Intenational Parity Conditions & Exchange Rates.2023 (MBA-Law)

INTERNATIONAL PARITY
CONDITIONS AND
EXCHANGE RATES
Dr. Tinaikar
Strictly for Private Circulation Only

Topic Outline
 International Parity Conditions

 Purchasing Power Parity
 Law of One Price (LOOP)
 Absolute Purchasing Power Parity
 Relative Purchasing Power Parity
 Covered Interest Parity (CIP)
 Uncovered Interest Parity (UIP)
 Fischer Effect
2
International Parity
Conditions
 International Parity Conditions are economic
theories in an open economy which link:
 Exchange rates
 Price Levels (Inflation)
 Interest Rates
 These linkages may not always work but are
important in understanding the behavior of
international financial markets, especially,
international money and foreign exchange
markets
 These linkages are important for corporate
treasures, forex dealers, exporter/importers etc.
3
Purchasing Power Parity
4
(PPP)
 Propounded by the Swedish economist
Cassel in the 1920s.
 Prices of identical goods sold in different
countries must be the same when expressed
in the same currency.
 For example, the price of a 24 karat gold in
the U.S. expressed in US dollars should be
the same as 24 karat gold in U.K. also
expressed in US dollars.
(PPP)
 This law applies in competitive markets
under the following assumptions:
 Goods produced by each country are
homogenous i.e. identical in characteristics.
 Goods produced are tradeable.
 There are no impediments to international
trade such as:
 official trade barriers
 transportation costs etc.
The Law of One Price
 It is PPP applied to a single good or commodity.
 It implies that the dollar price of good i is the
same wherever it is sold:
PiUS = (PiUK) x (E$/£)

where:
PiUS = $ price of good i when sold in
the U.S.
PiUK = £ price of good i when sold in
U.K.
E$/£ = dollar/pound exchange rate i.e.
$ per £
7
 Equivalently, the dollar/pound exchange
rate is the ratio of good i’s U.S. and U.K.
money prices.
(E$/£) = (PiUS )/(PiUK)

where:
PiUS = $ price of good i when sold in
the U.S.
PiUK = £ price of good I when sold in
U.K.
E$/£ = dollar/pound exchange rate i.e.
$ per £
8
 Law of One Price
 Disequilibrium:
 If PiUS > (PiUK) x (E$/£)  traders will buy the
commodity in UK and sell it in the US
  PiUK and  PiUS
 USD will depreciate and GBP will appreciate till
equilibrium is attained.
 Vice-versa if PiUS < (PiUK) x (E$/£)
 Therefore, arbitrage will ensure equilibrium:
PiUS = (PiUK) x (E$/£)  E$/£ = PiUS/PiUK 9

 Example-1:
If PUSwheat = $4/kg and PUKwheat = £2.5/kg
and E$/£ = $1.70/£ (theoretical rate = $1.60/£)
Then, PUSwheat = $4
PUKwheat x E$/£ = 2.50 x 1.70
= $4.25 (price of wheat in UK
expressed in USD)
Therefore, PUSwheat ($) < PUKwheat ($)
10
 Example-1 (cont…):
 Arbitrager will buy a kg of wheat in the US for $4
and sell it in the UK for £2.5
 At the prevailing exchange rate of $1.70/£ it will
fetch him $ 4.25
 Resulting in a profit = ($4.25 - $ 4.00)= $0.25/kg
 Price of wheat in US will increase and that of wheat
in UK will decrease till equilibrium is attained
11
 Example-2:
 Suppose 1 Kg of potato costs INR 60 in India
and similar quantity of potato costs USD 1 in the
U.S.
Then the PPP exchange rate would be:
EINR/USD = PINDIA = INR 60 per USD
PUSA
 Suppose the USD-INR rate in the market is INR
70 per USD .
 Is there an arbitrage opportunity?
12
 Example-2 (contd…):
 If 1 Kg of potato in India for INR 60 similar
 Sell the potato in US for USD 1.
 Convert the USD to INR at INR 70 per USD.
 Profit = (INR 70 – INR 60) = INR 10 per kg of
potato bought and sold
13
 Example-3:
 Apple I-phone model SE costs INR 26,000 in
India.
 In Bangladesh it costs Bangladeshi Taka (BTK)
35,000
 Suppose the exchange rate between INR and
BKT is INR 0.642/BTK
 Is there an arbitrage opportunity?
14
 Example-3:
 At exchange rate of INR 0.642/BTK the cost of
the mobile hand phone in Bangladesh in INR is:
35000 BKT x 0.642 INR/BKT = INR 22,470
 The cost of the hand phone in India = INR 26,000
 The trader will sell INR and buy BTK
 With the BKT he will buy the I-phone in
Bangladesh for Rs 22,470
 The trader will sell the handset in India for INR
26,000
15
 For every handset sold the trader makes a profit of:
INR 26,000 – INR 22,470 = INR 3530
 The exchange rate and the price of the I-Phone will
keep on adjusting till the price of the handset is the
same in both the countries in INR.
 If the trader is based in Bangladesh:
 He will buy the handset in Bangladesh for BKT
35,000.
 Sell the handset in India for INR 26,000
 Convert the INR 26,000 into BKT at 0.642
INR/BKT
16
 BKT received = BKT 40,498
 Profit = BKT 40,498 – BKT 35,000

= BKT 5,498
17
 Problems with Law of One Price
 Goods produced in different countries may
not be homogenous
 Obstacles to equalization of product price
across countries:
 Non-traded products globally
 Trade barriers such as import duties, tariffs etc.
 Transaction and Transportation costs
 Non-competitive markets and segmented
markets
 Sticky Prices - the nominal prices of many
goods and services do not change often 18
Big Mac Index:
The Economist
“Burgernomics” is based on the theory of PPP. The

Economist's Big Mac Index invented in 1986 is a light-
hearted guide to see whether currencies are at their
“correct” level, the “basket” being McDonalds' Big Mac,
which is produced locally in almost 120 countries. 19
The “Big Mac Index”
 The “Big Mac Index,” as christened by The Economist
is a prime example of the law of one price:
 Assuming that the “Big Mac” is identical in all
countries, applying PPP theory to Big Mac would
mean that hamburgers cost the same in all countries
as in America when expressed in US dollars
 Comparing the actual (market) exchange rate with
“Big Mac” PPP determined exchange rate indicates
whether a home currency is undervalued or
overvalued with respect to USD
 Big Mac in China costs Yuan 17.2 (local currency),
while the same Big Mac in the US costs $4.79
 The actual spot exchange rate is Yuan 6.2115/$ at
the time (Slide 22)
20
 The Economist then calculates the implied

purchasing power parity rate of exchange using
the actual price of the Big Mac in China over the
price of the Big Mac in U.S. dollars:
Yuan
Yuan 17.20
= 3.591/$
$4.79
 The price of a Big Mac in China in U.S. dollar-

terms using market exchange rate of Yuan
6.2115 = 1 USD is therefore:
Yuan 17.20 = $2.77
Yuan 6.2115/$ 21
• Now comparing the implied PPP exchange rate of

Yuan 3.591/$, with the actual market rate of
exchange at that time, Yuan 6.2115/$, the degree to
which the Chinese Yuan is either overvalued (+) or
undervalued (-) versus the U.S. dollar is calculated:
PPP Rate – Actual Rate = % Over (+) /Under (-)
Actual Rate Valuation of Yuan
Yuan 3.591/$ - Yuan 6.2115/$ = -42.2%

Yuan 6.2115/$
22
Selected Exchange Rates From
“Big Mack Index”
23
Research on “Big Mac Index”
 Research on Big Mac index shows that Big Mac PPP
holds in the long-run but currencies can deviate from it
for lengthy periods. The reasons why the Big Mac index
may be flawed:
 It assumes that there are no trade barriers
 Prices are distorted by import duties
 Profit margins may vary according to competition
 Prices of non-traded goods (real estate, utilities, labor)
are also inputs that affect production costs
 The Economist magazine publishes their Big Mac Index
twice a year:
 http://www.economist.com/markets/Bigmac/Index.cfm
 Google: big mac index 2021 24
A Guide to World Prices: March
2013 (US Dollars)
25
Absolute Purchasing Power
Parity
 Purchasing Power Parity (PPP)
 It is the application of the law of one price
across countries for all goods and services, or
typically for “baskets” of goods and services.
PUS = (PUK) x (E$/£)
PUS = price level of basket of goods and services in the US

