【正文】 ange currency immediately ? Spot rate – the exchange rate for an immediate trade ? Forward trade – agree today to exchange currency at some future date and some specified price (also called a forward contract) ? Forward rate – the exchange rate specified in the forward contract ? If the forward rate is higher than the spot rate, the foreign currency is selling at a premium (when quoted as $ equivalents). ? If the forward rate is lower than the spot rate, the foreign currency is selling at a discount. 3115 Absolute Purchasing Power Parity ? Price of an item is the same regardless of the currency used to purchase it (., “l(fā)aw of one price). ? Requirements for absolute PPP to hold: ? Transaction costs are zero ? No barriers to trade (no taxes, tariffs, etc.) ? No difference in the modity between locations ? For most goods, Absolute PPP rarely holds in practice. 3116 Relative Purchasing Power Parity ? Provides information about what causes changes in exchange rates. ? The basic result is that exchange rates depend on relative inflation between countries: ? E(St ) = S0[1 + (hFC – hUS)]t ? Because absolute PPP does not hold for many goods, we will focus on relative PPP from here on out. 3117 Example ? Suppose the Canadian spot exchange rate is Canadian dollars per . dollar. . inflation is expected to be 3% per year, and Canadian inflation is expected to be 2%. ? Do you expect the . dollar to appreciate or depreciate relative to the Canadian dollar? ? Since inflation is higher in the ., we would expect the . dollar to depreciate relative to the Canadian dollar. ? What is the expected exchange rate in one year? ? E(S1) = [1 + (.02 .03)]1 = 3118 Interest Rate Parity ? IRP is an arbitrage condition. ? If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. ? Since we do not typically observe persistent arbitrage conditions, we can safely assume that IRP holds. 3119 Interest Rate Parity Suppose you have $100,000 to invest for one year. You can either 1. Invest in the . at i$. Future value = $100,000 (1 + i$) 2. Trade your dollars for yen at the spot rate, invest in Japan at i165。800 at i163。1 $ Bring it on back to the . Domestic FV = $1,071 and British FV = $1,071 3125 Reasons for Deviations from IRP ? Transactions Costs ? The interest rate available to an arbitrageur for borrowing, ib,may exceed the rate he can lend at, il. ? There may be bidask spreads to overe, Fb/Sa F/S ? Thus (Fb/Sa)(1 + i165。800= $1,000 163。 360day forward rate F163。(0) = receive 163。)=85, so there is an arbitrage opportunity. So, how can we make money? 163。 Credit Lyonnais S163。Int