International financial

management
:Parity Conditions

1
 PARITY CONDITIONS
• In an open economy domestic economy characterized by its fiscal,
monetary and trade policies has to be integrated with international
environment.
• Under equilibrium inflation rates, interest rates and exchange rates must
move in tandem.
• The relationship among these parameters are referred as international
parity conditions.
 Law of One Price
The law of one price states:
Identical goods sell for the same price worldwide.
Theoretical basis:
If the price after exchange-rate adjustment were not equal, arbitrage in
the goods worldwide ensures eventually it will.
 Arbitrage and the Law of One Price
Five Parity Conditions Result From These Arbitrage Activities
1. Purchasing Power Parity (PPP)
2. The Fisher Effect (FE)
3. The International Fisher Effect (IFE)
4. Interest Rate Parity (IRP)
5. Unbiased Forward Rate (UFR)

Five Parity Conditions Linked by

The adjustment of various rates and prices to inflation. The notion that money should have no
effect on real variables
 Purchasing Power Parity (PPP)
• Purchasing Power Parity (PPP) theory is one of the early theories of exchange
rate determination. The demand for a country’s currency is derived from the
demand for the goods that this country produces.
• There are 2 variants
1. Absolute PPP
2. Relative PPP

• The theory of Absolute Purchasing Power Parity, states that One unit of currency
has same purchasing power globally.
Absolute Purchasing Power Parity (PPP)
• According to purchasing power parity (PPP) the exchange rate of two
currencies would be in the ratio of prices of common basket of goods in
two currencies.
• If a basket of goods costs Rs 6500 in India, while the same basket of
goods is priced US $ 100 in USA then the exchange rate of Indian rupee
in terms of US dollar is Rs 65/$.
Absolute Purchasing Power Parity (PPP)
• Arbitrage is the backbone of absolute PPP. For it to be true certain conditions must
hold. Some of them are:
• Common basket of goods that provide the same utility
• Quality of goods, styling etc must be same and should not be a price differentiator
• The goods can be bought and sold freely i.e. no trade barriers exist
• Transportation, logistics costs are minimal
• Increasing proportion of international trade relates to goods, since services are not subject to
arbitrage.
• For the above-mentioned factors that do not hold, absolute PPP may not hold good.
 Relative Purchasing Power Parity (PPP)
• Relative PPP focuses on changes in the exchange rate over a period of
time rather than their absolute values at a particular time.
• Even though the absolute form of PPP, i.e. exchange rate may be
different than the ratio of prices of common basket of goods, the changes
in exchange rate may be determined on the basis of changes in the prices
same common basket of goods.
• This may be so because factors responsible for distortion in exchange
rate may be carried over from one period to another.
 Relative Purchasing Power Parity (PPP)
• PPP says
• the currency with the higher inflation rate is expected to depreciate
relative to the currency with the lower rate of inflation.
 Relative Purchasing Power Parity (PPP)
• The current exchange rate of € 1.40/£ and the expected inflation rates in
France and Britain are 3% and 5% respectively. What is the likely
exchange rate after i) 1 year, and ii) 2 years if the inflation rates remain
same?
 Purchasing Power Parity (PPP)
Real Exchange Rates:
• Nominal rate adjusted for a country’s inflation rate
• If exchange rates adjust to inflation differential, PPP states that real
exchange rates stay the same.
• Changes in the real exchange rate indicate its strength.
• Changes in the real rates are more meaningful in determining the
competitive position of a currency and therefore the economy.
 Purchasing Power Parity (PPP)
• Assume the exchange rate of US dollar was Rs 35 in the Year 2000 and Rs 45 in the
Year 2010. The increase in prices in India and USA during the period of 10 years was
50% and 20% respectively, then the real exchange rate in the Year 2010 is
• 45(1.2/1.5) = 36.00
• The change in Real exchange rate is (36-35)/35 =2.86%
• As per PPP the rupee should have depreciated to Rs 43.75/$ means no erosion in the
value of rupee. The nominal exchange rate of Rs 45/$ indicates that rupee depreciated
by 2.86% in real terms, as against 28.57% [(45 – 35)/35] in nominal terms.
• Overvaluation(‐)/Undervaluation(+)
Empirical Evidence on PPP
 Explaining the poor performance of PPP Theory

• Statistical Problems
• Different countries have different consumption baskets and Quality of goods
• Transport costs and trade impediments
• Imperfect competition
• Differences between capital and goods markets
• PPP is about goods market not has not concerned with capital movement
• Dornbusch(1976) hypothesized that , in a world where capital markets are
highly integrated and goods markets exhibit slow price adjustment
 Exchange rate pass-through
• The degree to which the prices of imported and exported goods change as
a result of exchange rate changes is termed pass-through.
• Although PPP implies that all exchange rate changes are passed through
by equivalent changes in prices to trading partners, empirical research in
the 1980s questioned this long-held assumption.
• For example, a car manufacturer may or may not adjust pricing of its cars
sold in a foreign country if exchange rates alter the manufacturer’s cost
structure in comparison to the foreign market.

