Assessing the Long-run Fair Values of an Exchange Rate

Parity conditions are useful in the assessment of the fair value of currencies. Even then, it is worth clarifying that they cannot be used to gauge the currency value in real time.

As discussed previously, parity conditions include the covered interest rate parity, uncovered interest parity, forward rate parity, purchasing power parity, and International Fisher’s effect.

There exist authentic studies postulating that the parity conditions do not hold in the short term. The studies, instead, provide a view of exchange rates and the risks associated in the long run. In spite of this, the covered interest rate parity theory is an exception since it is based on the no-arbitrage condition.

For instance, statistical evidence has shown that, according to the relative PPP, there is little to see in the relationship between the change in exchange rates and inflation differentials within a short period, such as one year. However, if the investment horizon is extended to, say, 50 years, the connection will be more pronounced. Therefore, PPP would seem to be a suitable structure for assessing fair value in the FX markets. Note that to achieve this, the PPP equilibrium value is prolonged.

Question

Which one of the following is a no-arbitrage condition?

1. Covered interest rate parity.
2. Purchasing Power Parity (PPP).
3. Forward rate Parity.

Solution

The correct answer is A.

Covered interest rate parity is based on the no-arbitrage condition. This means that it equates the investment of two riskless investments, i.e. domestic and currency-hedged foreign investments.

Reading 8: Currency Exchange Rates: Understanding Equilibrium Value

LOS 8 (h) Explain approaches to assessing the long-run fair values of an exchange rate.