PURCHASING POWER

PARITY AND COVERED

INTREST ARBITRAGE
Submitted To:
Mr.Shakti Dodiya

Submitted By:
Prajapati Kuldip(42)
Prajapati Nirav (43)
Prajapati Vishvani (45)
purohit Suresh (46)
Raval Shilpa (47)

PART II. PURCHASING POWER PARITY

We use money to buy goods. Given a certain amount of
money, should we, in the long run, be able to buy the same
quantity of goods in either country?
If we can, then given the existing price levels (or inflation) in
each country, we should be able to figure out the exchange
rate.
P(DC) = S(DC/FC) x P*(FC)
Here, P is the price-level in the domestic country,and P* is
the price level in the foreign country (FC). S=exchange rate
in direct terms.
This equation is called the Law of One Price.
We can use the PPP to compute the real exchange rate.

PART II. PURCHASING POWER PARITY

states that spot exchange rates between currencies will
change to the differential in inflation rates between
countries.
II.

ABSOLUTE PURCHASING POWER PARITY

A.Price levels adjusted for exchange rates should be

equal

between countries

B. One unit of currency has same purchasing power globally.

III. RELATIVE PURCHASING POWER

PARITY
A. states that the exchange rate of one currency
against another will adjust to reflect changes in the
price levels of the two countries.

1. In mathematical terms:

where
e0 =
ih =
if =
t =

et = future spot rate

spot rate
home inflation
foreign inflation
the time period

2.

If purchasing power parity is expected to hold,

then the best prediction for the one- period spot
rate should be

3. A more simplified but less precise

relationship is

that is, the percentage change should be approximately

equal to the inflation rate differential.

4. PPP says
the currency with the higher inflation rate is
expected to depreciate relative to the currency with
the lower rate of inflation.

B. Real Exchange Rates:

the quoted or nominal rate adjusted for a countrys
inflation rate is

Covered Interest Arbitrage

Covered interest arbitrage is buying a countrys
currency in the spot market and selling it forward,
while making a net profit off:
the combination of higher interest rate in the
country and
any forward premium on its currency.

Because the spot and forward markets are not always in

a state of equilibrium as described by IRP, the
opportunity for arbitrage exists
The arbitrageur who recognizes this imbalance can
invest in the currency that offers the higher return on a
covered basis
This is known as covered interest arbitrage (CIA)
The following slide describes a CIA transaction in
much the same way as IRP was transacted

A deviation from CIA is uncovered interest arbitrage,

UIA, wherein investors borrow in currencies
exhibiting relatively low interest rates and convert
the proceeds into currencies which offer higher
interest rates
The transaction is uncovered because the investor
does not sell the currency forward, thus remaining
uncovered to any risk of the currency deviating

Rule of Thumb:
If the difference in interest rates is greater than the
forward premium (or expected change in the spot
rate), invest in the higher yielding currency.
If the difference in interest rates is less than the
forward premium (or expected change in the spot
rate), invest in the lower yielding currency.