated
? Covered Interest Rate Paríty (CIRP): ít refers to the condítíon ín whích a
forward contract has been used to cover (eíímínate exposure to) exchange
rate rísk.
In Si$#le )it* e+a$#le!,-
Thís theory assumes that íf two countríes have díherent ínterest rates, thís
díherence wííí íead to a díscount or a premíum for the exchange rate ín order to
avoíd arbítrage opportunítíes. IRP has to do wíth the ídea that money shouíd
(after ad|ustíng rísk) earn an equaí rate of return.
A símpíe exampíe wouíd be a sítuatíon, where ínterest rates ín the UK are say
2%; whííe ínterest rates ín |apan are say 1%. The sterííng (Brítísh money) wííí
need to deprecíate 1% agaínst the |apanese yen, so that the arbítrage
opportunítíes can be avoíded. The future exchange rate of GBP/|PY ís reñected ín
the forward exchange rate known today.
Suppose an ínvestor can earn 6% ínterest wíth a doííar deposít ín the Uníted
States bank; or can earn 4% ínterest wíth a Brítísh pound deposít ín a London
bank. The ínvestor can earn greater ínterest íncome by keepíng funds ín doííars
and, therefore, one míght expect aíí of hís funds to ñow to US banks. However,
exchange rate expectatíons aíso come ínto píay. Suppose the ínvestor expects
the Brítísh pound to apprecíate at the rate of 2% ín terms of doííar. That ínvestor
wouíd then be índíherent to eíther ínvestment choíces, as both are expected to
earn 6%.
I R P & P P P P a g e | 2
'URC-ASI%. '/0&R 'ARIT(
It’s a component of some economíc theoríes and ít’s a techníque to determíne
the reíatíve vaíue of díherent currencíes. The concept of Purchasíng Power Paríty
(PPP) aííows one to estímate what the exchange rate between two countríes
wouíd have to be ín order for the exchange to be at par wíth the purchasíng
power of the two countríes’ currencíes.
Usíng PPP rate for hypothetícaí currency conversíons, a gíven amount of one
currency thus has the same purchasíng power whether used dírectíy to purchase
a market basket of goods or used to convert at the PPP rate to the other currency
and then purchase the market basket usíng the currency. Observed devíatíons of
the exchange rate from purchasíng power paríty are measured by devíatíon of
the reaí exchange rate from íts PPP vaíue of 1.
PPP exchange rate heíps to mínímíse mísíeadíng ínternatíonaí comparísons that
can aríse wíth the use of market exchange rates. The PPP exchange rate serves
two maín functíons:
? PPP exchange rates can be usefuí for makíng comparísons between
countríes.
? Over a períod of years, exchange rates do tend to move ín the generaí
dírectíon of the PPP exchange rate.
In Si$#le )it* e+a$#le!,-
The theory of Purchasíng Power Paríty postuíates the foreígn exchange rates
shouíd be evaíuated by the reíatíve príces of a símííar basket of goods between
two natíons. A possíbíe change ín the rate of ínñatíon ín a gíven country shouíd
be baíanced byt the opposíte change of country exchange rate. If príces ín the
country are surgíng because of ínñatíon, country’s exchange rate shouíd
decrease ín order to return to paríty. PPP expresses the ídea that a bundíe of
good ín one country shouíd cast the same ín another country after exchange
rates are taken ínto account.
Suppose that wíth exístíng reíatíve príces and exchange rates, a basket of goods
can be purchased wíth fewer US doííars ín Canada than ín US. We wouíd then
expect US consumers to buy those goods ín Canada. Such actíons wouíd cause
US doííars to be soíd ín exchange for Canadían doííars. As a resuít, the US doííars
wouíd deprecíate ín reíatíon wíth the Canadían doííars. We wouíd expect the
currency deprecíatíon to contínue untíí the bundíe of goods cost the same ín both
countríes.
I R P & P P P P a g e | 3
...Thank You...
Su$it Ku$a Da!
95/MBA/130020
MBA (Ma|or Fínance, Mínor Marketíng)
Caícutta Uníversíty - Aíípur Campus
doc_946705205.docx
international finance
Reíatíon of
IRP & PPP
SUMIT KUMAR DAS
Roll- 95/MBA/130020
MBA – Calcutta Unive!it" Ali#u Ca$#u!
I R P & P P P P a g e | 1
I%T&R&ST RAT& 'ARIT(
It’s no-arbítrage condítíon representíng an equíííbríum state under whích
ínvestors wííí be díherent to ínterest rates avaííabíe on deposíts ín two countríes.
The fact that thís condítíon doesn’t aíways hoíd aííows for potentíaí opportunítíes
to earn rísk íess proñts from covered ínterest arbítrage.