PUK = price level of basket of goods and services in UK
E$/£ = US dollar/pound exchange rate i.e. $ per £
This is known as Absolute Purchasing Power Parity
26
Parity
 Absolute PPP implies :
E$/£ = PUS/PUK
 According to absolute PPP, the exchange rate of two
currencies is equal to the ratio of prices of common
basket of consumption of goods in the two countries
 The exchange rate between US$ and £ should equal
the ratio of price levels in US and UK for baskets of
common consumption in these two countries
27
Parity
 Example
 The price level of basket of consumption in the US =
US$200.
 The price level of an identical basket of consumption
in UK = £100
 Therefore, PPP implies that the US$/£ exchange rate
should be:
US$200/£100 = US$ 2/£
 Absolute PPP says that each country’s currency
has the same purchasing power : US$ 2 buy
the same amount of goods and services as
does £ 1
28
Parity - Generalization
 Absolute PPP implies :
Exchange Rate = P
P*
where,
P = Price of a common basket of goods in
home country
P* = Price of common basket of goods in
foreign country
29
Parity
 Example-1
 If a basket of goods in India costs INR 7500
 The same basket of goods in the U.S. costs
USD100
 Then as per PPP the fair value of the exchange
rate must prevail is:
= INR 7,500
USD 100
= INR 75
 If the exchange rate is different from INR75/USD
then arbitrage will bring about equilibrium in the
exchange rate 30
Parity
 Example-1 (cont….)
 Case-1:
 Suppose the exchange rate in the forex market is
> INR 75 say INR 76
 A trader will buy the basket of goods in India for
INR 7500
 Sell the same basket in the U.S. for USD 100
 Convert the USD back into INR at INR/USD of 76
 INR earned = INR 7600
 Profit = INR 100
31
Parity
 Example-1 (cont…)
 Case-2
 Suppose the exchange rate in the forex market
were < INR 75 say INR 74
 A trader will buy the basket of goods in the U.S.
for USD 100
 Sell the same basket in India for INR 7500
 Convert the INR back into USD at INR 74/USD to
obtain USD 101.35 (7500/74)
 Profit = USD 101.35 – USD 100= USD 0.35
32
Parity
 Example-2
 Assume that economic conditions of France and U.K
are almost the same and basket of goods
representing the same utility in both the countries
costs GBP1200 in U.K. and Euro 1,800 in France
 According to PPP theory the exchange rate must be:
Euro 1800/GBP 1200 = Euro 1.50/GBP
 Suppose the actual rate is Euro 1.40/GBP as
compared to PPP rate of Euro 1.50/GBP.
 Is the Euro Overvalued or Undervalued with respect to
GBP?
33
Parity
 Example-2
 Overvaluation (+)/Undervaluation(-) of the Euro is
= PPP Rate – Actual Rate x 100
Actual Rate
= 1.50 – 1.40 x 100
1.40
= 7.14%
34
Parity
 Price Level and Price Indexes
 Calculating the price level – cost of living
 Calculating a price index – ratio of price

levels at two different times
35
Parity
 Problems with Absolute PPP :
 Different baskets used in different countries for
computing price indices
 Even if the baskets are identical, the proportion
of items in the baskets may be different
 Non-tradable goods, services, and perishable
products which may be included in the
consumption basket
 Transaction and transportation costs
 However, PPP-determined exchange rates can
still provide a valuable benchmark
36
Relative Purchasing Power
Parity
 If the assumptions of absolute PPP theory
are relaxed, we observe Relative
Purchasing Power Parity:
 PPP is not particularly helpful in determining
what the spot rate is today, but that the relative
change in prices between countries over a
period of time determines the change in
exchange rates
 It focuses on change in exchange rates over a
period of time instead of absolute values at a
particular point in time
37
Parity
 Knowing the direction and quantum of

exchange rate change would help the finance
manager plan cash flows better and make
strategic decisions such as:
 Costing of the product
 Pricing of the product
 Hedging international trade
 Hedging foreign currency debt
38
Parity
 Assume at time t =0:
 The price levels in India and the U.S. are P0 and P0*
and the exchange rate is E0.
 Therefore exchange rate as per absolute PPP is:
E0 = P0/P0* (1)
 Assume at time t=1:
 The price levels in India and the U.S. are P1 and P1*
and the exchange rate is E1
 The exchange rate as per absolute PPP is:
E1 = P1/P1* (2)
39
Parity
 At time t = 1, the price levels change because of

inflation to P1 and P1* from P0 and P0* at time t = 0.
 If the domestic and foreign inflation rates are π and π*,
then
P1 = P0 (1+π) and P1* = P0*(1+π*)
40
Parity
 We know that both E0 and E1 as per absolute PPP
are not likely to be correct
 Therefore we do not use PPP as a predictor of
exchange rate but focus on change in the spot rate
E0 at time t=0 to E1 at time t=1
Therefore E1 = P1 = P0 (1+π) = E0 (1+π) P0 = E0
P0*
P1* P0*(1+π*) (1+π*)
E1 = (1+π)
E0 (1+π*)
Subtracting 1 from both sides of the above equation:
E1 – E0 = ΔE = (π – π*) ….(3)
E0 E0 (1+ π*) 41
Parity
 Therefore E1 – E0 = ΔE = (π – π*) ….(3)

E0 E0 (1+ π*)
 Even though PPP as given in Eq (1) may not hold, Eq
(3) may still hold because factors which distort PPP
would annul each other in the ratio
 Therefore, even if the spot exchange rate cannot be
forecast using PPP it can still be used for forecasting
changes in PPP as in equation (3) above
 Equation (3) is known as Relative Purchasing Power
Parity (Relative PPP)
42
Parity
 If the foreign inflation rate is assumed low so that
(1+ π*) ≈ 1
 Therefore, ΔE ≈ (π – π*)
E0
 Percentage change in the exchange rate is approx.
equal to inflation differential between home country
and foreign country
 The currency with higher inflation would depreciate
 If the inflation rates in India and USA are 6% and
2% then the rupee should depreciate by about 4%
(4/1.02 i.e. 3.92% to be exact) annually
43
Parity
 If the inflation rates are in nominal terms and the
time period is specified in terms of years t, then Eq
(3) can be modified as:
E1 = (1+π) tt
E0 (1+π*)
44
Forecasting Exchange Rates
with Relative PPP
 Example
 The actual exchange rate in Example-2 (slide 32)
of €1.40/£ does not confirm to PPP rate €1.50/£ .
 Assume inflation rates in Eurozone and Britain are
3% and 5% respectively
 Therefore, inflation in Britain being higher than in
Eurozone, the GBP will depreciate and Euro will
appreciate
 GBP will depreciate by approx. 2% annually being
inflation differential between Britain and Eurozone
45
Forecasting Exchange Rates
with Relative PPP
E1/2 = E0 (1+π)
1/2
After 6 months
(1+π*)
= 1.40 x (1.03/1.05)1/2
= €1.3867/£
1
After 1 year E1 = E0 (1+π)
(1+π*)
= 1.40 x (1.03/1.05)
= €1.3733/£
46
Parity (Alternative Derivation)
 Relative PPP :
 Absolute PPP implies:
E$/£ = PUS/PUK ln(E$/£) ≈ ln(PUS/PUK)
ln(E$/£) ≈ ln(PUS) – ln(PUK)
 Relative PPP states :
 Percentage change in exchange rate (‘E’)
during the period ‘t’ to ‘t+1’ is equal to
percentage change in price i.e. inflation
differential between two countries:
(E$/£,t+1 - E$/£,t)/E$/£,t ≈ US - UK
47
where  = inflation for the period t to t+1
Parity
 The previous formula can be approximated as:
E   D   F
where, πD and πF refers to domestic and foreign
inflation respectively and E to the percentage
change in the exchange rate.
 If domestic inflation > foreign inflation, PPP
predicts that the domestic currency should
depreciate and
 If domestic inflation < foreign inflation
domestic currency should appreciate. 48
Relative PPP Example
 Given the inflation rates of 2% and 5% in US and