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Calculating Real Exchange Rate of USD
• The exchange rate between $ and ₹ was $1=₹45.70 on January
2011 and that on December 2014 was $1=₹62.85. During the
same period the consumer price index (CPI) in India rose from
107.1 to 146.6 and CPI in US moved from 126.143 to 133.926.
If PPP had held over this period, what should be $/₹ exchange
rate in December 2014?
• As per PPP the $/₹ exchange rate should have been:
Calculating Real Exchange Rate of USD
• As per PPP the $/₹ exchange rate should have been:
• $/₹ PPP rate = 45.70x[146.6/107.1]/[133.926/126.143]
= 58.92

[(PPP rate – Actual rate)/Actual rate]*100

[(58.92-62.85)/(62.85)]*100=-6.25%
 Fisher Effect
• Normally interest rates are quoted are in nominal terms, but real rates matter to the
parties of loan agreement.
• The Fisher Effect states that nominal interest rates in each country are equal to the
required real rate of return plus compensation for expected inflation.
Stating it formally:

• International investment is guided by real returns and not nominal returns.

• Real Rates of Interest should tend toward equality everywhere through arbitrage.
• With no government interference nominal rates vary by inflation differential

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 Fisher Effect
• According to the Fisher Effect, countries with higher inflation rates have
higher interest rates.
• If returns in India are 8% and in Mexico are 12% then it is not necessary that
an American investor would invest in Mexico. For international investors, the
change in wealth in real terms is more important than change in wealth in
nominal terms.
• If inflation rates in India and Mexico are 3% and 8% respectively the real
returns in India and Mexico would approx. be 5% and 4% respectively.
• Based on real return the preferred destination of investment for international
investor is India even though Mexico offers better nominal returns.
 Fisher Effect
• Empirical tests (using ex-post) national inflation rates have
shown the Fisher effect usually exists for short-maturity
government securities (treasury bills and notes).
• In developing countries currency controls and other
government policies impose political risk on foreign investors
leading to wedge between real returns.
 International Fisher Effect
• The relationship between the percentage change in the spot exchange rate
over time and the differential between comparable interest rates in
different national capital markets is known as the international Fisher
effect.

• According to above Equation, the expected return from investing at home, 1 + rh, should equal the expected home
currency return from investing abroad, (1 + rf )e1∕e0.

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 International Fisher Effect
• Approximate form =
• “Fisher-open”, as it is termed, states that the spot exchange rate
should change in an equal amount but in the opposite direction
to the difference in interest rates between two countries.
• According to international Fisher effect, the extra returns earned
abroad due to higher interest rates in the foreign economy, are
exactly offset by depreciation of the currency of investment.
• This equalizes the returns earned in the home economy.
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 International Fisher Effect
• One year interest rate in India is 7.5% and USA 2.5% if the
current exchange rate is Rs. 75/- what is the expected future
exchange rate in 1 year?

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 International Fisher Effect-Empirical Evidence

• IFE, There is clear tendency for currency with high interest

rates to depreciate and those with low interest rates to
appreciate.
• IFE des not hold up very well in the short run for nations with
low to moderate rates of inflation.
 Interest Rate Parity
• The theory of Interest Rate Parity (IRP) provides the linkage
between the foreign exchange markets and the international
money markets.
• The theory states: In an efficient market with no transaction
costs, the interest differential should be (approximately) equal
to the forward differential. When this condition is met, the
forward rate is said to be at interest rate parity, and equilibrium
prevails in the money markets

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 Interest Rate Parity
•In equilibrium, returns on currencies will be the same i. e. No
profit will be realized and interest parity exists which can be
written
F 1  rh 

S 1  rf 

(1 +𝑟 h )
𝐹 1 =𝑆 0
(1 +𝑟 𝑓 )
 Interest Rate Parity Theory
• Spot and forward rate are closely linked to interest rates in different
currencies.
• A forward rate is an exchange rate quoted for settlement at some future date.
• A forward exchange agreement between currencies states that the rate of
exchange at which a foreign currency will be bought forward or sold
forward at a specific date in the future.
• Current Spot Exchange rate (eRs/$) Rs 73/$
• 3-month Forward Exchange rate (FRs/$) Rs73.5/$

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 Interest Rate Parity
• The forward rate is calculated for any specific maturity by
adjusting the current spot exchange rate by the ratio of
eurocurrency interest rates of the same maturity for the two
subject currencies.
• For example, the 90-day forward rate for the Rupee/US dollar
exchange rate (FRs/$90) is found by multiplying the current spot
rate (eRs/$) by the ratio of the 90-day Rupee deposit rate (rRs)
over the 90-day dollar deposit rate (r$).

