PPP and Interest Rate Arbitrage

This chapter focuses on the purchasing power parity (PPP) and the interest rate arbitrage. Professor Larraín begins by explaining the law of one price, which states that a good must cost the same everywhere when it is expressed in common currency, and why it won't be met exactly across economies. He uses the example of the Big Mac Index (of The Economist magazine), and shows that PPP can be calculated from the law of one price. Professor Larraín then explains the four conditions for PPP to hold: no transport costs, no artificial barriers such as trade tariffs or import quotas, all goods must be internationally tradable, and the local price index must have the same components. He also discusses the interest rate arbitrage and determination of the exchange rate, and how international investors choose to invest. Furthermore, he explains covered and uncovered interest arbitrage conditions as well as exchange risk.

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