2016/11/2 Big Mac Index 2014-Undervaluation Big Mac Index 2014-Undervaluation sPrice at Img Market Over/Under Price at Local 5 Pric Implied Market over/Under States SFr 6.5 HKS 16 2.12393 Rea10.25 244367 Africa Rand 19.9 2.45 1.14 4.644.774.31 NTS 75 4.63214419.45 经 CBN Cost of Living Index CBN Cost of Living Index Eg China Business News released the ppp exchange rate and undervaluation of RMb on july 21st 2010. …2# commodity for more than 50 economies, CBN focuses on RMB 1m“ by comparing the prices of 30 daily-living items in Shanghai with those in New York, London, Paris and Tokyo. The 30 chosen items reflect the cost of modern living in the cities, covering 6 categories including clothing, food lodging transportation, service and other. ot surprising--RMB is undervalued by 28%, 43%, 35% and 42% respectively CBN Cost of Living Index From appp to RPPp Relative purchasing power parity ange in the differential rate of inflation between two 日2三 ountries tends to be offset over the long run by an eq t opposite change in the exchange rate between the two :灬 oes RPpP hold? ": In the short run no. trade flows are much slower to ue aman sponse to return differentials. The slow response in the product market provides MNEs time and space to arbitrage on raw materials and products all over the world and make a profit
2016/11/2 6 Big Mac Index 2014- Undervaluation Price at Local Currency $ Price at Market Rate Implied PPP Market Rate Over/UnderValuation(%) United States $4.20 4.20 - - - Norway Kroner 41 6.79 9.77 6.04 62 Switzerland SFr 6.5 6.81 1.55 0.96 62 Sweden SKr 41 5.91 9.77 6.93 41 Brazil Real 10.25 5.68 2.44 1.81 35 Denmark DK 31.5 5.37 7.50 5.86 28 Australia A$4.80 4.94 1.14 0.97 18 Argentina Peso 20.0 4.64 4.77 4.31 10 Canada C$4.73 4.63 1.13 1.02 10 Uruguay Peso90 4.63 21.44 19.45 10 4-31 Big Mac Index 2014- Undervaluation Price at Local Currency $ Price at Market Rate Implied PPP Market Rate Over/UnderValuation(%) United States $4.20 4.2 - - - India Rupee 84.0 1.62 20.01 51.9 -61 Ukraine Hryvnia 17 2.11 4.05 8.04 -50 Hong Kong HK$ 16.5 2.12 3.93 7.77 -49 Malaysia Ringgit 7.35 2.34 1.75 3.14 -44 China Yuan 15.4 2.44 3.67 6.32 -42 South Africa Rand 19.95 2.45 4.75 8.13 -42 Indonesia Rupiah 22,534 2.46 5369 9160 -41 Thailand Baht 78 2.46 18.58 31.8 -41 Taiwan NT$ 75.0 2.5 17.87 30 -40 Egypt Pound 15.5 2.57 3.69 6.04 -39 4-32 CBN Cost of Living Index • China Business News released the PPP exchange rate and undervaluation of RMB on July 21st 2010. • Rather than providing the comparison based on one commodity for more than 50 economies, CBN focuses on RMB by comparing the prices of 30 daily-living items in Shanghai with those in New York, London, Paris and Tokyo. • The 30 chosen items reflect the cost of modern living in the cities, covering 6 categories including clothing, food, lodging, transportation, service and other. • The results are not surprising——RMB is undervalued by 28%, 43%, 35% and 42% respectively. 4-33 CBN Cost of Living Index 4-34 CBN Cost of Living Index 4-35 4-36 From APPP to RPPP • Relative purchasing power parity – any change in the differential rate of inflation between two countries tends to be offset over the long run by an equal but opposite change in the exchange rate between the two countries. • Does RPPP hold? – In the short run, no. Trade flows are much slower to respond to price differentials than capital markets response to return differentials. – The slow response in the product market provides MNEs time and space to arbitrage on raw materials and products all over the world and make a profit
