Parity Conditions in International Markets

17 Pages Posted: 5 Apr 2010

See all articles by Marc L. Lipson

Marc L. Lipson

University of Virginia - Darden School of Business

Abstract

This note reviews the four central parity conditions that underlie most theories regarding the relationship between exchange rates, inflation and interest rates. The concepts are illustrated through a unified example exploring the relation between the U.S. dollar and Norwegian krone. The note presents both an intuitive understanding of the relations as well as precise mathematical formulas frequently employed in analysis.

Excerpt

UVA-F-1572

Rev. Jun. 30, 2011

Parity Conditions in International Markets

Global firms are not the only ones affected by global markets. Even firms with only domestic operations and financing can be dramatically affected by changes in the international landscape associated with, among other things, exchange rate changes, global price changes, and capital market fluctuations.

This note presents an overview of the theoretical frameworks that underlie most thinking and discussion about exchange rates and the relation between exchange rates and both interest rates and inflation. All of the relations described in this note are based on one premise—that markets will move in response to profit seeking activities in such a manner as to reach a point where profits are eliminated. When markets are at this zero-profit point and there are no incentives to act, the markets are in equilibrium and deemed to be in “parity.” Hence, these basic relations are called parity conditions.

Throughout this note, we will consider a single pair of currencies, the U.S. dollar (USD) and the Norwegian krone (NOK). The discussion in this note assumes a familiarity with basic currency terminology and markets; however, a review of these topics is provided in Appendix A.

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Keywords: parity conditions, international finance, exchange rates, inflation

Suggested Citation

Lipson, Marc Lars, Parity Conditions in International Markets. Darden Case No. UVA-F-1572. Available at SSRN: https://ssrn.com/abstract=1583739

Marc Lars Lipson (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4837 (Phone)
434-243-5021 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/lipson.htm

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