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 Interest Rate Parity
• Formulaic representation of the forward rate:
FRs/$90 = eRs/$ x [1 + (rRs x 90/360)]
[1 + (r$ x 90/360)]

FRs/$90 =

=73.723
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 Interest Rate Parity
• The forward premium or discount is the percentage difference
between the spot and forward exchange rate, stated in annual
percentage terms.
f Rs/$ = Forward - Spot 360
x x 100
Spot days

•
• =+3.96% per annum forward premium for dollar
 Interest Rate Parity (IRP)

i Rs = 8.00 % per annum

(2.00 % per 90 days)
Start End
Rs. 1,000,000 x 1.02 Rs. 1,020,000
Rs. 1,020,003*
Rupee money market

S = Rs 73/$ 90 days F90 = Rs. 73.723/$

Dollar money market

$13,698.6 x 1.01 $ 13,835.6

i $ = 4.00 % per annum

(1.00 % per 90 days)
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•Note that the dollar investment yields Rs. 1,020,003, Rs. 3 more on a Rs. 1 million investment due to approximation.
 Interest Rate Parity
• The spot and forward exchange rates are not, however, constantly in the
state of equilibrium described by interest rate parity.
• When the market is not in equilibrium, the potential for “risk-less” or
arbitrage profit exists.
• The arbitrager will exploit the imbalance by investing in whichever
currency offers the higher return on a covered basis.
• This is known as covered interest arbitrage (CIA).

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 Covered Interest Arbitrage (CIA)

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 F180 = ¥ 103.50/$

Yen money market

¥ 106,000,000 x 1.02 ¥ 108,120,000

Euroyen rate = 4.00 % per annum

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 Interest Rate Parity
• A deviation from covered interest arbitrage is uncovered interest arbitrage
(UIA).
• In this case, investors borrow in countries and currencies exhibiting
relatively low interest rates and convert the proceed into currencies that
offer much higher interest rates.
• The transaction is “uncovered” because the investor does no sell the
higher yielding currency proceeds forward, choosing 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.

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 Uncovered Interest Arbitrage (UIA): The Yen Carry Trade

Investors borrow yen at 0.40% per annum

Start End
x 1.004 ¥ 10,040,000 Repay
¥ 10,000,000 ¥ 10,500,000 Earn
Japanese yen money market ¥ 460,000 Profit

S =¥ 120.00/$ 360 days S360 = ¥ 120.00/$

US dollar money market

$ 83,333 x 1.05 $ 87,500

Invest dollars at 5.00% per annum

In the yen carry trade, the investor borrows Japanese yen at relatively low interest rates, converts the proceeds to another currency such as the U.S.
dollar where the funds are invested at a higher interest rate for a term. At the end of the period, the investor exchanges the dollars back to yen to
repay the loan, pocketing the difference as arbitrage profit. If the spot rate at the end of the period is roughly the same as at the start, or the yen has
fallen in value against the dollar, the investor profits. If, however, the yen were to appreciate versus the dollar over the period, the investment may
result in significant loss. 6-41
 Interest Rate Parity
• 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.

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 Interest Rate Parity (IRP) and Equilibrium

2
Percentage premium on
foreign currency (¥)
1
4.83

-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1

-2

-3

Percent difference between foreign (¥) -4 X U

and domestic ($) interest rates
Y 6-43

Z
Summary:
Interest Rate Parity states:
• Higher interest rates on a currency offset by forward
discounts.
• Lower interest rates are offset by forward premiums.
 International Parity Conditions in Equilibrium (Approximate Form)

Forward rate Forecast change in Purchasing

as an unbiased spot exchange rate power
predictor +4% parity
(E) (USD strengthens) (A)

Forward premium International Forecast difference

on foreign currency Fisher Effect in rates of inflation
+4% (C) -4%
(USD strengthens) (less in USA)

Interest
rate Difference in nominal Fisher
parity interest rates effect
(D) -4% (B)
(less in USA)

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 THE UNBIASED FORWARD RATE

• Some forecasters believe that forward exchange rates are unbiased

predictors of future spot exchange rates.
• Intuitively this means that the distribution of possible actual spot rates in
the future is centered on the forward rate.
• Put in another way the forward rate is unbiased, then it should reflect the
expected future spot rate.
• Unbiased prediction simply means that the forward rate will, on average,
overestimate and underestimate the actual future spot rate in equal
frequency and degree.
 Forward Rate as an Unbiased Predictor for Future Spot Rate

Exchange rate
t1 t2 t3 t4

S2 F2

S1 Error F3
Error

Error
F1 S3

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 S t2 is F1; the actual spot
rate turns out to be S2. The vertical distance between the prediction and the actual spot rate is the forecast error.
When the forward rate is termed an “unbiased predictor of the future spot rate,” it means that the forward rate
over or underestimates the future spot rate with relatively equal frequency and amount. It therefore “misses the
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mark” in a regular and orderly manner. The sum of the errors equals zero.