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1Chapter 6 International Parity Conditions 1. Law of One Price. Define the law of one price carefully, noting its fundamental assumptions. Why are these assumptions so difficult to find in the real world in order to apply the theory? If identical products or services can be sold in two different markets, and no restrictions exist on the sale or transportation of product between markets, the product’s price should be the same in both markets. This is called the law of one price. A primary principle of competitive markets is that prices will equalize across markets if frictions or costs of moving the products or services between markets do not exist. If the two markets are in two different countries, the product’s price may be stated in different currency terms, but the price of the product should still be the same. Comparing prices would require only a conversion from one currency to the other. For example, where the price of the product in U.S. dollars, P$, multiplied by the spot exchange rate (S, yen per U.S. dollar), equals the price of the product in Japanese yen, P¥. Conversely, if the prices of the two products were stated in local currencies, and markets were efficient at competing away a higher price in one market relative to the other, the exchange rate could be deduced from the relative local product prices: The challenge in applying the theory in the real world is that few products exist that are truly identical across markets, and if they are identical, are truly “transportable” across markets with nearly zero transportation costs and fees. 4. Undervaluation and Purchasing Power Parity. According to the theory of purchasing power parity, what should happen to a currency which is undervalued? Theoretically, if the currency is undervalued then market participants, in search of potential profits, will continue to purchase the currency until they drive its price up eliminating the undervaluation. 8. Partial Exchange Rate Pass-Through. What is partial exchange rate pass-through, and how can it occur in efficient global markets? Partial pass-through is when prices of imported products rise by less than the full percentage change in the imported product’s currency. Many times an exporter that finds its price has risen in target foreign markets as a result of the exporter’s currency appreciating will attempt to keep the price from rising in the target market by as much as the exchange rate change, wishing to not lose sales as a result of the price increase. This means that the exporter, if not changing their cost structure, is earning a smaller margin on the sale. 10. The Fisher Effect. Define the Fisher effect. What would it say about real interest rates if markets are open and efficient? The Fisher effect, named after economist Irving Fisher, states that nominal interest rates in each country are equal to th

e required real rate of return plus compensation for expected inflation. More formally, this is derived from (1 + r)(1 + ?) – 1: where i is the nominal rate of interest, r is the real rate of interest, and ? is the expected rate of inflation over the period of time for which funds are to be lent. Assuming efficient and open markets, real interest rates should be equal across currencies. 12. The International Fisher Effect. Define the international Fisher effect. Would it discourage local investors from capitalizing on higher foreign interest rates? According to the IFE, with unrestricted capital flows, investors should be indifferent toward higher foreign interest rates because these higher rates are due to higher expected inflation rates. 13. Interest Rate Parity. Define interest rate parity. What would it say about interest rates if spot rates and forward rates were the same? The theory of interest rate parity (IRP) provides the linkage between the foreign exchange markets and the international money markets. The theory states: The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs. If the spot rate and forward rate are the same, IRP says that nominal interest rates are equal. 14. Covered Interest Arbitrage. Ignoring transaction costs, under what conditions will covered interest arbitrage be plausible? Covered interest arbitrage (CIA) involves an investment in a currency that is covered by a forward contract to sell that currency when the investment matures. CIA is plausible when the difference in interest rates is different from the forward premium. 15. Uncovered Interest Arbitrage. Define uncovered interest arbitrage and explain what expectations an investor or speculator would need to undertake an uncovered interest arbitrage investment? A deviation from covered interest arbitrage is uncovered interest arbitrage (UIA), wherein investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. The transaction is “uncovered” because the investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period. Exhibit 6.8 demonstrates the steps an uncovered interest arbitrager takes when undertaking what is termed the yen carry trade. Borrowing in the Japanese yen market has always been desirable as yen interest rates are frequently very low, Japanese banks— which are large—are frequently interested in lending to multinational companies, and the yen itself may hold its value for long periods of time.