Home > CFA L2, interest rates, macro economics > What is the theoretical relation among various rates in Economics?

What is the theoretical relation among various rates in Economics?

I have been reviewing study session 4 in CFA Level 2 Economics and I can’t seem to get my head around all the parity relations… hence a post to clarify my thoughts and develop a clear understanding.

All parity relations are a function of exchange rates, nominal interest rates, real interest rates and inflation rates between the a pair of countries/currencies.

Interest Rate Parity – Exchange Rate > Nominal Interest Rate

Covered Interest Rate Parity:

forward exchange rate as a function of the spot exchange rate and nominal interest rates.

Uncovered Interest Rate Parity:

expected spot exchange rate as a function of the current spot exchange rate and nominal interest rates

International Fischer Relation – Inflation Rate > Nominal Interest Rate

difference in nominal interest rates should be equal to difference in expected inflation rates because real rates as equal

Purchasing Power Parity (PPP) – Exchange Rate > Inflation Rate

Absolute PPP

price of a basket of similar goods between two countries should be equal (rarely is in practice)

Relative PPP

expected spot exchange rate as a function of the current spot exchange rate and inflation rates (note similarity to uncovered interest rate parity)

Approximate Relative PPP

difference in inflation rates is equal to the expected appreciation/depreciation of the currency

The above stuff is easy on its own but gets tricky when combined with International Asset Pricing reading from study session 18 on Portfolio Management.

Real Exchange Rate

explains the changes in nominal exchange rate not explained by the difference in price levels i.e.

(Note here that the price levels are already adjusted for inflation, hence if real exchange rates are constant then any change in nominal exchange rate is explained by the difference in inflation)

Also,

% Change in Real Exchange Rate = % Change in Nominal Exchange rate – (Inflation in DC – Inflation in FC)

Foreign Currency Risk Premium – Exchange Rate > Real Interest rates

is the difference between the % change in exchange rates and the difference in real interest rates

I think that should clarify the interplay of different rates.

About these ads
  1. jesse
    May 7, 2011 at 5:54 PM

    Good. I’ll read it in more detail. There is so much mis-information about higher and lower rates, related to exchange rates.

    PS you know your blog’s acronym is SFA ;)

    • May 8, 2011 at 5:35 PM

      thanks… however I doubt you will find it very helpful because none of the parity relations obey the no-arbitrage framework. If they did, carry-trade would be dead.

      hahaaa… i am not the artsy type, couldn’t come up with a half decent name when i started blogging.

  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Follow

Get every new post delivered to your Inbox.

%d bloggers like this: