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Spread Euro/USD


FIGURE 1.2 Yield spread between 10-year German and U.S. government bonds and
the euro-to-dollar exchange rate, September 1, 1999, to January 15, 2000.

of one currency ought to adjust itself to be more in line with the purchasing
power of another currency. Broadly speaking, in a world where exchange rates
are left free to adjust to market imbalances and disequilibria in a price con-
text, exchange rates can serve as powerful equalizers. For example, if the cur-
rency of country X was quite strong relative to country Y, then this would
suggest that on a relative basis, the prices within country Y are perceived to
be lower to consumers in country X. Accordingly, as the theory goes, since
consumers in country X buy more of the goods in country Y (because they
are cheaper) and eventually bid those prices higher (due to greater demand),
an equalization eventually will materialize whereby relative prices of goods in
countries X and Y become more aligned on an exchange rate“adjusted basis.
Although certainly to be taken with a grain of salt, Economist magazine
occasionally updates a survey whereby it considers the price of a McDonald™s
Big Mac on a global basis. Specifically, a Big Mac price in local currency (as
in yen for Japan) is divided by the price for a Big Mac in the United States
(upon conversion of yen into dollars). This result is termed “purchasing power
parity,” and when compared to respective actual dollar exchange rates, an
over- or undervaluation of a currency versus the dollar is obtained. The pre-
sumption is that a Big Mac is a relatively homogeneous product type and
accordingly represents a meaningful point of reference. A rather essential (and
perhaps heroic) assumption to this (or any other comparable PPP exercise)
is that all of the ingredients that go into making a Big Mac are accessible in


each of the countries where the currencies are being compared. Note that
“equal” in this scenario does not necessarily have to mean that access to
goods (inputs) is 100 percent free of tariffs or any type of trade barrier. If
trade were indeed completely unfettered then this would certainly satisfy the
notion of equally accessible. But if all goods were also subject to the same
barriers to access, this would be equal too, at least in the sense that equal in
this instance means equal barriers. Yet the vast number of trade agreements
that exist globally highlights just how bureaucratic the ideal of free trade can
become even if perceptions (and realities) are such that trade today is gener-
ally at the most free it has ever been. Another important and obvious con-
sideration is that certain inputs might enjoy advantages of proximity. Beef
may be more plentiful in the United States relative to Japan, for example.
The very fact that there is both an interest rate theory to explain cur-
rency phenomenon and a notion of purchasing power parity tells us that
there are at least two different academic approaches to thinking about where
currencies ought to trade relative to one another. No magic keys to unlock-
ing unlimited profitability here! But like any useful theories commonly
applied in any field, here they are popular presumably because they man-
age to shed at least some light on market realities. Generally speaking, mar-
ket participants tend to be a rather pragmatic and results-oriented lot; if
something does not “work,” then its wholesale acceptance and use is not
very likely.
So why is it that neither interest rate parity nor purchasing power par-
ity works perfectly? The answer lies within the question: The markets them-
selves are not perfect. For example, interest rates generally are influenced to
an important degree by national central banks that are trying to guide an
economy in some preferred way. As interest rates can be an important tool
for central banks, these are often subject to the policies dictated by well-
meaning and certainly well-informed people, yet people do make mistakes.
Monetarists believe that one way to eliminate independent judgment of all
kinds (both correct and incorrect) is to allow a country™s monetary policy
to be set by a fixed rule. That is, instead of a country™s money supply being
determined by human and subjective factors, it would be set by a computer
programmed to allow only for a rigid set of money growth parameters.
As to other price realities in the marketplace that may inhibit a smoother
functioning of interest rate or PPP theories, there are a number of consid-
erations, including these three.

1. Quite simply, the supply and demand of various goods around the world
differ by varying degrees, and unique costs can be incurred when spe-
cial efforts are required to make a given good more readily available.
For example, some countries can produce and refine their own oil, while
others are required to import their energy needs.


