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International Finance: DR Duc Vo
International Finance: DR Duc Vo
International Finance: DR Duc Vo
INTERNATIONAL FINANCE
Dr DUC VO
Chapter 6
International Parity
Conditions
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Learning Objectives
6.1 Examine how price levels and price level changes
(inflation) in countries determine the exchange rates at
which their currencies are traded
6.2 Show how interest rates reflect inflationary forces within
each country and currency
6.3 Explain how forward markets for currencies reflect
expectations held by market participants about the future
spot exchange rate
6.4 Analyze how, in equilibrium, the spot and forward
currency markets are aligned with interest differentials and
differentials in expected inflation
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SF 90
indirect from American view 1 + i 360
F SF/$ = S SF/$
$ 90
90
1 + i 360
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Copyright
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Appendix 1
Long Description for a formula expresses a currency
conversion from dollars to yen.
P to the power of dollar sign, times S to the power of start
expression Yen sign times dollar sign end expression
equals P to the power of Yen sign.
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Appendix 2 (1 of 2)
Long Description for a comparison of 12 foreign currencies based on the price of a Big Mac against the US Dollar.
A table shows Big Mac prices in 14 currencies, and shows the conversion of that price into dollars. It then compares the
currency to the dollar showing the difference in valuation.
A table has 14 rows and 7 columns. The columns have the following headings from left to right. Country, Currency,
Column 1, Big Mac Price in Local Currency, Column 2, Actual Dollar Exchange Rate July 2017, Column 3, Big Mac
Price in Dollars, Column 4, Implied PPP of the Dollar, Column 5, Under or over valuation against the dollar. Footnote
asterisk, asterisk, . The row entries are as follows. Row 1. Country, United States. Currency, Dollar sign. Column 1, Big
Mac Price in Local Currency, 5.3. Column 2, Actual Dollar Exchange Rate July 2017, blank. Column 3, Big Mac Price in
Dollars, 5.3. Column 4, Implied PPP of the Dollar, blank. Column 5, Under or over valuation against the dollar. Footnote
asterisk, asterisk, blank. Row 2. Country, Britain. Currency, Pound sign. Column 1, Big Mac Price in Local Currency,
3.19. Column 2, Actual Dollar Exchange Rate July 2017, 1.2889 asterisk. Column 3, Big Mac Price in Dollars, 4.11.
Column 4, Implied PPP of the Dollar, 1.6614. Column 5, Under or over valuation against the dollar. Footnote asterisk,
asterisk, Negative 22.4%. Row 3. Country, Canada. Currency, C, dollar sign. Column 1, Big Mac Price in Local
Currency, 5.97. Column 2, Actual Dollar Exchange Rate July 2017, 1.2823. Column 3, Big Mac Price in Dollars, 4.66.
Column 4, Implied PPP of the Dollar, 1.1264. Column 5, Under or over valuation against the dollar. Footnote asterisk,
asterisk, Negative 12.2%. Row 4. Country, China. Currency, Yuan. Column 1, Big Mac Price in Local Currency, 19.8.
Column 2, Actual Dollar Exchange Rate July 2017, 6.7875. Column 3, Big Mac Price in Dollars, 2.92. Column 4, Implied
PPP of the Dollar, 3.7358. Column 5, Under or over valuation against the dollar. Footnote asterisk, asterisk, negative
45.0%. Row 5. Country, Denmark. Currency, D, K. Column 1, Big Mac Price in Local Currency, 30. Column 2, Actual
Dollar Exchange Rate July 2017, 6.5126. Column 3, Big Mac Price in Dollars, 4.61. Column 4, Implied PPP of the
Dollar, 5.6604. Column 5, Under or over valuation against the dollar. Footnote asterisk, asterisk, negative 13.1%. Row
6. Country, Euro area. Currency, Euro sign. Column 1, Big Mac Price in Local Currency, 3.91. Column 2, Actual Dollar
Exchange Rate July 2017, 1.1419 asterisk. Column 3, Big Mac Price in Dollars, 4.46. Column 4, Implied PPP of the
Dollar, 1.3555 asterisk. Column 5, Under or over valuation against the dollar. Footnote asterisk, asterisk, negative
15.8%.
