TOPICONE

INTERNATIONALFINANCIALMARKETSINTEGRATION

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OutlineEfficiencyoftheforeignexchangemarketandarbitragePurchasingPowerParityOvervaluationandundervaluationofacurrencyLoanableFundsMarketandInterestRateParityCoveredinterestparityUncoveredinterestparityRealinterestparityIsthereaGlobalCapitalMarket?22

1.ArbitrageandtheLawOfOnePrice

(onegood)-alongrunconceptIncompetitivemarkets,freeoftransportationcostsandofficialbarriersoftrade,identicalgoodssoldindifferentcountriesmustsellforthesamepricewhentheirpricesareexpressedintermsofthesamecurrencybecauseofarbitrage3

Itimpliesthatthedollarpriceofgoodiisthesamewhereveritissold:PiUS=(E$/€)x(PiE) where:PiUSisthedollarpriceofgoodiwhensoldintheU.S. PiEisthecorrespondingeuropriceinEurope E$/€isthedollar/euroexchangerate TheLawofOnePrice4

ARBITRAGEANDTHELAWOFONEPRICETHELAWOFONEPRICE:Theoreticalbasis:Ifpricesafterexchange-rateadjustmentwerenotequal,arbitrageofthegoodsensureseventuallytheywillconvergeworldwide.ThegeneralpricelevelsoftwocountriesshouldbelinkedinthesamefashionPPP5

2.PurchasingPowerParity-PPP

(basketofgoods)-alongrunconceptThetheoryofpurchasingpowerparitystatesthattheexchangeratebetweentwocountriesequalstheratioofthecountries’pricelevels-canbeusedforbenchmarkingPPPtheorythereforepredictsthatafallinacurrency’sdomesticpurchasingpowerwillbeassociatedwithaproportionalcurrencydepreciationintheforeignexchangemarket6

PurchasingPowerParity-PPPTheoryofPurchasingPowerParity(PPP):AbsolutePPPItcomparesaveragepricesacrosscountries.Itpredictsadollar/euroexchangerateof: E$/€=PUS/PE where:PUSisthedollarpriceofareferencecommodity basketsoldintheUnitedStates PEistheeuropriceofthesamebasket