2. The cost of some goods in certain countries are subsidized by local gov-
ernments. This extra-market involvement can serve to skew price rela-
tionships across countries. One example of how a government subsidy
can skew a price would be with agricultural products. Debates around
these subsidies can become highly charged exchanges invoking cries of
the need to take care of one™s own domestic producers, to appeal for the
need to develop self-reliant stores of goods so as to limit dependence on
foreign sources. Accordingly, by helping farmers and effectively lower-
ing the costs borne to produce foodstuffs, these savings are said to be
passed along to consumers who enjoy lower-cost items relative to the
price of imported things. Ultimately whether this practice is good or bad
is not likely to be answered here.
3. As alluded to above, tariffs or even total bans on the trade of certain
goods can have a distorting effect on market equilibriums.
There are, of course, many other ways that price anomalies can emerge (e.g.,
with natural disasters). Perhaps this is why the parity theories are most help-
ful when viewed as longer-run concepts.
Is there perhaps a link of some kind between interest rate parity and pur-
chasing power parity? The answer to this question is yes; the link is infla-
tion. An interest rate as defined by the Fischer relation is equal to a real rate
of interest plus expected inflation (as with a measure of CPI or Consumer
Price Index). For example, if an annual nominal interest rate is equal to 6
percent and expected inflation is running at 2.5 percent, then the difference
between these two rates is the real interest rate (3.5 percent). Therefore, infla-
tion is an important factor with interest rate parity dynamics. Similarly, price
levels within countries are affected by inflation phenomena, and so are price
dynamics across countries. Therefore, inflation is an important factor with
PPP dynamics as well. In sum, whether via a mechanism where an interest
rate is viewed as a “price” (as in the price to borrow a particular currency)
or via a mechanism where a particular amount of a currency is the “price”
for obtaining a certain good or service, inflation across countries (or, per-
haps more accurately, inflation differentials across countries) can play an
important role in determining respective currency values.
As of this writing, there are over 50 currencies trading in the world
today.3 While many of these currencies are well recognized, such as the U.S.
dollar, the Japanese yen, or the United Kingdom™s pound sterling, many are
not as well recognized, as with United Arab Emirates dirhams or Malaysian
ringgits. Although lesser-known currencies may not have the same kind of
recognition as the so-called majors (generally speaking, the currencies of the

International Monetary Fund, Representative Exchange Rates for Selected
Currencies, November 1, 2002.


Group of Seven, or G-7), lesser-known currencies often have a strong price
correlation with one or more of the majors. To take an extreme case, in the
country of Panama, the national currency is the U.S. dollar. Chapters 3 and
4 will discuss this and other unique currency pricing arrangements further.
The G-7 (and sometimes the Group of Eight if Russia is included) is a
designation given to the seven largest industrialized countries of the world.
Membership includes the United States, Japan, Great Britain, France,
Germany, Italy, and Canada. G-7 meetings generally involve discussions of
economic policy issues. Since France, Germany, and Italy all belong to the
European Union, the currencies of the G-7 are limited to the U.S. dollar, the
pound sterling, Canadian dollar, the Japanese yen, and the euro. The four
most actively traded currencies of the world are the U.S. dollar, pound ster-
ling, yen, and euro.

This chapter has identified and defined the big three: equities, bonds, and
currencies. The text discussed linkages among equities and bonds in partic-
ular, noting that an equity gives a shareholder the unique right to vote on
matters pertaining to a company while a bond gives a debtholder the unique
right to a senior claim against assets in the event of default. A discussion of
pricing for equities, bonds, and currencies was begun, which is developed
further in a more mathematical context in Chapter 2.
As a parting perspective of the similarities among bonds, equities, and
currencies, it is well to consider if one critical element could serve effectively
to distinguish each of these products. In the case of what makes an equity

Absence of a final maturity date


Absence of right
to vote

Absence of
the ability to
print money Currencies

FIGURE 1.3 Key differences among bonds, equities, and currencies.


an equity, the Achilles™ heel is the right to vote that is conveyed in a share
of common stock. Without this right, an equity becomes more of a hybrid
between an equity and a bond. In the case of bonds, a bond without a stated
maturity immediately becomes more of a hybrid between a bond and an
equity. And a country that does not have the ability to print more of its own
money may find its currency treated as more of a hybrid between a currency
and an equity. Figure 1.3 presents these unique qualities graphically. The text
returns time and again to these and other ways of distinguishing among fun-
damental product types.


Cash Flows


If the main thrust of this chapter can be distilled into a single thought, it is
this: Any financial asset can be decomposed into one or more of the fol-
lowing cash flows: spot, forwards and futures, and options. Let us begin with


“Spot” simply refers to today™s price of an asset. If yesterday™s closing price
for a share of Ford™s equity is listed in today™s Wall Street Journal at $60,
then $60 is Ford™s spot price. If the going rate for the dollar is to exchange
it for 1.10 euros, then 1.10 is the spot rate. And if the price of a three-
month Treasury bill is $983.20, then this is its spot price. Straightforward
stuff, right? Now let us add a little twist.
In the purest of contexts, a spot price refers to the price for an imme-
diate exchange of an asset for its cash value. But in the marketplace, imme-
diate may not be so immediate. In the vernacular of the marketplace, the
sale and purchase of assets takes place at agreed-on settlement dates.



For example, a settlement that is agreed to be next day means that the


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