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Appendix 2 (2 of 2)
Row 7. Country, India. Currency, Rupee. Column 1, Big Mac Price in Local Currency, 178. Column 2, Actual Dollar
Exchange Rate July 2017, 64.558. Column 3, Big Mac Price in Dollars, 2.76. Column 4, Implied PPP of the Dollar,
33.585. Column 5, Under or over valuation against the dollar. Footnote asterisk, asterisk, negative 48.0%. Row 8.
Country, Japan. Currency, Yen sign. Column 1, Big Mac Price in Local Currency, 380. Column 2, Actual Dollar
Exchange Rate July 2017, 113.06. Column 3, Big Mac Price in Dollars, 3.36. Column 4, Implied PPP of the Dollar,
71.698. Column 5, Under or over valuation against the dollar. Footnote asterisk, asterisk, negative 36.6%. Row 9.
Country, Mexico. Currency, Peso. Column 1, Big Mac Price in Local Currency, 49. Column 2, Actual Dollar Exchange
Rate July 2017, 17.7908. Column 3, Big Mac Price in Dollars, 2.75. Column 4, Implied PPP of the Dollar, 9.2453.
Column 5, Under or over valuation against the dollar. Footnote asterisk, asterisk, negative 48.0%. Row 10. Country,
Norway. Currency, k, r. Column 1, Big Mac Price in Local Currency, 49. Column 2, Actual Dollar Exchange Rate July
2017, 8.2852. Column 3, Big Mac Price in Dollars, 5.91. Column 4, Implied PPP of the Dollar, 9.2453. Column 5, Under
or over valuation against the dollar. Footnote asterisk, asterisk, 0.116. Row 11. Country, Peru. Currency, S o l. Column
1, Big Mac Price in Local Currency, 10.5. Column 2, Actual Dollar Exchange Rate July 2017, 3.2515. Column 3, Big
Mac Price in Dollars, 3.23. Column 4, Implied PPP of the Dollar, 1.9811. Column 5, Under or over valuation against the
dollar. Footnote asterisk, asterisk, negative 39.11%. Row 12. Country, Russia. Currency, Ruble. Column 1, Big Mac
Price in Local Currency, 137. Column 2, Actual Dollar Exchange Rate July 2017, 60.1369. Column 3, Big Mac Price in
Dollars, 2.28. Column 4, Implied PPP of the Dollar, 25.849. Column 5, Under or over valuation against the dollar.
Footnote asterisk, asterisk, negative 57.0%. Row 13. Country, Switzerland. Currency, Swiss Franc. Column 1, Big Mac
Price in Local Currency, 6.5. Column 2, Actual Dollar Exchange Rate July 2017, 0.9642. Column 3, Big Mac Price in
Dollars, 6.74. Column 4, Implied PPP of the Dollar, 1.2264. Column 5, Under or over valuation against the dollar.
Footnote asterisk, asterisk, 0.272. Row 14. Country, Thailand. Currency, Baht. Column 1, Big Mac Price in Local
Currency, 119. Column 2, Actual Dollar Exchange Rate July 2017, 34.0365. Column 3, Big Mac Price in Dollars, 3.5.
Column 4, Implied PPP of the Dollar, 22.4528. Column 5, Under or over valuation against the dollar. Footnote asterisk,
asterisk, negative 34.0%.
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Appendix 3
Long Description for a graph plots the change in the spot exchange rate versus the difference in
expected rates of foreign inflation.
The graph is known as the Purchasing Power Parity, or PPP line. The following list details how the
features of the graph represent the strength or weakness of the home currency based on the spot
exchange rate and expected rates of inflation.
• The PPP line falls through point P at (negative 4, 4) and the origin. Point P forms the top left vertex
of a square region in quadrant 2. The other vertices of the square are at (0, 4), (0, 0), and (negative
4, 0). As a result, the right side of the square lies on the positive vertical axis, and the bottom side
of the square lies on the negative horizontal axis.
