Theempirical evidenceoWhetherornotPPpholdsisanongoingcontroversy.Thereasonswhyitmightnothold are numerous.oThe strictest formof PPP reguiresthat:--financial marketsareperfectwithno controls,taxes,transactioncosts,etc;--goodsmarketsareperfectwithinternational shipmentofgoodsabletotakeplacefreely,instantaneouslyandwithout cost;--thereis a single consumptiongood commontoeveryone;--thesamecommoditiesappearinthesameproportions in each country's consumption basket
The empirical evidence Whether or not PPP holds is an ongoing controversy. The reasons why it might not hold are numerous. The strictest form of PPP requires that: - financial markets are perfect with no controls, taxes, transaction costs, etc; - goods markets are perfect with international shipment of goods able to take place freely, instantaneously and without cost; - there is a single consumption good common to everyone; - the same commodities appear in the same proportions in each country’s consumption basket
Reasons for divergence from short-term PPPoTheassetmarketapproachoOvershootingoTheportfoliobalanceapproach
Reasons for divergence from short-term PPP The asset market approach Overshooting The portfolio balance approach
5.2CoveredinterestparityBackgroundTheClPconditiono Consider an investorwho has initial capital,K, and faces two alternatives:(i)domesticinvestment,wherebytheinvestorbuysdomesticassets,earningthedomesticinterestrate,i(ii)foreigninvestment,wherebytheinvestorconvertsthedomesticcurrencyintoforeigncurrencytobuyforeignassets,earningtheforeigninterestrate,i*
5.2 Covered interest parity Background The CIP condition Consider an investor who has initial capital, K, and faces two alternatives: (i) domestic investment, whereby the investor buys domestic assets, earning the domestic interest rate, i; (ii) foreign investment, whereby the investor converts the domestic currency into foreign currency to buy foreign assets, earning the foreign interest rate, i*
The mechanics of covered arbitrageArbitragefromthedomesticcurrencytoaforeign currencyF(1+i*)-(1+i)元三Sorapproximatelyπ=i*-i+f
The mechanics of covered arbitrage Arbitrage from the domestic currency to a foreign currency (1 ) (1 ) F i i S = + − + i i f = − + or approximately
oArbitragefromaforeigncurrencytothedomesticcurrencyS(1+i)-(l+i*)元二Forapproximatelyπ=i-i-Theno-arbitrageconditionF
The no-arbitrage condition 1 [ ] 1 i F S i + = + Arbitrage from a foreign currency to the domestic currency or approximately (1 ) (1 ) S i i F = + − + i i f = − −