Justification of Volatility of Foreign Exchange Rates given PPP and UIP

The aim of the assignment is the analysis on the international finance. The analysis will be based on the conditions of the exchange rate equilibrium conditions of Purchasing Power Parity and Uncovered Interest Parity. In addition, discussion will also be based on the justification of the high levels of the volatility in the foreign exchange rates.

Running Head: INTERNATIONAL FINANCE
INTERNATIONAL FINANCE
Name of the Student
Name of the University
Author Note

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Table of Contents
Justification of Volatility of Foreign Exchange Rates given PPP and UIP...............................2
Purchasing Power Parity............................................................................................................2
Uncovered Interest Parity...........................................................................................................2
Volatility of Exchange Rates and Relation with PPP or UIP or both........................................3
Devaluation of Pound against other major currencies...............................................................5
Shocks to Other Currencies........................................................................................................5
Econometric approach................................................................................................................7
Reference....................................................................................................................................8

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Justification of Volatility of Foreign Exchange Rates given PPP and UIP
The aim of the assignment is the analysis on the international finance. The analysis
will be based on the conditions of the exchange rate equilibrium conditions of Purchasing
Power Parity and Uncovered Interest Parity. In addition, dicussion will also be based on the
justification of the high levels of the volatility in the foreign exchang rates . Volatility of the
exchange rates makes the international trade as well as decisions of investments much more
difficult beacause the volatility increases the risk of exchange rate (Grossmann, Love and
Orlov 2014).
Purchasing Power Parity
It is the theory of economy which compares the currencies of the different countries
through the approach of the “basket of goods”. It is concerned with the concept of the
equilibrium of the two currencies that is at par when the price of the basket of goods is same
for both the countries that takes the account of the exchange rates. Hence, it is the way of the
measurement of the economic variables in the different countries for which the there is
variations of the irrelevant exchange rate does not distort the comparison. This rate is
required in the comparisons of that is equal to the ratio of respective purchasung power of the
currencies (Jolliffe and Prydz 2015).
Uncovered Interest Parity
This theory defines the interest rates differences between the two countries that is
equal to the currency of the foreign exchange rate’s relative change over the same time frame.
It is the form of the interest rate parityh that is used besides the covered interet rate parity.
The conditions of the uncovered interest rate parity is consists with the two streams of return,
one is from the investment’s interest rate of foreign money market as well as other from the
changes in the spot rate of foreign currency(Lothian 2016).

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Volatility of Exchange Rates and Relation with PPP or UIP or both
The volatility of the exchange rate is the most important aspects of the international
economies. There is the strong variability of the emerging markets as well as more failure of
the fixed regime. Countries usually commence on the period of the controlled nominal
exchange rates that is in the hope of achieving the stability for both internal and external.
These are the efforts, which rarely lasts and most of such countries are forced for devaluing
(Plakandaras, Papadimitriou and Gogas 2015).
The empirical evidence that explained the volatility of the exchange rate as well as
relation to either UIP or PPP or even both can be done by the Dornbusch’s influential
overshooting model. This model has explains the reason behind the high variance of the
floating exchange rates. This model is highly influential because recently the world has
switched from the system of Bretton Woods to the flexible exchange rates (Moore, and Wang
2014).
The assumption that was made by Dornbusch is as follows:
 Uncovered interest rate parity assumes that the differential of the interest rates is
equal to the spot rate’s expected change. This assumes that there is perfect mobility of
the capital, the investors have risk, which is neutral and the perfect substitutes are
assets of domestic and foreign. (Jegajeevan 2015)
 Absolutes purchasing power parity assumes that when the basket of goods, expressed
in the common currency, then across the countries, it should have the same cost. The
model assumes that the in the short run, deviation from the PPP is permitted.
However, in the long-run, exchange rate will return to the PPP. The real exchange rate
in the short run can increase which ultimately increase the economy competitiveness
as well as increases the net exports (Jegajeevan 2015).

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 There is equilibrium in the money market when the supply of the real money is equal
to the demand of the real money where the demand of real money is the output’s
rising function as well as interest rate’s falling functions (Hodrick 2014)..
 From the curve of the standard IS, output is given that is rising in real exchange rate
as well as falling in interest rate.
 Given by Philip curve, inflation rate is the function of output gap.
 Under the scrutiny, the economy is the small open economy so as it does not affect
the foreign interest rates, output and its prices (Engel 2014).
 There is the beginning of the economy at the stationary state where, the output is at
the potential, PPP holds, prices are constant, there are equal foreign and domestic
interest rates and the equilibrium rate is at level of equilibrium (Jegajeevan 2015).
In carrying trade, UIP is tied in the speculation of foreign exchange. Hence, it is
suggested, either, there is insufficiency for generating UIP by the volume of the carry trade or
the association of the risk premium with carry trade is quite large. In addition, to this, there is
significant transaction cost and liquidity shortage in carry trade, which leads to the deviations
from the UIP (Jegajeevan 2015).
The evidence of PPP suggests that there is some validity in the long-run as well as it
holds better than what it is in short run. The puzzle PPP is the real exchange rate, which does
not equal to the unity among the countries. The exchange rate is more and highly volatile as
well as rigidity of prices of goods (Twarowska and Kakol, 2014).
Therefore, from the conclusion, it has been find that the model of Dornbusch has the
mixed empirical evidence. Some evidence of the long purchasing power parity has been
accessed. However, in case of unrelated interest rates, most of the academician due to range
of overshooting, undershooting, delayed overshooting as well as no overshooting whatsoever

