Chapter 6

The act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits.

Involves (i) no net investment, as well as (ii) no risk, and then requiring that such a portfolio should not generate any net cash flow in equilibrium.

A situation that occurs when IRP does not hold, thereby allowing certain arbitrage profits to be made without the arbitraguer investing any money out of pocket or bearing any risk.

Involves buying a high-yielding currency and funding it with a low-yielding currency, without any hedging. It is profitable if the interest rate differential is greater than the appreciation of the funding currency against the investment currency.

Hypothesis stating that financial markets are informationally efficient in that the current asset prices reflect all the relevant and available information.

Theory stating that the nominal interest rate is the sum of the real interest rate and the expected inflation rate.

Theory stating that the forward premium or discount is equal to the expected change in the exchange rate between two currencies.

An arbitrage equilibrium condition holding that the interest rate differential between two countries should be equal to the forward exchange premium or discount. Violation of this gives rise to profitable arbitrage opportunities.

A theory stating that the expected change in the spot exchange rate between two countries is the difference in the interest rates between the two countries.

The requirement that similar commodities or securities should be trading at the same or similar prices.

Uses various models to forecast exchange rates. Difficulties of this approach are:
1. One must forecast a set of independent variables to forecast the exchange rates, and forecasting the former will certainly be subject to errors and may not be necessarily easier than forecasting the latter.
2. Parameter values that are estimated using historical data may change over time because of changes in government policies and/or the underlying structure of the economy.
3. Model itself can be wrong.

Examples include haircuts, housing, etc.

A theory stating that the exchange rate between currencies of two countries should be equal to the ratio of the countries' price levels of a commodity basket.

States the exchange rate between the dollar and pound should be
S = P$ / P£

When PPP relationship is presented in the "rate of change" form, we obtain...
If PPP holds for tradables and the relative prices between tradables and nontradables are maintained, then PPP can hold in this version.

An identity stating that for each country, the general price level times the aggregate output should be equal to the money supply times the velocity of money.

A hypothesis stating that in an efficient market, asset prices change randomley (i.e., independently of historical trends), or follow a "random walk". Thus, the expected future exchange rate is equivalent to the current exchange rate.

Measures the degree of deviation from PPP over a period of time, assuming PPP held at the beginning of the period.

A method of predicting the future behavior of asset prices based on their historical patterns.

This parity condition hols that the difference in interest rates between two countries is equal to the expected change in exchange rate between the countries' currencies.