Law Of One Price

Law of one Price This states that the domestic price of domestic and foreign items shall be equal. If this is not true then people will buy only less expensive item out of foreign or domestic item.

Price of foreign goods in domestic market are determined by exchange rate DPfg = ER X FPfg Where, DPfg = Domestic

price of foreign goods. FPfg = Foreign price of Foreign Goods ER = Exchange Rate (Domestic currency/ foreign currency).

Law of one Price requires  DPdg = FPdg Where, DPdg = Domestic price of domestic goods FPdg = Domestic price of foreign goods. “There is only one success - to spend your life in your own way."

International parity relationship [A]. Interest rate parity: It is relationship between interest rates & exchange rates of two countries. Interest Differential = Exchange rate differential (1+ro) = SF/D (1+ rf) FF/D "Happiness is like jam. You can't spread even a little without getting some on yourself."

[B] Purchasing Power Parity Exchange rate of two countries currencies equal the ratio between the prices of goods in these countries. Further the exchange rate must change to adjust to changes in prices of goods in the two countries. Inflation rate = Current spot rate & expected differential spot rate differential (1+id) = SF/D (1+ if)

E(SF/D)

It's not what you know, it's what you use that makes a difference.

[c]. Expectation theory of forward rates: If market participants are risk-neutral then forward rate must equal to expected future spot rate. Forward Rate & = Expected & current spot spot rate differential rates differential FD/F = E(SD/F) SD/F SD/F

OR

FD/F = E(SD/F)

“To be a great champion you must believe you are the best. If you’re not, pretend you are.”

[D]. International Fisher Effect  

Nominal interest rate = real interest rate + inflation Nominal interest = Expected interest rate differential differential (1+rD) = E(1+iD) (1+ rf) E(1+if)

In effect, Fisher effect implies that expected future spot rate of a currency with a higher interest rate will tend to fall in value in long run & future (exp.) spot rate of currency with lower interest rate will tend to rise in long run. Thus :(1+rD) = E(SD/F) (1+ rf) SD/F

"Two men look out the same prison bars; one sees mud and the other stars."

Foreign Currency rates

Direct

Indirect

A). Spot Exchange Rate - BID-ASK spread Percentage spread = Ask Price – Bid Price ASK Price e.g. Currency

Buying

Australian 25.75 $

Selling 26.00

"The optimist sees opportunity in every danger; the pessimist sees danger in every opportunity."

B). Cross rates A cross rate is an exchange rate between the currencies of two countries that are not quoted against each other, but are quoted against common currencies. e.g. US$ 0.02339/ Baht US$ 0.02583/ INR

C). Forward Exchange Rates:- Forward Premium/ Discount  It refers as annualized % Deviation from spot rate. Forward premium = Spot rate – Forward rate Forward rate Forward Discount = Forward rate – Spot rate Spot Rate Currency Arbitrage

X 360 Days X 360 Days

The foreign Exchange Market Customer Buys $ with DM Stock Broker Local Bank

Foreign Exchange Broker

Participants:

Major Banks Inter bank Market

Local Bank

1.Arbitrageurs

Stock Broker

2. Traders 3. Hedgers 4. Speculators

IMM LIFFE PSE

Customer Buys DM with $

Exchange rate forecasting 1). Trend Analysis ER( T+1) = A +B X ER(T) 2). Moving Standard deviation. 3). Using Purchasing Power Parity 4). Forward Exchange Rate as a forecast of Future Spot Exchange Rates "Circumstances do not make a man, they reveal him."