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International Parity Conditions and the Relationships with Exchange Rate - Application of PPP Hypoth
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1INTRODUCTION

1.1 Background

In the international financial markets, international trade and exchange of goods and services across countries have raised the chances of transactions in different currencies, and therefore rises some of the fundamental questions such as: ‘What are the determinants of exchange rate?; Are changes in exchange rates predictable?’ etc are being asked everyday by those international portfolio investors, importers, exporters and government officials. However, different countries have their own economic situation. Sometimes, if only one country did some change on their government policy, it leads to the fluctuation in the exchange rate between countries. How can the exchange rate been predicted in a comparative stable economy environment? In the academia, it provided a corn theory. The three main parity conditions are: Purchasing Power Parity (PPP), International Fisher effect (IFE) and Interest Rate parity (IRP).

 

The purchasing power parity (PPP) condition concerns with the relative values or the exchange rate of two currencies and the prices in the two countries, while that the interest rate parity (IRP) condition identifies the relationship between the exchange rate, the forward rate and the interest rate in the two countries. And the relationship between changes in the exchange rate and the interest rate differential in the two countries was established by the international fisher effect (IFE) for exploiting the relationship between the interest rate differential and the inflation differential.

 

However, the exchange rate was always been considered is uncertain and unpredictable. It is easy to see that, the exchange rate is the prime concern for international traders and the same time relative policy maker is also important. In the rapidly developing global economy, understanding and predicting the main currencies in exchange rate market are no doubt was defined to a necessity for each investment. As a result, serious analysis and understanding of what is the fundamental influence determined the exchange rate is quite important. This investigation is the only way for the success of future investment. However, the complicated nature of exchange rate market is a challenging task. The recent empirical result showed that, the exchange rate were largely random walk and extremely unpredictable in the long term. This can certainly be said to be true for the US Dollar as it has constantly been changing since 1973 on a daily basis. More recently, some research has indicated that while the random walk model is a relatively accurate approximation in short run, real exchange rates show a tendency to revert back to the mean over the medium in the long term.

 

Before trying to predict exchange rates, it is crucial to understand the determinants and influences. Professor the three main approaches to understand exchange rate.  However, his view only provides a starting point as there are several other theories regarding the determination of exchange rates. It is crucial to understand the way in which these theories can combine and complement each other. In doing so, it can deepen and extend the ability to comprehend the complex nature of the global economic market.

 

According to the starting point of Professor Dornbusch, the three major schools of thought on exchange rates determination are as follows: purchasing power parity (PPP) approach, balance-of-payment (BOP) and the asset market (relative price of bonds) approach. The PPP approach is the more widely accepted theory of the three and also happens to be the oldest. The long-term equilibrium exchange rates of two currencies were used to balance their purchasing power. This theory was developed by  states that identical goods within an ideal efficient market would be priced the same. This is also known as the absolute version of PPP.

 

The asset market approach argues that the supply and demand of a wide variety of financial assets would alter exchange rates similar to the way in which changes in both fiscal and monetary policies can alter expected returns and forecasted relative risks of financial asset, thus leading to changes in the exchange rate. This approach assumes those foreigners’ decisions on whether with regard to the holding of monetary claims depends on investment considerations. Key considerations include relative real interest rates, prospects for economic growth, political safety and corporate governance practices. The asset market view is also embodied also agrees how monetary policy changes can alter financial assets to influence exchange rate changes. However, the asset market approach is also applicable to emerging markets that will result in additional variables can help determine the exchange rate.

 

Many other individuals have also been trying to drive out some other approaches, such as . Despite numerous research and work there still isn’t a single model that is capable of explaining and forecasting the fluctuations in exchange for the short and medium term, let alone the long term.

 

Based on most of the empirical studies and researches conducted over the last 2 decades, the PPP hypothesis consistently seems to be the most accepted approach with regards to forecasting exchange rates in the long run, although contested by The importance and credibility of using PPP is largely due to its important role and use within macroeconomic monetary models. Furthermore, PPP is considered to be more useful when comparing differences in living standards across countries, as it takes into account the relative inflation rates as well as living costs.

 

Accordingly, for being an effective tool in the exchange rate analysis, the absolute version of PPP hypothesis is rejected by many economists and econometric models. It is often the weaker version (relative) of PPP that survives in most of the cases. This is explained that the relative PPP concerns about the real exchange rate, which the real exchange rate is the relative price of a set of foreign goods. In the long run, this relative price is determined by the supply and demand for this set of goods. And hence, information of the relative competiveness of different countries is given by the fluctuations in the real exchange rate. For example, if the real exchange rate is increasing, then the domestic economy’s competitive position is improving; in opposite, if decreasing, which indicates the competitive position is slipping. This is saying that the real exchange rate is more meaningful than the nominal exchange rate in the absolute version.