UK respectively what is the prediction of PPP with
regards to USD/GBP exchange rate?
Relative PPP
Et 1  Et π D  π F

Et 1
= (0.02 – 0.05)/(1) = - 0.03 = - 3.0%

The general implication of relative PPP is that countries
with high rates of inflation will see their currencies
depreciate against those with low rates of inflation. In
the above case USD should appreciate against GBP 49
Purchasing Power Parity (PPP)
Percent change in the spot exchange
rate for home currency
4
P
3
-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1 Percent difference in
expected rates of inflation
-2 (home relative to
foreign country)
-3
-4
50
Purchasing Power Parity:
Empirical Tests
 Empirical tests of both relative and absolute
purchasing power parity show that for the most
part, PPP is not accurate in predicting future
exchange rates
 Two general conclusions can be drawn from the
tests:
 PPP holds up well over the very long term but is
poor for short term estimates
 The theory holds better for countries with relatively
high rates of inflation and underdeveloped capital
markets
 However PPP can be used as a “benchmark” to
test whether a currency is overvalued or
undervalued against other currencies
51
Theory: Utility
 Simple theory of exchange rate determination.
 Provides baseline forecast of future exchange
rates necessary to forecast cash flows in
different currencies when inflation rates differ
across countries
 Plays a fundamental role in corporate decision
making e.g. location of plants, pricing products,
and hedging decisions.
 Helps central bankers to make appropriate
decision on market intervention in response to
overvaluation/undervaluation of home currency 52
Interest Parity Conditions
53
Interest Parity Conditions
 They are equilibrium conditions between foreign
exchange markets and international money markets
when investors invest in assets of the same class i.e.
with the same risk characteristics and maturity
 Covered Interest Parity (CIP) is an equilibrium condition
when investors are risk averse and hedge the foreign
exchange risk while investing in assets with comparable
risk characteristics and maturity
 Uncovered Interest Parity (UIP) or Carry Trade is an
equilibrium condition when investors are risk neutral and
do not hedge the foreign exchange risk when investing in
assets with comparable risk characteristics and maturity
54
Covered Interest Parity
 CIP provides the linkage or equilibrium
condition between the foreign exchange
markets and the international money markets.
 Covered Interest Parity (CIP) states that
investors earn the same returns regardless of
the two currencies in which they invest when
expressed in the same currency after hedging
exchange rate risk.
 In other words, the theory states: The premium
or discount of the forward rate for the foreign
currency is approximately equal to the interest
differential between domestic and foreign
nominal interest rates for securities of similar
risk and maturity(except for transaction costs)
55
CIP- Derivation
US UK 100 x 70 = Rs 7000
i i* (interest rates on 1-yr T-Bills in US and UK)
4% 6%
1(1+i) 1/S (1+i*) $S=1£
1(1+i) F x 1/S x (1+i*) $F=1£
If RHS > LHS money will flow in the UK from US
i*↓ i ↑ S ↑ F ↓ and in equilibrium
F (1+i*) = (1+i)
S
F = S(1+i)
(1+i*) 56
CIP- Derivation
F = (1+i)
S (1+i*)
F - 1 = (1 + i) - 1
S (1+i*)
F - S = (i - i*)
S (1+i*)
F - S  (i – i*) (Assuming i* is very small
S compared to i)
57
CIP- Derivation – Return on
Investment Adjusted for Currency
Depreciation
USD 100 x 70 (INR/USD) = INR 7000

Return of 20% = INR 8400
After 1 year: 75 INR/USD (INR depreciated by 7%)
Return = USD 112 (INR 8400 ÷ 75)
Effective Return is approx. 13% (20% - 7%)
58
CIP- Derivation (Approximate
Form)
F/S(1+i*) = (1+ i)
F/S(1+i*) – (1 + i) = 0
(F/S – 1) + F/S x i* – i = 0
(F/S – 1) + F/S x i* – i + (i* – i*) = 0
(F – S) / S + (F/S i* – i*) – i + i* = 0
(F – S) / S + i*x (F – S)/S – (i – i*) = 0
(F – S) / S – (i – i*)  0 (Assuming i*x (F – S)/S  0)
59
 Covered Interest Parity:
Ft, t+1– St
= i$ - i£
St
 Where i $ and i£ are the interest rates in the US
and UK respectively and St is the spot exchange
rate at time t and Ft,t+1 is the forward exchange
rate quoted at time t for delivery at time t+1
expressed as Dollars per Pound ($/£)
 If i$ > i£ then Dollar being the high interest
currency must quote at a discount in the forward
market or Pound must quote at a premium
60
 Rearranging the terms:
Ft, t+1– St
+ i£ = i$
St
 Return in Pounds on a “covered basis” i.e.

hedging exchange rate risk is equal to return
in Dollars
 Investors must earn the same returns
regardless of the two currencies in which they
invest i.e. Dollars or Pounds
61
 If the spot and forward rates are not in a

state of equilibrium described by interest
parity, the potential for “riskless” or arbitrage
profit exists
 The arbitrager will exploit the imbalance by
investing in a currency which offers higher
return on a “covered basis” thus bringing
about equilibrium in the returns between the
two currencies
 Therefore, this is known as Covered Interest
Parity (CIP) 62
CIP : Assumptions
 No Transaction Costs
 Invest only if covered differential favoring
foreign assets is greater than transactions
costs
 No Cost of gathering and processing
information
 Compatibility of Assets
 Assets must be identical in liquidity, maturity,
and risk class
 No Government intervention and regulation
 Capital controls, transfer risk, differential tax
treatment
 Capital market are perfections 63
CIP Derivation
Consider alternative one-year investments for $1:
1. Invest in the U.S. at i$. Future Value = $1× (1 + i$)
2. Sell your $ for £ at the spot rate S$/£, and invest £ 1/S$/£ in
Britain at i£ while eliminating any exchange rate risk by
selling the FV of the British investment forward at F$/£
F$/£
Future Value = $1 × (1 + i£) ×
S$/£
Since these investments have the same risk, they must have the
same future value (otherwise an arbitrage would exist) :
F$/£
(1 + i£) × = (1 + i$)
S$/£ 64
CIP Derivation
F$/£
If (1 + i£) × > (1 + i$)
S$/£
• Dollars will flow from U.S. to U.K. because of higher
return on Pound-denominated securities
• Dollar will depreciate against the Pound ( S$/£) in the
spot market or Pound will appreciate against Dollar
• Simultaneously, Dollar will appreciate ( F$/£) in the
forward market as investors will sell Pounds and buy
Dollars to hedge exchange rate risk
• The demand for Pound-denominated securities will cause
Pound interest rates to fall ( i£) while higher level of
borrowings in the US will cause Dollar interest rates to
rise ( i$) 65
CIP Derivation
• Exploiting the above risk-less arbitrage opportunity by

several investors will equalize the returns between
Dollar and Pound denominated securities
F$/£
If (1 + i$) × < (1 + i£)
S$/£
• Money will flow from UK to US and rates will move in
opposite direction till returns between Dollar and
Pound denominated securities are equalized
Dollar return on dollar asset = Dollar return on

pound sterling asset.
66
CIP in Equilibrium
 In equilibrium CIP must hold:
F$/£ × (1+ i )
(1 + i$) = £
S$/£
CIP is approximated as:

