• Global Frameworks: CFA Level 2 (Economics), Advanced Corporate Finance Standards.

1. The Law of One Price and Absolute Purchasing Power Parity (PPP)
The Law of One Price states that in frictionless markets with no transaction costs or trade barriers, identical goods must sell for the same price globally when expressed in a common currency. Absolute PPP scales this concept to an entire basket of consumer goods:
S = P_domestic / P_foreign
Where S is the spot exchange rate. If a domestic inflation spike causes local prices to rise, the domestic currency must depreciate to maintain purchasing power parity.
  • Relative PPP: Focuses on inflation differentials over time rather than absolute price levels:
    (S₁ − S₀) / S₀ ≈ I_domestic − I_foreign

2. Interest Rate Parity (IRP) Frameworks
Interest Rate Parity states that the interest rate differential between two countries must match the forward premium or discount of their currencies, preventing risk-free arbitrage.
                     ┌─────────────── Interest Rate Parity ───────────────┐
                     ▼                                                    ▼
       [Covered Interest Parity]                           [Uncovered Interest Parity]
   Hedged using forward contracts;                      Unhedged; Forward rate acts as an
   Enforced strictly by market arbitrage.                unbiased predictor of future spot rates.

  • Covered Interest Rate Parity (CIP): Applies when investors use forward contracts to eliminate exchange rate risk. The mathematical equilibrium is defined as:

    F = S × [(1 + r_price × (Days/360)) / (1 + r_base × (Days/360))]If the market forward rate disconnects from this calculation, traders execute Covered Interest Arbitrage—borrowing in the low-rate currency, converting to the high-rate currency at the spot rate, investing in the foreign asset, and locking in the exit return using a forward contract. This rapid trading quickly forces the market back to parity.

3. The International Fisher Effect (IFE)
The Fisher Effect states that a nominal interest rate (r) consists of a real interest rate (R) plus an expected inflation premium (I). Assuming real interest rates equalize globally due to integrated capital markets, the International Fisher Effect demonstrates that nominal interest rate differentials are driven entirely by expected inflation differences:

r_domestic − r_foreign ≈ I_domestic − I_foreign
 
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