Two assumptíons centraí to ínterest paríty are capítaí mobíííty and perfect
sustaínabíííty of domestíc and foreígn assets. Gíven foreígn exchange market
equíííbríum the ínterest rate paríty condítíon ímpííes that the unexpected return
on domestíc assets wííí be equaí to the exchange rate ad|usted expected on
foreígn currency assets. Inventors that can’t earn arbítrage proñts by borrowíng
ín a country wíth a hígher ínterest rate, due to gaín or íosses from exchangíng
back to theír domestíc currency at maturíty.
Interest rate paríty takes 2 dístínctíve forms:-
? Uncovered Interest Rate Paríty (UIRP): ít refers to the paríty condítíon ín
whích exposure to foreígn exchange rísk(unantícípated change ín
exchange rates) ís unhabítuated
? Covered Interest Rate Paríty (CIRP): ít refers to the condítíon ín whích a
forward contract has been used to cover (eíímínate exposure to) exchange
rate rísk.
In Si$#le )it* e+a$#le!,-
Thís theory assumes that íf two countríes have díherent ínterest rates, thís
díherence wííí íead to a díscount or a premíum for the exchange rate ín order to
avoíd arbítrage opportunítíes. IRP has to do wíth the ídea that money shouíd
(after ad|ustíng rísk) earn an equaí rate of return.
A símpíe exampíe wouíd be a sítuatíon, where ínterest rates ín the UK are say
2%; whííe ínterest rates ín |apan are say 1%. The sterííng (Brítísh money) wííí
need to deprecíate 1% agaínst the |apanese yen, so that the arbítrage
opportunítíes can be avoíded. The future exchange rate of GBP/|PY ís reñected ín
the forward exchange rate known today.
Suppose an ínvestor can earn 6% ínterest wíth a doííar deposít ín the Uníted
States bank; or can earn 4% ínterest wíth a Brítísh pound deposít ín a London
bank. The ínvestor can earn greater ínterest íncome by keepíng funds ín doííars
and, therefore, one míght expect aíí of hís funds to ñow to US banks. However,
exchange rate expectatíons aíso come ínto píay. Suppose the ínvestor expects
the Brítísh pound to apprecíate at the rate of 2% ín terms of doííar. That ínvestor
wouíd then be índíherent to eíther ínvestment choíces, as both are expected to
earn 6%.
I R P & P P P P a g e | 2
'URC-ASI%. '/0&R 'ARIT(
It’s a component of some economíc theoríes and ít’s a techníque to determíne
the reíatíve vaíue of díherent currencíes. The concept of Purchasíng Power Paríty
(PPP) aííows one to estímate what the exchange rate between two countríes
wouíd have to be ín order for the exchange to be at par wíth the purchasíng
power of the two countríes’ currencíes.
Usíng PPP rate for hypothetícaí currency conversíons, a gíven amount of one
currency thus has the same purchasíng power whether used dírectíy to purchase
a market basket of goods or used to convert at the PPP rate to the other currency
and then purchase the market basket usíng the currency. Observed devíatíons of
the exchange rate from purchasíng power paríty are measured by devíatíon of
the reaí exchange rate from íts PPP vaíue of 1.
PPP exchange rate heíps to mínímíse mísíeadíng ínternatíonaí comparísons that
can aríse wíth the use of market exchange rates. The PPP exchange rate serves
two maín functíons:
? PPP exchange rates can be usefuí for makíng comparísons between
countríes.
? Over a períod of years, exchange rates do tend to move ín the generaí
dírectíon of the PPP exchange rate.
In Si$#le )it* e+a$#le!,-
The theory of Purchasíng Power Paríty postuíates the foreígn exchange rates
shouíd be evaíuated by the reíatíve príces of a símííar basket of goods between
two natíons. A possíbíe change ín the rate of ínñatíon ín a gíven country shouíd
be baíanced byt the opposíte change of country exchange rate. If príces ín the
country are surgíng because of ínñatíon, country’s exchange rate shouíd
decrease ín order to return to paríty. PPP expresses the ídea that a bundíe of
good ín one country shouíd cast the same ín another country after exchange
rates are taken ínto account.
Suppose that wíth exístíng reíatíve príces and exchange rates, a basket of goods
can be purchased wíth fewer US doííars ín Canada than ín US. We wouíd then
expect US consumers to buy those goods ín Canada. Such actíons wouíd cause
US doííars to be soíd ín exchange for Canadían doííars. As a resuít, the US doííars
wouíd deprecíate ín reíatíon wíth the Canadían doííars. We wouíd expect the
currency deprecíatíon to contínue untíí the bundíe of goods cost the same ín both
countríes.
I R P & P P P P a g e | 3
...Thank You...
Su$it Ku$a Da!
95/MBA/130020
MBA (Ma|or Fínance, Mínor Marketíng)
Caícutta Uníversíty - Aíípur Campus
doc_946705205.docx