• Point W is above the line at (negative 2, 4) on the top side of the square. If the market was at point
W, the expected change in the spot exchange rate would be 4%, although the percentage
difference in expected inflation was only negative 2%. the home currency would be weak.
• Point S is below the line at (negative 4, 2) on the left side of the square. If the market was at point
S, the expected change in the spot exchange rate would be 2%, although the percentage
difference in expected inflation was negative 4%. the home currency would be strong.
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Appendix 4
Long Description for E subscript R in dollars equals E
subscript N in dollars times start expression C in dollars
divided by C in F, C end expression.
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Appendix 5
Long Description for a graph plots the real effective exchange rate index for the U. S. dollar, Japanese yen, and the Euro
from 1980 to 2017.
The graph has three curves representing the exchange rate indexes for United States dollar, Japanese yen, and Euro Area
euro. The following list outlines the trends demonstrated by the graph. All rates are based on base year 2010 = 100. All
values are estimated.
• The index for the United States dollar started at 106 in January 1980, before rising to a peak at 145 around August
1984. The index then fell to a low at 95 in December 1991, before fluctuating between 95 and 130 during the period
from 1991 and 2017. The index for the dollar reached notable peaks at 125 in 2001, at 112 in 2008, and at 129 in
2016. The index reached notable valleys at 95 in 1991, 2007, and 2010. By 2017, the index for the United States dollar
was at 120.
• The index for the Japanese yen started at 73 in January 1980. Despite fluctuations of up to 30 points over 2 years, the
index generally rose between the years 1982 and 1995, with notable peaks at 115 in 1998 and at 142 in 1995. From
1995 to 2017, the index for the yen then generally declined. During this period, the index had notable peaks at 123 in
2001 and at 108 in 2011. The index had notable valleys at 93 in 1997, at 75 in 2006, and at 72 in 2014. By 2017, the
index for the Japanese yen was at 95.
• The index for the Euro Area euro started at 98 in 1980, before falling to near 80 by 1981. From 1981 to 1984, the index
for the euro fluctuated between 78 and 88, before rising to near 98 in 1986. From 1986 to 1998, the index fluctuated
between 85 and 100, ending at 95. The index then fell to near 74 in 2000, before once again climbing to near 110 by
2007. From 2007 to 2017, the index for the euro generally fell, ending at 95.
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Appendix 6
Long Description for a formula summarizes the previous
paragraph.
Price elasticity of demand equals epsilon subscript rho
equals start expression percent delta Q subscript d end
expression divided by start expression percent delta P end
expression.
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Appendix 7
Long Description for a diagram presents the impossible trinity of pegged exchange rate, free
flow of capital and independent monetary policy.
A triangle has vertices that represent the pegged exchange rate, the free flow of capital, and
independent monetary policy. Points A, B, and C on the sides of the triangle represent the
changing approach of emerging market nations to their exchange rates. The following list
outlines this changing approach.
• Emerging market nations generally start at point A on the side of the triangle between the
pegged exchange rate and independent monetary policy. These nations traditionally
value exchange rate stability and monetary independence.
• Emerging market nations want to attract capital inflows. So, they have shifted toward
point C on the side of the triangle between independent monetary policy and free flow of
capital.
• Exchange rate pass through has also led emerging market nations to shift toward point B
on the side of the triangle between pegged exchange rate and free flow of capital. Now
that these countries are experiencing changing exchange rates, exchange rate pass
through is a growing source of inflationary pressure and price instability.
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Appendix 8
Long Description for a math formula represents the last
point of the previous slide.
Start expression start expression S subscript 1 minus S
subscript 2 end expression divided by S subscript 2 end
expression times 100 equals I in dollars minus I in yen
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Appendix 9
Long Description for a math formula represents the last
point of the previous slide.
F to the power of S, F divided by $90 equals start
expression S to the power of S, F divided by dollar sign end
expression times start fraction 1 plus left parenthesis i to
the power of S, F times 90 divided by 360 right parenthesis
over 1 plus left parenthesis i to the power of dollar sign
times 90 divided by 360 right parenthesis end fraction.
