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PART I. ARBITRAGE AND THE LAW OF ONE PRICE

PART I. ARBITRAGE AND THE LAW OF ONE PRICE

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ARBITRAGE AND THE LAW OF ONE

PRICE

B. Theoretical basis:

If the price after exchange-rate

adjustment were not equal,

arbitrage in the goods worldwide

ensures eventually it will.

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ARBITRAGE AND THE LAW OF ONE

PRICE

C. Five Parity Conditions Result

From These Arbitrage Activities

1. Purchasing Power Parity (PPP)

2. The Fisher Effect (FE)

3. The International Fisher Effect

(IFE)

4. Interest Rate Parity (IRP)

5. Unbiased Forward Rate (UFR)

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ARBITRAGE AND THE LAW OF ONE

PRICE

D. Five Parity Conditions Linked

by

1. The adjustment of

various

rates and prices to

inflation.



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ARBITRAGE AND THE LAW OF ONE

PRICE

2.



The notion that money

should have no effect on

real variables (since they

have been adjusted for

price changes).

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ARBITRAGE AND THE LAW OF ONE

PRICE

E. Inflation and home currency

depreciation:

1. jointly determined by the

growth of domestic money

supply;

2. Relative to the growth of

domestic money demand.

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ARBITRAGE AND THE LAW OF ONE

PRICE

F. THE LAW OF ONE PRICE

- enforced by

international

arbitrage.

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PART II. PURCHASING POWER

PARITY

I. THE THEORY OF PURCHASING

POWER PARITY:

states that spot exchange rates

between currencies will change

to the differential in inflation

rates between countries.

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PURCHASING POWER PARITY

II.



ABSOLUTE PURCHASING

POWER PARITY



A. Price levels adjusted for

exchange rates should be

equal between countries

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PURCHASING POWER PARITY

II.



ABSOLUTE PURCHASING

POWER PARITY



B. One unit of currency has

same purchasing power

globally.

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PURCHASING POWER PARITY

III. RELATIVE PURCHASING

POWER PARITY

A. states that the exchange

rate of one currency against

another will adjust to reflect

changes in the price levels

the two countries.



of



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PURCHASING POWER PARITY

1.In mathematical terms:



et

e0

where

e0 =

ih =

if =

t =



(1 +



ih

=

(1 + i f



)



)



t

t



et = future spot rate

spot rate

home inflation

foreign inflation

the time period

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PART I. ARBITRAGE AND THE LAW OF ONE PRICE

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