2016/11/2 Interest Rates and Exchange Rates Covered Interest Parity If Janet Yellen hints the fed will raise s interest rate, how will Investor has USD 10 S/E Spot RMB respond in the foreign exchange market? million to put on deposit S/E 360 day forward In the capital market, investors arbitrage on interest rates G0-day Libor rying to finance with currencies of low interest and invest in pot, put proceeds d ∈360- day libor 4.3% emember this may be prohibited by the capital control. sell balance forward for Even if not, investors may also encounter exchange rate changes, which may eat all the arbitrage profit. They need to cover(hedge) the profit in the forward market. Covered Interest Parity Covered Interest Arbitrage(CIA) Eurodollar rate 400% per anau will have $10*(1+4)=510, 4 million in 360 days Invest on毛 exchange s to e at the spot rate get 66 4516 million will have E6 7290 million in 360 days(=6.4516x1043). emro meT maker s104165 million(=67290×1.548) The better choice is investing in E an also borrow in s and investing in interest rat arbitrage Covered Interest Parity Forward rate and and Forward rate Interest Rate Parity risk free arbitrage terest Rate Parity(IRP) he difference in the national interest rates for securities of Spot and forward rates and yields will adjust very quickly so that similar risk and maturity should be equal to, but opposite in the return is the same for the two transactions sign to, the forward rate discount or premium for the In fact, The forward rate is determined by the following formula foreign currency, except for transaction costs. It holds well for those free-floating currencies. F-51+ 1≈4%-4.3%=-0.3%; disappears in less than one second expect for the transaction cost
2016/11/2 7 4-37 Interest Rates and Exchange Rates • If Janet Yellen hints the Fed will raise $ interest rate, how will RMB respond in the foreign exchange market? • In the capital market, investors arbitrage on interest rates, trying to finance with currencies of low interest and invest in high. (Remember : this may be prohibited by the capital control. ) • Even if not, investors may also encounter exchange rate changes, which may eat all the arbitrage profit. • They need to cover(hedge) the profit in the forward market. Covered Interest Parity • Investor has USD 10 million to put on deposit for 360 days. • Could also buy euro spot, put proceeds on deposit at € Libor and sell balance forward for USD. $/€ Spot $1.550 $/€ 360 day forward $1.548 $ 360-day Libor 4.0% € 360-day Libor 4.3% Which is the better investment? 4-38 Covered Interest Parity • Invest on $ – will have $10*(1+4)=$10.4 million in 360 days • Invest on € – exchange $ to € at the spot rate, get €6.4516 million (=10÷1.55) – will have €6.7290 million in 360 days (=6.4516×1.043). – sell this amount forward at the forward rate and get $10.4165 million (=6.7290×1.548) • The better choice is investing in € – Can also borrow in $ and investing in € interest rate arbitrage! 4-39 4-40 Eurodollar rate = 4.00 % per annum 360 days Dollar money market euro money market $10,000,000 $10,400,000 $10,416,542 S=$1.55//€ €=10M/1.5 =6.4516M €6.7290M F360 ==$1.548/€ x 1.043 x 1.04 Start End Euroeuro rate = 4.30 % per annum Arbitrage Potential Covered Interest Arbitrage (CIA) 4-41 Covered Interest Parity and Forward Rate • This cannot persist as it represents a risk free arbitrage opportunity. • Spot and forward rates and yields will adjust very quickly so that the return is the same for the two transactions. • In fact, The forward rate is determined by the following formula: ଷܨ ୣ୳୰୭/$ = ܵଷ ୣ୳୰୭/$ 1 + ݅$ 1 + ݅௨ = 1.55 ∗ 1 + 4% 1 + 4.3% = 1.5455 < 1.548 ிିௌ ௌ = ଵାସ% ଵାସ.ଷ% − 1 ≈ 4% − 4.3% = −0.3% ; ܨ ≈ 1.55 ∗ 1 − 0.3% = 1.5454 *In this example, € in the forward market is more expensive than predicted by the formula, so we buy € in the spot market and sell in the forward to make a profit. In real life, the spread disappears in less than one second expect for the transaction cost. Forward Rate and Interest Rate Parity • Interest Rate Parity (IRP) – 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. – It holds well for those free-floating currencies. 4-42