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Appendix 10
Long Description for a math formula represents how the
forward premium or forward discount is derived.
F to the power of S, F equals start fraction spot minus
forward over forward end fraction times start fraction 360
over days end fraction times 100.
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Appendix 11
Long Description for a graph plots interest yield in percent for the euro
dollar and euro Swiss franc versus maturity or days forward.
The graph has two yield curves for the euro dollar and euro Swiss
franc. Each curve rises with decreasing steepness from a point on the
positive vertical axis. The euro dollar yield curve rises from (0, 3.5)
through (90, 8.0) to (180, 8.6). So, at 80 days forward, the interest yield
for the euro dollar is 8.0%. The euro Swiss franc yield curve rises from
(0, 1.6) through (90, 4.0) to (180, 4.6). So, at 80 days forward, the
interest yield for the euro Swiss franc is 4.0%. The forward pendulum is
the percentage difference between interest yields. The percentage
difference is equal to the vertical distance between the curves at 80
days forward. The percentage difference is 3.96%. All values
estimated.
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Appendix 12
Long Description for a diagram shows interest rate parity for the US dollar passing through US and
Japanese money markets for 90 days.
A diagram demonstrates how the same US dollar amount can generate very similar final amounts
when it passes through the US dollar money market and the Swiss franc money market over a 90 day
period. The following list outlines the conversion process in each market and compares the final
amounts.
• Start. $1,000,000 enters the US dollar money market and the Swiss franc money market.
• The US dollar money market uses the euro dollar interest rate of 8.00%, which is equivalent to 2%
for 90 days. $1,000,000 times 1.02 = $1,020,000.
• Before entering the Swiss franc money market, the starting amount is converted using the spot
exchange rate of S F 1.4800 = $1.00. $1,000,000 times 1.4800 = S F 1,480,000. The Swiss franc
money market uses the Swiss franc interest rate of 4.00% per annum, which is equivalent to 1% for
90 days. S F 1,480,000 times 1.01 = S F 1,494,800. This Swiss franc amount is then converted
using the 90 day forward rate, or F 90, of S F 1.4655 = $1.00. S F 1,494,800 divided by 1.4655 =
$1,019,993.
• End. The final amount from the US dollar money market is $1,020,000. The final amount from the
Swiss franc money market is $1,019,993. The amounts only differ by a transaction cost of $7.00.
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Appendix 13
Long Description for a diagram shows covered interest arbitrage for U S dollars passing through U S
and Japanese markets for 180 days.
A diagram demonstrates how the same U S dollar amount can generate different final amounts when it
passes through the U S dollar money market and the Japanese money market over a 180 day period.
The following list outlines the conversion process in each market and compares the final amounts.
• Start. $1,000,000 enters the U S dollar money market and the Japanese yen money market.
• The U S dollar money market uses the euro dollar interest rate of 8.00%, which is equivalent to 4%
for 180 days. $1,000,000 times 1.04 = $1,040,000.
• Before entering the Japanese yen money market, the starting amount is converted using the spot
exchange rate 106.00 yen = $1.00. $1,000,000 times 106 = S F 106,000,000 yen. For the
Japanese yen money market, the investor uses a euro yen account with an interest rate of 4.00%
per annum, which is equivalent to 2% for 180 days. 106,000,000 yen times 1.02 = 108,120,000
yen. This yen amount is then converted using the 180 day forward rate, or F 180, of 103.50 yen =
$1.00. S F 108,120,000 yen divided by 103.50 = $1,044,638.
• End. The final amount from the U S dollar money market is $1,040,000. The final amount from the
Japanese yen money market is $1,044,638. The amounts only differ by an arbitrage potential of
$44,638.
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Appendix 14
Long Description for a diagram shows uncovered interest arbitrage for Japanese yen passing through
Japanese and US markets for 360 days.
A diagram demonstrates how the same Japanese yen amount can generate different final amounts when
it passes through the Japanese yen money market and the US dollar money market over a 360 day
period. The following list outlines the conversion process in each market and compares the final
amounts.
• Start. 10,000,000 yen enters the Japanese yen money market and the US dollar money market.