 

However, long-run forecasts for foreign exchange rates can never satisfy or overcome the rapidly growing and fluctuating economy. The accuracy in short-term prediction is the key to successful near future investments, especially to hedge a receivable or payable. In such circumstances, dividends can be as short as three months. In these cases, it is apparent that long-run forecasting cannot take into account future changes, technical factors in the market places and government intervention. The use of Famma’s market efficiency hypothesis is suggested in Penm, andto explain the short run changes in exchange rates. Hopper argues that in order to understand the market sentiment to determine the fluctuations and correlation between exchange rates in the short term, would work better than economic fundamentals. In his book, Michael Roy Rosenberg suggests some models and strategies, such as trading rules and risk appetite indices to form the basis of short run forecasting. It seems the market efficiency hypothesis would be the more appropriate in this short-run forecasting area as is relies on targeting profitable trading opportunities at the appropriate time.

 

Amongst the theories of forecasting, several technical analyses have been further developed in an attempt to produce an accurate insight into future exchange rate fluctuations. The majority of these analyses assume that exchanges follow certain trends. These trends can then be applied to forecast the exchange rates. In reality however, exchange rates appear to be non-stationary (non-linear), contradicting most theories that suggest a fair value and this value will return eventually.

 

1.2 The definition of PPP

The purchasing power parity, also called the International Comparison Program (ICP), based on domestic commodity prices compare the same commodity price in the benchmark countries’, and use the weighted average rate as the purchasing power parity to calculate. ICP is a comparison system provided by the United Nations Statistical Office and the World Bank, which aims to put forward the GDP and its components keep in an international consensus price in the cross-country comparison. ICP has developed from a bilateral to a multilateral, to the sub-regional comparison (multilateral comparison in regions, and then combined into a global comparison) the development process, but the basic idea of their research is through price surveys and the use of GDP calculated as a basis in terms of expenditure the real purchasing power parity ratio between the different countries ( PPP as the currency conversion factor), thereby replacing the exchange rate, a country''s GDP converted to a base currency or the GDP which represent the international currency. The absolute PPP idea, states that the long-run equilibrium exchange rate is derived from the ratio of domestic price and foreign price. However, this hypothesis is rejected by econometric analysis as the PPP calculation and forecasts can contain internationally standardized baskets of goods prices which will force economic agents to go back to the relative (weak) version of PPP. (The relative PPP relates the change of price levels in each country to the change in the market exchange rate).

 

The second most frequently used theoretical approach is the Balance-of-payment approach. This approach involves the supply and demand for currencies on the foreign exchange market. This approach treats exchange rate, as in the flow market for international transactions (trade), similar to the price of a good (foreign currency). This price is obtained from the intersection of the market supply and demand. However, over the past 20 years it has become increasingly evident that exchange rates do not behave in the ways presented by the BOP approach. The main problem lies in its fundamental emphasis on the flow of currency rather than stocks of money or financial assets.states that the BOP approach does not represent a ‘true’ steady equilibrium exchange rate.

 

1.3 Forecasting tools

There are numerous technical models that can be used for testing the reliability of PPP. Exponential smooth transition auto regressive (ESTAR) model is one such method adopted by to test euro exchange rates. The test found that when PPP deviations are small, exchange rates appear to be random walk in the unit root test. Only in the significant deviations period would exchange rates be brought back towards its long-term trend. Penm, 2005), states that the traditional method for PPP yields results in unfavourable of the PPP hypothesis and suggests using  co-integration model to test PPP to determine a long run equilibrium result2008) argues that testing the validity of PPP is close to testing for unit roots in real exchange rate and finds evidence to support the Quasi-PPP hypothesis. (2007) also utilise the co-integration model for both the absolute and relative PPP where the results generally support the weak PPP.  in his paper used two old and two new unit root tests to analyse PPP which gave mixed results.

suggests that in short run forecasting, the state-of-the-art econometric method to capture the short run dynamics should be utilised. In terms of testing the market efficiency in forecasting short-run exchange rate, Penm, Penm & Terrell prefer the more traditional OLS model for forward rate spot rate differences. The use of efficient market hypothesis is also considered by Timmerman& Granger (2003) to capture the financial returns and obtain predictable patterns.

 

1.4 Motivation

Having analysed various literatures, this paper has chosen the PPP as an effective tool in analysing the foreign exchange rates patterns in the long-run and short-run. This paper compares the exchange rates of the Canadian Dollar vs US Dollar, Swiss Franc vs UK Pound and also the US Dollar vs UK Pound from the period January 1994 to July 2009. In addition, it would be more convincing to test the accuracy of PPP in producing future exchange rate forecasting. This can be tested by comparing the forecasted exchange rates and the actual known spot rates for the period during the three years from August 2006 to July 2009.