F–S
≈ i$ – i£
S
If i$ > i£ then F > S 67

CIP in Equilibrium
 Depending upon how you quote the exchange

rate (as £ per $ or $ per £) we have:
1 + i£ F£/$ 1 + i$ F$/£
= or =
1 + i$ S£/$ 1 + i£ S$/£
…so be a bit careful about that.
68
Multi-Period CIP
 CIP states that the T-period future
exchange rate prevailing today must be:
FT($/£) = S × (1+ i$)T
(1+ i£)T
i = ‘T’ period domestic interest rate

i*= ‘T’ period foreign interest rate
F = Forward exchange rate, t-periods from now
69
Covered Interest Parity: Equilibrium
between Money and Forex Markets
 Deviation from CIP involves the following risk-less
arbitrage between international money and foreign
exchange markets to earn risk-less profit:
1. Borrow 1 unit of domestic currency @ ‘i’ and repay
(1+i) at maturity.
2. Sell 1 unit of domestic currency and buy 1/S units
foreign currency at spot exchange rate ‘S’ (units of
home currency per unit of foreign currency e.g. $
per £ )
3. Invest the foreign currency (1/S) in a deposit @
‘i*’ which will yield 1/S x (1+i*) at maturity and
simultaneously at the time of investment enter
into a forward contract ‘F’ to “lock in” a future
exchange rate at which to convert the foreign
currency proceeds back to the domestic currency.
4. Amount received at maturity of foreign currency
deposit is F/S x (1+i*)) in home currency units70
Covered Interest Parity: Equilibrium
between Money and Forex Markets
Time India London
T=0 Borrow Re 1 @ i for 1 year 1) Convert Re 1 to $ @ spot exchange
rate of $ 1 = Rs S.
You get $1/S.
2) (i) Invest $ 1/S in a dollar deposit in
London @ i*
(ii) Simultaneously
hedge exchange rate risk by
entering into a forward contract
@ $1 = Rs F
T= 1 Repay Rs 1.(1+ i) 1) Earn $ 1/S (1 + i*) in 1-year.

2) Convert $ earnings back to Rs @
$1= Rs F
3) You get Rs F/S (1 + i*)
4) Repay the Rupee loan
(1 + i) = F/S (1 + i*) 71
Covered Interest Parity:
Equilibrium between Money and
Forex Markets
 Repay the domestic loan with interest with the
amount received when the foreign currency deposit
matures or else there will be risk free arbitrage:
Therefore, (1 + i) = F × (1+ i*)

S
CIP is approximated as:
F–S ≈ i – i*
S
If i > i* then F > S 72

Covered Interest Parity:
Equilibrium between Money
and Forex Markets
In Equilibrium:
Home currency return on domestic deposit =

Foreign currency return on foreign currency
deposit measured in home currency after
hedging exchange rate risk.
or
Forward premium/discount on foreign currency
= Interest differential between domestic and
foreign interest rates
73
 Example
 Assume that the spot rate is INR74/USD
 Interest rates in India and the U.S. are 6% and 2%
respectively
 What is the forward rate so that is no arbitrage
opportunity?
Here S = 74, i = 6% and i* = 2%
Therefore F = S (1+i) = 74 (1.06)
(1+i*) (1.02)
= INR 76.90 /USD
74
 Example (cont..)
1. Borrow USD 1 @ 2% for 1 year and repay USD
1.02 at the end of the year (1+i*)
2. Convert USD 1 at the spot exchange rate and get
INR 74 (S)
3. Invest INR 74 @ 6% for 1 year and realize INR
74(1.06) = INR 78.44 S(1+i)
4. Repay the USD 1.02 loan (1+i*)
5. Therefore USD 1.02 = INR 78.44
6. Or the forward INR/USD exchange rate F is:
F = 78.44/1.02 = 76.90
i.e. F = S (1+i)
(1+i*) 75
1. If F > S(1+i) / (1+i*) assuming F = INR78/USD
then
LHS > RHS or
F (1+i*) > S (1+i) i.e. INR 79.56 > INR 78.44 …...(1)
1) Investor will borrow INR 74 @ 6% for 1 year and repay
INR 74(1.06) = 78.44 at the end of 1 year
2) Buy USD 1 with INR 74 in the spot market
3) Invest USD 1 @ 2% for 1 year and earn USD 1.02
4) Convert USD 1.02 at the forward rate INR 78 and get INR
79.56
5) Repay the loan of 78.44
6) Earn profit of INR 1.12 (=INR 79.56 – INR 78.44) 76
 Example (cont…)
2. If F < S(1 + i) / (1+i*) assuming F = 76 then
LHS < RHS or
F (1+i*) < S(1+i) i.e. 77.52 < 78.44 ……(2)
1) Investor will borrow USD 1 @ 2% for 1 year and repay USD
1.02 at the end of the year
2) Buy INR 74 in the spot market by selling USD 1
3) Invest for INR 74 for 1 year @ 6% and earn INR 74(1.06) =
INR 78.44
4) Convert INR 78.44 to USD at the forward rate of INR 76 and
get USD1.0321
5) Repay the loan i.e. USD 1.02
6) Earn profit of USD 0.0121 (= USD1.0321 – USD 1.0200)
77
 Therefore in equilibrium:
F= S (1+i)
(1+i*)
78
 Because the Value of assets in INR > Cost of
Liabilities when expressed in INR, there will be
arbitrage.
 Therefore, arbitrage will be eliminated if and only if
F = S (1 + i)
(1+i*)
 Therefore F = 74 (1.06/1.02)
= INR 76.90/USD
79
Currency Yield Curves &
The Forward Premium
Interest
yield Eurodollar
10.0 % yield curve
9.0 %
8.0 %
7.0 %
Forward premium is the
6.0 % percentage difference of 4.00%
5.0 % Euro Swiss franc
yield curve
4.0 %
3.0 %
2.0 %
1.0 %
30 60 90 120 150 180

80
Days Forward
and Equilibrium
 The following exhibit illustrates the conditions
necessary for equilibrium between interest
rates and exchange rates.
 The disequilibrium situation, denoted by point
“U”, is located off the interest rate parity line.
 However, the situation represented by point “U”
is unstable because all investors have an
incentive to execute the same covered interest
arbitrage, which is virtually risk-free.
81
CIP and Equilibrium
Z
Y
X
Percentage premium on 4
foreign currency (¥) U
= (F-S)/S 3
-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1 4.83
Percent difference between domestic ($)

-2
and foreign (¥) interest rates i.e. (i - i*)
-3
-4
82
Reasons for Deviation from CIP
 Transaction Costs
 Invest only if covered differential favoring
foreign assets is greater than transactions
costs
 Cost of gathering and processing information
 Non-compatibility of Assets
 Assets must be identical in liquidity, maturity,
and risk class
 Government intervention and regulation
 Capital controls, transfer risk, differential tax
treatment
 Capital market imperfections
83
Reasons for Deviation from CIP
• Transactions Costs
– The interest rate available to an arbitrageur for
borrowing, ib, may exceed the rate he can lend
at, il.
– There may be bid-ask spreads to overcome,
Fb/Sa < F/S.
– Thus, (Fb/Sa)(1 + i€l)  (1 + i€ b)  0.
• Capital Controls
– Governments sometimes restrict import and
export of money through taxes or outright
bans.
84
CIP with Transactions Costs
F1($/€) –S0($/€)
S0($/€)
←Unprofitable “arbitrage”
opportunity
exploitable arbitrage i$ − i¥
opportunity →
Unprofitable
arbitrage 85
Evidence on Covered Interest Parity
Financial Liberalization and Covered Interest Parity: Arbitrage between the

United Kingdom and Germany The chart shows the difference in monthly pound
returns on deposits in British pounds and German marks using forward cover from
1970 to 1995. In the 1970s, the difference was positive and often large: traders would
have profited from arbitrage by moving money from pound deposits to mark deposits,
86
but capital controls prevented them from freely doing so.
Financial Liberalization and Covered Interest Parity: Arbitrage between the

United Kingdom and Germany (continued)
After financial liberalization, these profits essentially vanished, and no
arbitrage opportunities remained. The CIP condition held, aside from small 87
deviations resulting from transactions costs and measurement errors.