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rejects parity. Therefore, even though being the most influential model, it has not been able to
give the accuracy of the forecast for the movements of the exchange rates (Adeniran, Yusuf
and Adeyemi 2014).
Devaluation of Pound against other major currencies
The history of pound of British is as unique as the empire of British. It is one of the
oldest reserve currencies; therefore, it is the most reliable to the store wealth. However, there
has been devaluation of the Pound as compare to the other major currencies. It is because
based on short term; there has been immediate devaluation that was driven by the expectation
of the market. Even though, pound was in the market of bear for already more than two years.
It was due to the result of Brexit that came as shock to the financial and political elites that
have forced the positions of long speculative for exit at the level of painful as an evidence by
poor performances of the large number of the hedge funds over the Brexit. It has led to
stabilize of the volatility of pound but it began to spreading of the downward pressure on
currency. Moreover, in the long run, the actions taken by the central banks are to stabilize as
well as immunize the selloff of equity as well as potential crisis have ensured further
depreciation of this currency at lower rates. Therefore, this volatility in the exchange rate
increases the exchange rate risk (Plakandaras, Papadimitriou and Gogas 2015).
Shocks to Other Currencies
The other examples of shocks to other currencies are Bitcoin. There have been major
movements in the bitcoin as compare to other currencies. The below graph shows that, even
in the short run, holding of the bitcoin is very risky. It is inconsistent with the currency that
acts as a value’s store as well as it undermine greatly the currency’s ability for functioning as
account’s unit (Plakandaras, Papadimitriou and Gogas 2015).

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Figure 1: Bitcoin Volatility
The next example is of Venezuelan bolivar. Venezuela has also witnessed major
crisis. The government has announced the massive 95% of the currency devaluation. It was
due this, there was relaunching of the currency as bolivar soberano, by replacing bolivar
fuerte. As a result, the currency code has been changed from VEF to VES (Plakandaras,
Papadimitriou and Gogas 2015).

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Figure 2: Venezuelan bolivar Volatility
Econometric approach
1. Uncovered interest rate parity:st +k=st + ^it , k
Where s presents the (log) exchange rate, it,k presents the interest rate of maturity k and ^
presents the intercountry difference. Unlike the other specifications, this relation does not
involve estimation in order to make predictions. The study found that the long run maturity
interest rate is not able to predict the changes in long run exchange rate (Zhang et al. 2015).
2. Relative purchasing power parity: st =β0 + ^pt
Where p presents log price level and ^ presents the intercountry difference. The recent
research has shown the usefulness of PPP deviations for predicting exchange rate changes
(Ca’Zorzi, Muck and Rubaszek 2016).
The economic model, purchasing power parity and interest rate parity has importance
and the probable reason is the parsimonious nature of specification where interest rate parity
does not require the estimation of the parameter.

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Reference
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fluctuation on the Nigerian economic growth: An empirical investigation. International
Journal of Academic Research in Business and Social Sciences, 4(8), p.224.
Ca’Zorzi, M., Muck, J. and Rubaszek, M., 2016. Real exchange rate forecasting and PPP:
This time the random walk loses. Open Economies Review, 27(3), pp.585-609.
Engel, C., 2014. Exchange rates and interest parity. In Handbook of international
economics (Vol. 4, pp. 453-522). Elsevier.
Grossmann, A., Love, I. and Orlov, A.G., 2014. The dynamics of exchange rate volatility: A
panel VAR approach. Journal of International Financial Markets, Institutions and
Money, 33, pp.1-27.
Hodrick, R., 2014. The empirical evidence on the efficiency of forward and futures foreign
exchange markets. Routledge.
Jegajeevan, S., 2015. Validity of the Monetary Model of the Exchange Rate: Empirical
Evidence from Sri Lanka. Staff Studies, 42(1).
Jolliffe, D. and Prydz, E.B., 2015. Global poverty goals and prices: how purchasing power
parity matters. The World Bank.
Lothian, J.R., 2016. Uncovered interest parity: The long and the short of it. Journal of
Empirical Finance, 36, pp.1-7.
Moore, T. and Wang, P., 2014. Dynamic linkage between real exchange rates and stock
prices: Evidence from developed and emerging Asian markets. International Review of
Economics & Finance, 29, pp.1-11.

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Plakandaras, V., Papadimitriou, T. and Gogas, P., 2015. Forecasting daily and monthly
exchange rates with machine learning techniques. Journal of Forecasting, 34(7), pp.560-573.
Twarowska, K. and Kakol, M., 2014. Analysis of Factors Affecting Fluctuations in the
Exchange Rate of Polish Zloty against Euro. In Human Capital without Borders: Knowledge
and Learning for Quality of Life; Proceedings of the Management, Knowledge and Learning
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Zhang, Z., Perez, E.C.V., Chinn, A. and Davies, J., 2015. Tree Diversity has Limited Effects
on Beech Bark Disease Incidence in American Beech Population of Mont St-Hilaire. McGill
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