Though this be madness, yet there is method in it.
— William Shakespeare
This chapter introduces the international parity conditions that relate forward premiums and expected exchange rate changes to cross-currency differentials in nominal interest rates and inflation. These relations are then used to develop a measure of a currency's purchasing power relative to other currencies, called the real exchange rate. The chapter concludes with a discussion of exchange rate forecasting from the international parity conditions and other predictors.
4.1 The Law of One Price
The law of one price, also known as purchasing power parity or PPP, is the single most important concept in international finance.
The implication for international finance is that an asset must have the same price or value regardless of the currency in which value is measured. If PPP does not hold within the bounds of transaction costs, then there is an opportunity to profit from cross-currency price differentials.
Although the popular press often uses the term “arbitrage” or “risk arbitrage” to refer to speculative positions, arbitrage is more strictly defined as a profitable position obtained with
- No net investment
- No risk
“No money down and no risk” profit is great work—if you can get it. Such opportunities are difficult to find in the currency markets, ...