 There is strong empirical evidence that the CIP

condition holds for different foreign currency
deposits issued within a single financial centre.
 Currency traders often set the forward exchange
rates they quote by looking at current interest
rates, spot exchange rates using the CIP formula.
 Deviations from CIP can occur when:
 When deposits being compared are located in
different countries.
 When asset holders fear that governments may
impose regulations (political risk) that will
prevent free movement of foreign funds across
national borders.
88
Covered Interest Parity : Example (1)
 Assume a US dollar-based investor has $1
million to invest for 3 months (90 days) and
can select from two investments:
 Invest in the U.S. and earn 8.0% p.a.
 Invest in Switzerland and earn 4.0% p.a.
 Solution for investor:
 Cover the SFr exchange rate risk by selling
the SFr anticipated from the investment at
the 90 days SFr forward rate.
 But what will the 90 days SFr forward rate be
assuming spot exchange rate is SFr 1.48/$?
89
Covered Interest Parity : Example (1)
 In equilibrium, the forward rate must settle at

a rate to offset the interest rate differential
between the two currencies in question
 This is to insure that investments in the two
currencies will yield similar returns to prevent
covered interest arbitrage opportunities!!!
90
Covered Interest Parity: Example (1)
(Cont..)
i $ = 8.00 % per annum
(2.00 % per 90 days)
Start End
$1,000,000  1.02 $1,020,000
Dollar money market $1,019,993*
S = SF 1.4800/$ 90 days F90 = SF 1.4655/$
Swiss franc money market
SF 1,480,000  1.01 SF 1,494,800
i SF = 4.00 % per annum

(1.00 % per 90 days)
* Rounding error. In equilibrium, SFr 1,494,800 must be equal to

$1,020,000 i.e. F 90 must be SFr 1.4665/$ to prevent covered interest 91
arbitrage opportunity (CIP must hold)
CIP: Example (2)
 USD interest rate = 5% p.a.; GBP interest rate = 8% p.a.
Current spot rate = $1.50/£; 1 year forward rate = $1.48/£.
Can arbitrage profits be made?
Ft ,t 1 1.48
1  id   (1  i f ) 1.05   (1.08) ??
St 1.50
1.05 ≠ 1.0656
1. Borrow $1m @ 5%
2. Purchase £666,667 Spot using $1m at $1.50/£
3. Invest £ at 8% (will receive £720,000 in one year’s time)
4. Simultaneously sell £720,000 Forward at $1.48/£ (receive
$1,065,600)
5. Repay loan + interest = $1,050,000
6. ARBITRAGE PROFIT = $15,600
92
7. To eliminate arbitrage, £720,000 = $1.05 m or F = $1.4583/£
CIP: Example (2) (cont..)
(5.00 % per 360 days)
Borrow End
$1,000,000  1.05 $1,050,000 Arbitrage
Potential
Dollar money market $1,065,000
S = $ 1.5000/£ 360 days F 360 = $1.48/ £
Pound Sterling money market
£ 666,667  1.08 £ 720,000
i £ = 8.00 % per annum

(8.00 % per 360 days)
Assume the forward rate is 1.48. Then, the covered Pound investment 93
yields $1,065,000 which is $15,600 more than the U.S. investment.
CIP: Example-2 (cont..)
(5.00 % per 360 days)
Start End
$1,000,000  1.05 $1,050,000
Dollar money market $1,050,000
S = $ 1.5000/£ 360 days F 360 = $1.4583/ £
Pound Sterling money market
£ 666,667  1.08 £ 720,000
i £ = 8.00 % per annum

(8.00 % per 360 days)
In equilibrium, £720,000 must be equal to $1,050,000 i.e. F360 must

94
be $1.45833/£ to prevent arbitrage opportunity
CIP: Example (2) (cont..)
 Cash Flows:
US$ £
At the time of borrowing +1000,000 -
Convert into £ @ $1.50/£ -1000,000 666,667
After 1 year pay (@ 5%)
receive (@ 8%) interest -50,000 53,333
_________ _______
Amount Paid / Received -1,050,000 720,000
No Arbitrage is possible if US$ 1.05 m = £ 0.72 m or

Forward Rate = 1.4583 US$/£
95
 Covered interest arbitrage should continue

until interest rate parity is re-established,
because the arbitrageurs are able to earn
risk-free profits by repeating the cycle.
 But their actions nudge the foreign
exchange and money markets back toward
equilibrium:
 Purchase of Pounds in the spot market
and sale of £ in the forward market would
narrow the premium on forward pounds.
 The demand for pound-denominated
securities causes pound interest rates to
fall, while the higher level of borrowing in
U.S. causes dollar interest rates to rise. 96
 In the previous example, the pound being

higher interest currency will be at a discount
of 3% to the U.S. Dollar being lower interest
currency or the U.S. Dollar will quote at 3%
premium to the Pound
 In other words, when the U.S. investor covers
exchange rate risk, the 8% Pound return is
reduced by the 3% discount, resulting in a
covered return of 5%.
97
CIP – Example 3
Eurodollar rate = 8.00 % per annum

Start End
$1,000,000 x 1.04 $1,040,000 Arbitrage
$1,044,638 Potential
Dollar money market
S =¥ 106.00/$ 180 days F 180 = ¥ 103.50/$
Yen money market
¥ 106,000,000 x 1.02 ¥ 108,120,000
Euroyen rate = 4.00 % per annum

98
In equilibrium F180 must be ¥ 103.9615/$ to prevent arbitrage
CIP and Indian Forex Market
Example-1 (February 16-2018)
 Does CIP hold true in Indian Forex /
Money Markets?
MIBOR LIBOR USD/INR
(USD) FORWARD
PREMIUM
o/n 6.05% 1.44375% 4.68%
3-month 7.20% 1.8725% 4.73%
(F-S)/S = 4.73% p.a. (3-mth Fwd Premium)

(i-i*) = (7.22% – 1.8725%)
= 5.3475% p.a.
Therefore, (F-S)/S < (i-i*) or (F-S)/S + i* < i
99
CIP and Indian Forex Market –
Example-1 (Cont..)
1) Borrow 1 USD at 3 mth-LIBOR @ 1.8725% p.a.
2) “Sell” USD Spot and “Buy” INR Spot (-1.8725%)
3) Simultaneously, hedge INR-USD exchange rate risk by
“Buying” USD Forward i.e. “Sell-Buy” Swap i.e. pay
premium @ 4.73% p.a. (-4.73%)
4) Invest in 3 mth INR deposit @3 mth MIBOR = 7.22%
p.a. (+7.22%)
 When the INR deposit matures in 3 mths, pay back the
USD loan.
Net Profit = -1.8725% - 4.7300% + 7.22%
= 0.6175% (in USD terms)*
* Does not include statutory costs viz. SLR, CRR etc. After 100
inclusion of these costs the Net Profit will be lower.

Example-1 (Feb 16-2018)
 Does CIP hold true in Indian Forex / Money
Markets?
 MIBOR : o/n @ 6.05% p.a.
 LIBOR (USD) : o/n @ 1.44375% p.a.
 USD/INR Forward Premium: 1 day @ 4.68% p.a.
 So, (F-S)/S = 4.68% p.a. (1-day Fwd Premium)
(i-i*) = (6.05% – 1.44375%)
= 4.6062% p.a.
Therefore, (F-S)/S - (i-i*) = 0.07%
Little scope for arbitrage 101

Example-2 (Aug11-2017)
Markets?
 MIBOR : o/n @ 5.99% p.a.
: 3-mth @ 6.29% p.a.
 LIBOR (USD) : o/n @ 1.177%
: 3-mth @ 1.3150% p.a.
 USD/INR Forward Premium: 3-mth @ 4.65% p.a.
: 1 day @ 4.83% p.a.
So, (F-S)/S = 4.65% p.a. (3-mth Fwd Premium)
(i-i*) = (6.29% – 1.3150%)
= 4.975% p.a.
102
Example-2 (Cont..)
 Borrow 1 USD at 3 mth-LIBOR @ 1.3150% p.a.
 “Sell” USD Spot and “Buy” INR Spot
 Simultaneously, hedge INR-USD exchange rate risk by
premium @ 4.65% p.a.
 Invest in 3 mth INR deposit @3 mth MIBOR = 6.29% p.a.
USD loan.
Net Profit = -1.3150% - 4.65% + 6.29%
* Does not include statutory costs viz. SLR, CRR etc. After
inclusion of these costs the Net Profit will be lower. 103
Markets?
 MIBOR : o/n @ 5.99% p.a.
 LIBOR (USD) : o/n @ 1.177% p.a.
(i-i*) = (5.99% – 1.177%)
= 4.813% p.a.
Therefore, (F-S)/S = (i-i*)
No scope for arbitrage 104

Markets?
 MIBOR : o/n (Call Money Rate)@ 6.51% p.a.
3-mth @ 6.92% p.a.
 LIBOR (USD) : 3-mth @ 0.83% p.a.