 

The decision to use the four currencies is based on the discussion paper by Frankel & Kahler on the topic of the global trend toward three major economic blocs. The three economic blocs are identified in the paper as North America, Europe and East Asia. The paper goes on having a broadly definition is “the economic bloc as a group of countries that are concentrating their trade and financial relationships with preference to one another”.

 

In particular, the four countries that have been selected are all under the floating exchange rates regimes, but within the two largest economic regions, Europe and North America. Naturally, the hypothesis here is that whether PPP can pass through either within the same bloc or cross trading region. In this respect the hypothesis should be examined empirically and not be accepted uncritically.

 

The United Kingdom, United States, Switzerland and Canada are four of the world’s most elite economic super-powers. In particular, UK and US, which are often seen as economic role models of effective and well-run capitalist markets. Despite their high status in the economic world, the recent downturn in the economy has had great effect on both countries. Each is currently in a weak economic activity among, and faces some similar problems, but for different reasons. However, after the stock storm at the beginning of the year, they are all staying at the difficult time, facing credit crunch, and experiencing economic recession.

 

The UK has the fifth largest economy in the world in terms of purchasing power parity and exchange rate market. It is a globalised country that boasts experience and the longest period of sustained economic growth for more than 150 years, having grown in every quarter since 1992. Despite this, the UK economy is at risk of recession, at it experiences the weakest period of growth in 15 years. A report warns of the risk to recession claiming it will last for the next two years. The Deloitte Economic Review claimed the housing market would be at the heart of the downturn with the global credit squeeze making borrowing even more difficult. The reports also suggest that the European economy-the UK’s biggest export market, will remain strong relatively. However, this will not be sufficient to balance out the down turn in the US.

 

The economy of US is the world’s largest economy, however, recently, it had experienced four years of recession is due to high stock market valuation impact, the future sustainable development of inaccurate forecasts, as well as excess capacity and capital markets, demand has far exceeded the U.S. consumption habits. The consumption habits increased while personal savings has grown from little or none at all. This situation has been formed since the mid-80s, until the 90''s gradually broke out. The labour department data provides further evidence of the pressure grows for action on US economy.

 

Within Europe the Swiss economy is the eighth largest. However, over the last 30 years, it has been experiencing the worst economic slump. It has been compounded by the buoyancy of the Franc, which has fuelled the risk of deflation by making imports cheaper. On top of this, the global recession has severely affected demand for exports in the Swiss economy. This accounted for around half of Swiss gross domestic product (GDP) which dropped 0.3 percent in the second quarter this year. In March, the Swiss Bank has started selling the Franc in an attempt to increase consumer prices, which is forecasted to fall by 0.5 percent.

 

In Canada, Minister of Finance Jim Flaherty states that Canada''s economy is currently the period of strong economic growth in its history, its overall development will be accompany with the developing of labour market, and the growth of family''s net assets and corporate profits at record levels, therefore, in Canada''s economic adjustment period, it will be able to successfully to the rise in the U.S. dollar and increasing global competition.

 

Back to a decade ago, the introduction of the single European currency in 1999 had profound effects on the global economy and the international monetary system. Before evaluating the future impact of the new currency area, it is imperative to understand how the international transmission mechanisms worked in the preceding system, such as the post - Bretton woods system. In this context, it would be provide an understanding of how the external float of the European Union area worked relative to the Pound Sterling, US dollar, Canadian dollar and Swiss Franc areas. studied the international parity condition between the USA and Europe from the mid 70s to 1998. They utilise co-integration analysis on monthly data. They found that the very slow but significant price adjustment towards sustainable levels of real exchange rate was off-set by similar changes in the spread of the long-term bond rates. Related to this was the strong empirical support for the weak erogeneity of the long-term bond rates. This is important as it signified the importance of the large US trade deficit (i.e., the low level of US saving) and shows the intertwining with international finance.  These results pointed out as reversal linkage, partly from the long end of the market to short end; partly from the nominal interest rates to inflation rates.

 

Basically, ever since the first experiment with exchange rates in the 1920s, the discussions of rate fluctuations have been put in attentions by economists and investors. Some economic elements which are expected to link with exchange rate such as interest rate and inflation rate are being studied. The general, PPP and IRP are considered to be the economic fundamentals which drive the exchange rate market, but also subject to other effects that sometimes prevent an observer from identifying the effect of these parities in practice. However, PPP is more preferable to be used to forecast exchanges on its own or combines with IRP rather than using IRP only. And therefore, the application of PPP will apply in this paper for testing.

 

 

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