• For the Japanese yen money market, the investor borrows yen for 360 days at 0.40% per annum.
10,000,000 yen times 1.004 = 10,040,000.
• Before entering the US dollar money market, the starting amount is converted using the spot
exchange rate of 120.00 yen = $1.00. 10,000,000 yen divided by 120.00 = $83,333.33. The investor
deposits this amount in the US dollar money market at 5.00% per annum. $83,333.33 times 1.05 =
$87,500.00. The investor then converts this dollar amount back to yen, using the expected spot
exchange rate of 120.00 yen = $1.00. $87,500.00 times 120.00 = 10,500,000 yen.
• End. The final amount from the Japanese yen money market is 10,040,000, which is repaid. The final
amount from the US dollar money market is 10,500,000, which is earned. The amounts differ by a
profit of 4460,000 yen.
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Appendix 15
Long Description for a graph plots the difference between foreign and
domestic interest rates versus the premium on foreign currency.
The graph falls diagonally through the origin, point X at (4, negative 4),
point Y at approximately (4.41, negative 4.41), and point Z at (4.83,
negative 4.83). The line intersects a rectangular region in quadrant 4.
Counterclockwise from the top right, the rectangular region has vertices
at (4.83, 0), (0, 0), (0, negative 4), and point U at (4.83, negative 4).
Point X lies on the bottom side of the region, 0.83 units to the left of
point U. Point Z is 0.83 units below point U. If market interest rates
were at point U, covered interest arbitrage profits are available, and
would be undertaken until the market drove interest rate differences
back to point X, Y, or Z.
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Appendix 16
Long Description for a graph plots spot exchange rate S and forward rate F versus time t
for times t sub 1 to t sub 4.
The graph includes separate plots for spot rate S and forward rate F, as described in the
following list.
• The plot of spot rate S rises from (t sub 1, S sub 1) to (t sub 2, S sub 2) and then falls
through (t sub 3, S sub 3) to (t sub 4, S sub 4). Vertical lines rise through the t axis at t
sub 1, t sub 2, t sub 3, and t sub 4. The vertical lines intersect the graph of S at S sub
1, S sub 2, S sub 3, and S sub 4, respectively.
• The plot of forward rate F consists of three line segments with end points on the
vertical lines at t sub 1, t sub 2, t sub 3, and t sub 4. The first line segment falls from (t
sub 1, S sub 1) to (t sub 2, F sub 1), where F sub 1 is less than S sub 2. The second
line segment rises from (t sub 2, S sub 2) to (t sub 3, F sub 2), where F sub 2 is
greater than S sub 3. The third line segment rises from (t sub 3, S sub 3) to (t sub 4, F
sub 3), where F sub 3 is greater than S sub 4.
• On each vertical line, the distance between the S and F values represents the error in
the forward rate.
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Appendix 17
Long Description for a diagram represents international parity conditions in equilibrium.
A diagram represents international parity conditions in equilibrium. This approximate model of
equilibrium involves five relations identified by the letters A, B, C, D, and E. The following list describes
each relation based on changes to exchange rates, interest rates, and inflation for the Japanese yen.
• Relation A. purchasing power parity. The forecast change in the spot exchange rate is plus 4%,
meaning the yen strengthens. The forecast difference in rates of inflation is minus 4%, meaning less
in Japan.
• Relation B. Fisher effect. The forecast difference in rates on inflation is minus 4%, meaning less in
Japan. The difference in nominal interest rates is minus 4%, meaning less in Japan.
• Relation C. international Fisher effect. The forecast change in the spot exchange rate is plus 4%,
meaning the yen strengthens. The difference in nominal interest rates is minus 4%, meaning less in
Japan.
• Relation D. interest rate. The difference in nominal interest rates is minus 4%, meaning less in Japan.
The forward premium on foreign currency is plus 4%, meaning the yen strengthens.
• Relation E. forward rate as an unbiased predictor. The forward premium on foreign currency is plus
4%, meaning the yen strengthens. The forecast change in the spot exchange rate is plus 4%,
meaning the yen strengthens.
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