(i-i*) = (6.92% – 0.83%)
= 6.09% p.a.
Therefore, (F-S)/S > (i-i*) or (F-S)/S + i* > i 105
Example-3 (Cont..)
 Borrow 1 INR at 3 mth-MIBOR @ 6.92% p.a.
 “Buy” USD Spot and “Sell” INR Spot
“Selling” USD Forward i.e. “Buy-Sell” Swap i.e. receive
 Invest in 3 mth USD deposit @ 3 mth LIBOR = 0.83% p.a.
 When the USD deposit matures in 3 mths, pay back the
INR loan.
Net Profit = -6.92% + 6.25% + 0.83%
= 0.16% (in INR terms)*
inclusion of these costs the Net Profit will be lower. 106
Markets?
 MIBOR : o/n @ 6.50% p.a.
 LIBOR (USD) : o/n @ 0.4183% p.a.

(i-i*) = (6.50% – 0.4183%)
= 6.082% p.a.
107
Example-3 (Cont..)
 Borrow 1 USD at o/n LIBOR @ 0.4183% p.a.
 “Sell” USD Spot and “Buy” INR Spot
 Invest in o/n INR deposit @o/n MIBOR = 6.50% p.a.
 When the INR deposit matures pay back the USD loan.
Net Profit = -0.4183% - 5.44% + 6.50%
inclusion of these costs the Net Profit will be lower.
108
Example-4 (Aug-2015)
Market?
 MIBOR : o/n (Call Money Rate)@ 7.25% p.a.
3-mth @ 7.68% p.a.
 LIBOR (USD) : 3-mth @ 0.329% p.a.

(i-i*) = (7.68% – 0.329%)
= 7.35% p.a.
Therefore, (F-S)/S < (i-i*) or i > (F-S)/S + i*
109
Example-4 (Cont..)
 Borrow 1 USD at 3 mth-LIBOR @ 0.329% p.a.
 “Sell” USD Spot and Buy INR Spot
 Simultaneously hedge USD-INR exchange rate risk by
“buying” USD Forward i.e. “Buy-Sell” Swap i.e. pay
 Invest in 3 mth INR deposit @ 7.68% p.a.
USD loan.
Net Profit = -0.329% - 6.71% + 7.68%
= 0.641% (in USD terms)
110
-2.000%
-3.000%
-1.000%
0.000%
1.000%
2.000%
3.000%
4.000%
5.000%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
Jan-06 Jan-06
May-06 May-06
Sep-06 Sep-06
Jan-07 Jan-07
May-07 May-07
Sep-07 Sep-07
Jan-08 Jan-08
May-08 May-08
Sep-08 Sep-08
Jan-09
US 1Y LIBOR
Jan-09
May-09 May-09
Sep-09 Sep-09
Jan-10 Jan-10
May-10 May-10
Sep-10 Sep-10
Jan-11 Jan-11
May-11 May-11
Sep-11 Sep-11
Jan-12
Arbitrage
Jan-12
May-12 May-12
Sep-12 Sep-12
Jan-13 Jan-13
May-13 May-13
USD1Y - Annualized Forward %
Sep-13 Sep-13
Jan-14 Jan-14
May-14 May-14
Sep-14 Sep-14
Jan-15 Jan-15
May-15 May-15
Sep-15 Sep-15
Jan-16 Jan-16
May-16 May-16
India 1Y T-Bill %
Sep-16 Sep-16
Jan-17 Jan-17
May-17 May-17
Sep-17 Sep-17
111
Jan-18 Jan-18
CIP – Arbitrage between Offshore USD Market
and INR Market
2013 Taper
Lehman crisis
Tantrum 26 Aug 2016
112
0
2
4
6
8
-4
-2
10
12
Mar-06
Jun-06
Sep-06
Dec-06
Mar-07
Jun-07
Sep-07
Dec-07
Mar-08
Jun-08
Sep-08
Dec-08
Mar-09
Jun-09
Sep-09
1Y GSEC
Dec-09
Mar-10
Jun-10
Lehman crisis
Sep-10
Dec-10
Mar-11
Market and INR Market
1Y MIFOR
Jun-11
Sep-11
Dec-11
Mar-12
2013
Jun-12
Tantrum
Sep-12
Taper
Arbitrage
Dec-12
Mar-13
Jun-13
Sep-13
Dec-13
Mar-14
CIP – Arbitrage between Offshore USD
Jun-14
Sep-14
Dec-14
Mar-15
113
04 Sep 2015
Jun-15
Sep-15
Uncovered Interest Parity (UIP)
 Uncovered interest parity (UIP) also known as

“International Fischer Effect” or “Carry Trade”
 UIP states that the expected change in the
spot exchange rate between two currencies is
directly proportional to the difference between
the two countries nominal interest rates at a
particular time
 The investor is “risk neutral” and chooses to
remain uncovered and accept the currency risk
of exchanging the higher yield currency into
the lower yielding currency at the end of the
period.
114
 In the case of UIP, investors borrow in

currencies with relatively low interest rates
(‘funding currency’) and convert the proceeds
into currencies that offer much higher interest
rates (‘investment currency’) without hedging
exchange rate risk.
115
 In Equilibrium UIP:
e
(1 + i) = S × ( 1+ i *)
S
or
Se = S (1 + i)
(1 + i* )
116
Se – S (i – i*)
=
S ( 1 + i *)
UIP is approximated as:
Se – S
≈ i– i
* Assuming i* is
S small compared to i
117
 Example:
 Suppose GOI issued a G-Sec having a maturity of
1-year on 1st January 2022 with yield of 4.5%
 The corresponding yield on 1 year U.S. T-Bill
issued on 1st January 2022 is 0.5%
 Then the expected depreciation of INR at the end
of 1 year is as follows;
Se – S (i – i*)
=
S (1 + i* )
= 4.5% – 0.5%
1.005
= 3.98% 118
 Suppose on 1st Jan 2022 the exchange rate is
INR 74/USD
 On this date an investor has INR 14,800 at his
disposal to invest
 He invests INR 7400 in GOI 1 year paper at 4.5%
p.a. to earn INR 7733
 He converts the balance INR 7400 to USD 100 at
the spot exchange rate of INR 74/USD
 He invests USD 100 in 1 year US T-Bill at 0.5% p.a.
to earn USD 100.50
 After 1 year he has INR 7733 and USD 100.5 from
INR and USD investments respectively
119
 According to Fischer effect the spot exchange rate

on 1st January 2023 is :
INR 7733 / USD 100.5 = INR 76.94 / USD
 Therefore,
Se – S = (76.9453 – 74.0000)
S 74
= 2.9453
74
= 0.0398
= 3.98%
120
 In theory, according to UIP, carry trades
should not be systematically profitable
because the differences in interest rates
between two currencies should be offset by
depreciation of high-interest-rate currency
against low-interest-rate currency i.e.
appreciation of low-interest-rate currency
against the high-interest-rate one.
 In reality, carry trade weakens the currency
which is borrowed because investors sell the
low-interest-rate borrowed currency by
converting (buying) the high-interest-rate
currency causing the high-interest-rate
currency to appreciate.
121
 Carry Trade is profitable as long as

the interest differential between high
interest currency and low interest
currency is greater than the
depreciation of the high interest
currency i.e. the investment currency.
122
 Example
 Interest rate on 1 year borrowing in JPY = 0.1%
 Interest rate on 1 year US T-Bill = 0.5%
 Therefore:
1. Borrow 1 year in JPY at 0.1%
2. With the JPY buy USD
3. Invest USD in 1 year US-T Bill at 0.6% without
hedging JPY-USD exchange rate risk
4. Assume the USD-JPY exchange rate remains the
same at the end of 1 year
5. Net return realised by investing in USD 0.5%
6. If USD depreciates by more than 0.5% then the
investor would incur a loss 123
 Yen Carry Trade:
 Over much of 2000s Bank of Japan (BOJ) had
maintained near “zero interest rate policy” making it
profitable to borrow in JPY to fund high interest rate
currencies such as AUD, NZD, and USD.
 The Yen carry trade collapsed in 2008 following
Lehman shock and appreciation of Yen.
 The 2008-2012 Icelandic financial crisis has its
origin in undisciplined borrowing of Euro at low
interest rates denominated loans to purchase
homes and other assets which defaulted when
Icelandic currency depreciated dramatically making
loan repayments unaffordable and causing banking
crisis
124
 Iceland Banking Crisis

