Parity Conditions

Week 6
What Weve Learned
Money is Neutral it represents a means of
exchanging goods and not the creation of
goods themselves
Purchasing Power Parity (PPP): The price of
goods in one country should be the same as
the price of goods in another country
Fisher Effect: An interest rate can be
decomposed into two parts a real rate of
interest and inflation
International Fisher Effect
IFE = PPP + FE
Due to Capital Market Integration, real
interest rate differential is eroding and should
be zero (assuming zero difference in risk)
Therefore, the movement of the exchange
rate should be driven by the change in the
nominal interest rates which in turn is driven
by the interest rate differential
International Fisher Effect
S(t) / S(0) = [(1+rreal)(1+i)]^t Domestic
[(1+rreal)(1+i)]^t Foreign

OR
(1+r)^t Domestic
(1+r)^t Foreign
Interest Rate Parity
Money is neutral No Arbitrageif interest
rates go up, it must be associated with a
decrease in FUTURE exchange rates
The forward rate, F(t), which is the expected
spot rate at time = t, S(t), differs from the spot
rate by the interest rate differential
A discount/premium is defined as:
F(t) S(0) / S(0)
Interest Rate Parity Example 1
Let USD/JPY = 100, the expected one year
interest rate in the US to be 5% p.a. and the
interest rate in Japan to be 3% p.a.
Therefore, F(1) = (1.03)/(1.05) = 98.0952
Or USD is discounted 1.9%
Example 1
Borrow $100 at 5%
Buy Yen: $100*100 = JPY 10,000
Invest JPY at 3% for one year and enter one
year forward contract to sell JPY for USD @
98.0952
At t=1, you have JPY 10,000*(1.03) = 10,300
Sell JPY 10,300 10,300 / 98.0952 = $105
You owe the bank $105, left with $0
Example 2
Imagine JPY interest rates go up, but forward rate
stays the samewhat could you do?
Borrow $100 at 5% p.a. JPY 10,000
Enter forward contract @ 98.0952
At t=1, you have JPY 10,400
Convert back to USD 10,400 / 98.0952 =
$106.02
Give back $105 to bank, you have $1.02
This is an arbitrage profit
Example 2
If this were the case, what would happen?
More people would BUY JPY Spot and/or SELL
JPY Forward
Example 2 Modified: F(1) still equals 98.0952
What is S(0)?
F/S = (1.04)/(1.05) or S(0) = 99.0384
Value of JPY Spot went up (higher demand)
Interest Rate Parity
Takeaways:
When Interest Rates go up, Spot Prices typically go
UP
This INCREASES the rate of decline in the value of
the currency
No Free Lunch: If interest rates go up, its made up
for by the future exchange rate
What happens if currency is in high demand?
Interest Rates go down
Unbiased Forward Rate
The forward rate is the EXPECTED future spot
rate.
Predicting Future Spot Rates