 Collapse of Iceland’s Banking System
and the Economy in Oct 2008 :
 Iceland’s banking system grew enormously
post its liberalization in 2003:
 Iceland’s three largest banks – Glitnir,
Landsbanki and Kaupthing represented
85% of Iceland’s banking sector
 These banks grew rapidly domestic and
internationally – capital inflows met strong
domestic demand and led to bubbles in
Iceland’s property and equity markets
125
(Cont..)
 The banking system accounted for 900% or
10 times Iceland’s GDP
 The foreign currency deposits held in the
balance sheets of the Icelandic trio was more
than 20 times the Central Bank’s foreign
exchange reserves
 Icelandic banks were highly leveraged
institutions with long-term illiquid assets as
compared to short-term liabilities (maturity
mismatch) 126
(Cont..)
 To pay rapidly maturing liabilities these
banks have to tap international capital
markets for extra finance effectively bringing
more debt into their balance-sheets
 The availability of credit dried up as a result
of the failure of U.S. sub-prime mortgage
market and credit crunch following the
bankruptcy of Lehman
 The three Icelandic banks were not able to
refinance their liabilities in international
capital markets 127

(Cont..)
 In early Oct 2008 the three Icelandic banks
defaulted on their foreign currency deposits
 Given their high leverage they quickly
collapsed their liabilities exceeding USD 60
bn and required a bailout threatening to suck
the entire nation down
 The Icelandic central bank could not act as
Lender of Last Resort (LOLR) because the
three banks’ liabilities were denominated in
foreign currency and exceeded 8 times the
Icelandic GDP 128
(Cont..)
 This resulted in a run on the Icelandic krona
which lost 40% of its value from Oct-Dec’08
and Iceland’s Central Bank lost most of its
reserves in vain attempt to prevent its
currencies collapse
 Iceland sought help of the IMF and its Nordic
neighbors and nationalized banks
129
Example: The Yen Carry Trade
 Suppose:
 1 year JPY interest rate ‘i’ is 0.4% p.a.
 1 year USD interest rate ‘i*’ is 5% p.a.
 Current USD /JPY spot exchange rate ‘S’ is 120.
 USD/JPY exchange rate is expected to remain
stable over next 1 year.
 How much profit can an investor earn in JPY by
borrowing JPY 10 mio, investing in USD deposit
for 1 year and converting the earnings in USD
back into JPY?
130
Example: The Yen Carry Trade
Investors borrow yen at 0.40% per annum
Start End
¥ 10,000,000  1.004 ¥ 10,040,000 Repay
¥ 10,500,000 Earn
Then exchanges Japanese yen money market ¥ 460,000 Profit
the yen proceeds
for US dollars,
S =¥ 120.00/$ 360 days S360 = ¥ 120.00/$
investing in US
dollar money
markets for US dollar money market
one year
$ 83,333  1.05 $ 87,500
Invest dollars at 5.00% per annum
131
Carry Trade Analysis- USD/JPY
US 2Y Yield RoI USDJPY Currency
80 180
USD/JPY (Jan 2013): 91.71
70 USD/JPY (Jan 2015): 117.49
Currency Return : 14.05% p.a. 160
UST-2Y Return : 0.67% p.a. Return based on
60 Total Return: : 29.44% p.a. investment made in
Jan 2013 & maturing 140
50 in Jan 2015
120
40
30 100
20 80
10
60
0
40
-10
20
-20
-30 0
Jan-90
Jul-90
Jan-91
Jul-91
Jan-92
Jul-92
Jan-93
Jul-93
Jan-94
Jul-94
Jan-95
Jul-95
Jan-96
Jul-96
Jan-97
Jul-97
Jan-98
Jul-98
Jan-99
Jul-99
Jan-00
Jul-00
Jan-01
Jul-01
Jan-02
Jul-02
Jan-03
Jul-03
Jan-04
Jul-04
Jan-05
Jul-05
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
Jul-10
Jan-11
Jul-11
Jan-12
Jul-12
Jan-13
Jul-13
Jan-14
Jul-14
Jan-15
Jul-15
Jan-16
Jul-16
Jan-17
Jul-17
Jan-18
LHS = US 2 Year- T yield and Carry Trade Return
RHS = JPY-USD exchange rate 132
Carry Trade Analysis- USD/JPY
USD/JPY (Nov 2012): 82.48

USD/JPY (Nov 2014): 118.63
Currency Return : 22.03% p.a.
UST 2Y Return : 0.24% p.a.
Total Return : 44.54% p.a.
Return based on
investment made
in Nov 2012 &
maturing in Nov
2014
133
 Carry Trade Strategy:
1) Choose currency pair with high positive
interest rate difference e.g. AUD/JPY and
NZD/JPY being the most popular currencies
2) Select a currency pair which has been
either:
 Stable; or
 The interest rate on high yield currency is likely
to increase and the high yield currency is likely
to appreciate which would given an opportunity
for an investor to stay as long as possible.
3) The interest difference based on over-night
interest rates is paid on a daily basis 134
 Carry Trade Strategy (Cont..):
 Example-1:
 Over much of the 2000’s, JPY interest rates
were close to zero while Australia’s interest
rates were comfortably positive climbing to 7%
p.a. by spring 2008.
 The average annual interest differential
between AUD and JPY was about 5.00% p.a.
 With many people indulging in carry trade the
high yield currency appreciates. For e.g.
between Jan 2001 and Dec 2007 the AUD
appreciated by 70%
 The effective return earned by investors was 135
about 75%
 Carry Trade Strategy (Cont..):
 Example-1 (Cont..):
 The graph in the next slide illustrates the
cumulative return of investing JPY 100 in Yen
bonds and in Australian Dollar bonds over a period
from 2003 to 2013 with initial investment being
made at the start of 2003.
 JPY investment yields next to nothing.
 AUD pays off handsome returns not only because
of high interest rate but because of appreciation of
AUD against JPY till mid-2008.
 In mid-2008 the AUD crashed against the JPY,
falling from JPY 104 to JPY 61 between July to Dec
2008 i.e. depreciation by about 40%.
 This crash did not wipe out the gains in carry trade
strategy entirely if the strategy had been initiated136
early enough!
Cumulative Total Investment Return in
Australian Dollar Compared to Japanese
Yen 2003-2013
JPY 104
JPY 61
137
AUD/JPY spot exchange rate movement
over a 13-year period from 2000 to 2013
During the two periods,

an investor who was
short JPY and long
AUD enjoyed
substantial returns
IINewIne 138
AUD-JPY Carry Trade: Jan 2009 to
Jan 2010
 Carry Trade Strategy

 Example-2:
 As of Jan 2009 the interest rates for 1 year on
JPY an AUD were as follows:
Currency Interest Rate
Japanese Yen 1.00%
Australian Dollar 4.50%
139
Jan 2010
USD
/JPY
83.19
60.91
Jan 2009 Jan 2010
• From Jan’09 to Jan’10, JPY/AUD moved from 60.91 to 83.19 i.e.

JPY depreciated by 36.6% (AUD appreciated by 36.5%)
• With interest differential of 3.5% p.a. between AUD & JPY the
investor would have earned an effective return of about 40%
140
Jan 2010
(Return = 41%)
141
INR-Euro Carry Trade (One year
period 2012-2013)
Forward Rates and Future Spot Rates
• If the forward rate equals the expected spot rate,

then the expected rate of depreciation
(between today and the future period) equals the
forward premium (the proportional difference
between the forward and spot rates):
F-S = Se - S
S S
(Forward premium) (Expected rate of depreciation)
• While the left-hand side is easily observed, the

expectations on the right-hand side are typically
unobserved.
143
Forward Rates as Unbiased
Predictors of Future Spot Rates
 If foreign exchange markets are “efficient”
then forward exchange rates should be
unbiased predictors of future spot exchange
rates.
 The unbiased forward rate (UFR) concept
states that the forward exchange rate, quoted
at time t for delivery at time t+1, is equal to
the expected value of the spot exchange rate
at time t+1:
Ft, t+1 = Et[St+1]

144
Forward Rates as Unbiased
Predictors of Future Spot Rates
 Unbiased predictor does not mean that the
future spot rate will actually be equal to the
forward rate
 Unbiased prediction simply means that the
forward rate will, on average, overestimate
and underestimate the actual future spot rate
with equal frequencies and magnitudes such
that the sum of errors (deviations) is equal to
zero
 Therefore you can either make a speculative
profit or a speculative loss. However, if you
were to conduct such uncovered arbitrage
time and again, on an average you would not
make any return 145
Forward Rates: Unbiased Predictor
Exchange rate
S2 F2
Error Error
S1 F3
F1 S3 Error
S4
Time
t1 t2 t3 t4
The forward rate available today (Ft,t+1 ), time t, for delivery at future time t+1, is used as a
“predictor” of the spot rate that will exist at that day in the future. Therefore, the forecast spot
rate for time St2 is F1; the actual spot rate turns out to be S 2. The vertical distance between the
prediction and the actual spot rate is the forecast error. When the forward rate is termed an
“unbiased predictor,” it means that the forward rate over or underestimates the future spot rate
with relatively equal frequency and amount, therefore it misses the mark in a regular and orderly
146
manner. Over time, the sum of the errors equals zero.
Empirical Evidence on Uncovered
Interest Parity
Evidence on Interest Parity
When UIP and CIP hold,
the 12-month forward
premium should equal the
12-month expected rate of
depreciation. A scatterplot
showing these two
variables should be close
to the diagonal 45-degree
line.
Using evidence from
surveys of individual forex
traders’ expectations over
the period 1988 to 1993,
UIP finds some support, as
the line of best fit is close
to the diagonal.
147
Empirical Tests of UFR
 Empirical tests of efficient market hypothesis

are not conclusive
 It appears that the forward rate may not be
an unbiased predictor of the future spot rate
and that it does pay to use resources in an
attempt to forecast exchange rates.
 The existence and success of foreign
exchange forecasting services suggest that
managers are willing to pay a price for
forecast information even though they can
use the forward rate to forecast at no cost. 148
Fischer Effect
 The Fisher effect states that nominal interest rates in
each country are equal to the required real interest rate
plus compensation for expected inflation.
 This equation reduces to (in approximate form):
i = r +
Where i = nominal interest rate, r = real interest rate and
 = expected inflation.
 Empirical tests (using ex-post) of national inflation rates
have shown the Fisher effect usually exists for short-
maturity government securities (T-bills and notes).
149
Fischer Effect The Fisher Effect
 The international Fisher relation is inspired by the
domestic relation postulated by Irving Fisher (1930).
 The Fisher effect (also called Fisher-closed) states:
1 i   1 r 1    i  r    r
 This relation is often presented as a linear
approximation stating that the nominal interest rate is
equal to a real interest rate plus expected inflation:
i  r 
150
Fischer Effect
 Applied to two different countries, home country and
foreign country, “The Fisher Effect” would be stated
as:
i  r  i  r 
* * *
 It should be noted that this requires a forecast of the

future rate of inflation, not what inflation has been in
the past.
 In equilibrium:
r  r*
or
i  i*    * 151
Fischer Effect
 Applied to two different countries, like U.S. and
Japan, “The Fisher Effect” would be stated as:
i  r 
$ $ $
i ¥  r ¥  ¥
 It should be noted that this requires a forecast of the
future rate of inflation, not what inflation has been in
the past.
 In equilibrium:
r$  r¥
or i $ i ¥   $   ¥
152
Prices, Interest Rates and
Exchange Rates in Equilibrium
 (A) Purchasing Power Parity
 Percentage change in spot exchange rate is equal to
expected inflation differential between the two countries
(St+1 - St)/St =  - *
 (B) Covered Interest Parity

 Interest differential between home and foreign currency is
equal to premium / discount of foreign currency
F–S ≈ i – i*
S
153
 (C) Uncovered Interest Parity (“Carry Trade”)
 Interest differential between home and foreign currency is
equal to change in expected future spot rate
(Set+1 - St)/St ≈ i – i*
 (D) Forward Rate as an Unbiased Predictor

 Forward rate is an unbiased predictor of future spot rate
assuming that the foreign exchange market is reasonably
efficient
F = Se
154
 (E) Fisher Effect
 Nominal interest differential between two currencies is
equal to expected inflation differential between the two
countries
i i *   *
155
(Set+1 - St) /St =  - * = i – i* = (Ft+1 – St) /St

(1) (2) (3) (4)
 (1) – (2) : PPP

 (1) – (3) : UIP
 (1) – (4) : Forward Rate = Expected Future Spot Rate
 (2) – (3) : Fisher Effect
 (3) – (4) : CIP
156
International Parity Conditions in
Equilibrium (Approximate Form)
Forward rate Forecast change in Purchasing
as an unbiased spot exchange rate power
predictor +4% parity
(yen strengthens)
(E) (A)
Forward premium Uncovered Forecast difference

on foreign currency Interest Parity in rates of inflation
+4% +4%
(yen strengthens)
(C) (less in Japan)
Covered
Difference in nominal Fisher
Interest interest rates effect
Parity +4% (B)
(D) (less in Japan)
157

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INTERNATIONAL PARITY

Strictly for Private Circulation Only

 International Parity Conditions

PiUS = (PiUK) x (E$/£)

(E$/£) = (PiUS )/(PiUK)

 Law of One Price

 Profit = BKT 40,498 – BKT 35,000

“Burgernomics” is based on the theory of PPP. The

 The Economist then calculates the implied

 The price of a Big Mac in China in U.S. dollar-

• Now comparing the implied PPP exchange rate of

Yuan 3.591/$ - Yuan 6.2115/$ = -42.2%

PUS = price level of basket of goods and services in the US

 Calculating a price index – ratio of price

 Knowing the direction and quantum of

 At time t = 1, the price levels change because of

 Therefore E1 – E0 = ΔE = (π – π*) ….(3)

 Given the inflation rates of 2% and 5% in US and

= (0.02 – 0.05)/(1) = - 0.03 = - 3.0%

USD 100 x 70 (INR/USD) = INR 7000

 Return in Pounds on a “covered basis” i.e.

 If the spot and forward rates are not in a

• Exploiting the above risk-less arbitrage opportunity by

Dollar return on dollar asset = Dollar return on

CIP is approximated as:

If i$ > i£ then F > S 67

 Depending upon how you quote the exchange

…so be a bit careful about that.

FT($/£) = S × (1+ i$)T

i = ‘T’ period domestic interest rate

T= 1 Repay Rs 1.(1+ i) 1) Earn $ 1/S (1 + i*) in 1-year.

Therefore, (1 + i) = F × (1+ i*)

If i > i* then F > S 72

Home currency return on domestic deposit =

30 60 90 120 150 180

Percent difference between domestic ($)

Financial Liberalization and Covered Interest Parity: Arbitrage between the

Financial Liberalization and Covered Interest Parity: Arbitrage between the

deviations resulting from transactions costs and measurement errors.

 There is strong empirical evidence that the CIP

 In equilibrium, the forward rate must settle at

S = SF 1.4800/$ 90 days F90 = SF 1.4655/$

Swiss franc money market

SF 1,480,000  1.01 SF 1,494,800

i SF = 4.00 % per annum

* Rounding error. In equilibrium, SFr 1,494,800 must be equal to

S = $ 1.5000/£ 360 days F 360 = $1.48/ £

Pound Sterling money market

£ 666,667  1.08 £ 720,000

i £ = 8.00 % per annum

Dollar money market $1,050,000

S = $ 1.5000/£ 360 days F 360 = $1.4583/ £

Pound Sterling money market

£ 666,667  1.08 £ 720,000

i £ = 8.00 % per annum

In equilibrium, £720,000 must be equal to $1,050,000 i.e. F360 must

No Arbitrage is possible if US$ 1.05 m = £ 0.72 m or