International Parity Relationships &

Forecasting Foreign Exchange Rates

 Concepts
 Interest Rate Parity
 Purchasing Power Parity
 PPP Deviations and the Real Exchange Rate
 Evidence on Purchasing Power Parity
 The Fisher Effects
 Forecasting Exchange Rates
Interest Rate Parity Defined
 IRP is an arbitrage condition.
 If IRP did not hold, then it would be possible for an
astute trader to make unlimited amounts of money
exploiting the arbitrage opportunity.
 Since we don’t typically observe persistent arbitrage
conditions, we can safely assume that IRP holds.
 Interest Rate Parity Defined

Formally,
1 + i₹ F₹/$
=
1 + i$ S₹/$

IRP is sometimes approximated as

i₹ – i$
F–S
≈
S
 Forward Premium
 It’s just the interest rate differential implied by forward
premium or discount.

 For example, suppose the $ is appreciating from S(₹/$) =

82.00 to F180(₹/$) = 84.00

 The forward premium is given by:

F180(₹/$) – S(₹/$) 360 ₹ 84.00 – ₹82.00

f180,$/₹ = × = × 2 = 4.8%
S(₹/$) 180 ₹ 82.00
Interest Rate Parity Carefully Defined
 Depending upon how you quote the exchange rate (₹
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

 Arbitrage opportunities in Forward Market
– Covered Interest Arbitrage
 If the forward rate differential is lesser than the
interest rate difference then borrow money from the
low interest market and invest in high interest market

 If forward rate differential is higher than the interest

rate difference. Borrow money form the high interest
market and invest in the low interest market
 Example - 1
Forward premium Rate : (82.5-82)/82 * 12/3
Spot Rate is 82 – INR/USD = 2.44%

Three months forward is Interest rate difference : 4% (6.5% - 2.5%)

82.5 – INR/USD
Interest Rate in US – 2.5%
Interest Rate in India -6.5%
Forward premium rate < Interest rate difference :
Borrow money from low interest market and invest in
high interest market cover the future cash inflow by
selling a forward contract

1. Borrow money from US market - $10000 with 2.5%

2. Convert $10000 to ₹8,20,000 in spot market and invest in India for
6.5%
3. Enter into 3 months forward contract for 82.5 – INR/USD
4. After three months investment would be 820000+ (820000
*6.5%)*3/12 = INR 833325
5. Convert the INR 833325 using the forward contract $10101
6. Pay the money borrowed at US market with interest 10000 +
(10000*2.5%)*3/12 = $10,062
7. Profit made - $38.41
Example - 2
Spot Rate is 82 – INR/USD Forward premium Rate : (83-82.5)/82.5 *
12/3 = 4.88%

Three months forward is 83 Interest rate difference : 4% (6.5% - 2.5%)

– INR/USD
Interest Rate in US – 2.5%
Interest Rate in India -6.5%
Forward premium rate > Interest rate difference :
Borrow money from high interest market and invest
in low interest market cover the future cash inflow
by buying a forward contract

1. Borrow money from Indian market – INR 1000000 with 6.5%

2. Convert INR 1000000 – $12195.12 in spot market and invest in US
for 2.5%
3. Enter into 3 months forward contract for 83 – INR/USD
4. After three months investment would be $12195.12 + ($12195.12
*2.5%)*3/12 = $12271.34
5. Convert the $12271.34 using the forward contract INR
10,18,521.34
6. Pay the money borrowed at Indian market with interest 1000000 +
(1000000*6.5%)*3/12 = INR 1054428
7. Profit made - INR 2271.34
Transactions Costs Example
 Will an arbitrageur facing the following prices be
able to make money?

  Borrowing Deposits 1 + i₹ F₹/ $

=
₹ 6.5% 5.5% 1 + i$ S₹/ $
$ 4%   3.5 Bid Ask
%
Spot ₹82=$1 ₹82.3=$1
Forward ₹85.1=$1 ₹85.90=$1
 Reasons for Deviations from IRP
 Transactions Costs
 The interest rate available to an arbitrageur for borrowing,
ib,may exceed the rate he can lend at, il.
 There may be bid-ask spreads to overcome, Fb/Sa < F/S
 Thus
(Fb/Sa)(1 + i$l)  (1 + i$ b)  0
 Capital Controls
 Governments sometimes restrict import and export of money
through taxes or outright bans.
 Transactions Costs Example
 Try borrowing ₹10,000 at 5%:
 Trade for $ at the ask spot rate ₹82.3 = $1.00
 Invest $121.51 at 5.5%
 Hedge this with a forward contract on
$125.76 at ₹85.1 = $1.00
 Receive ₹10702.13
 Owe ₹10650 on your rupee-based borrowing
 Profit of ₹ 52.13
Interest Rate Parity
 In equilibrium, the forward rate differs from the
spot rate by a sufficient amount to offset the
interest rate differential between two currencies.
 Derivation of Interest Rate Parity

1  ih
p 1
1 if
where
p  forward premium
ih  home interest rate
i f  foreign interest rate
 Interest Rate Parity
Determining the Forward Premium
Effect of the interest rate differential: The relationship between the
forward premium (or discount) and the interest rate differential
according to IRP is simplified in an approximated form:

F S
p  ih  i f
S
where
p  forward premium (or discount)
F  forward rate in dollars
S  spot rate in dollars
ih  home interest rate
i f  foreign interest rate

Implications: If the forward premium is equal to the interest rate

differential as just described, then covered interest arbitrage will not
be feasible.
Comparing Arbitrage Strategies
Market Corrections (if FPR < IRD)

 Interest rate will raise in foreign country

 Interest rate will fall in India
 Rupee appreciate in the SPOT market
 Rupee will depreciate in the forward market
Purchasing Power Parity
 Purchasing Power Parity and Exchange Rate
Determination
 PPP Deviations and the Real Exchange Rate
 Evidence on PPP
 Purchasing Power Parity and Exchange
Rate Determination
 The exchange rate between two currencies should equal
the ratio of the countries’ price levels:
P₹
S (₹ /$) = P$
 For example, if an ounce of gold costs ₹35000 in India. and
$430 in the U.S., then the price of one dollar in terms of
Rupees should be:

P₹ ₹35000
S(₹/$) = P $ = $430 = 81.40
Purchasing Power Parity and Exchange Rate
Determination
 Suppose the spot exchange rate is ₹74.5 = $

 If the inflation rate in the U.S. is expected to be 3% in the

next year and 5% in India
 Then the expected exchange rate in one year should be
₹74.5 (1.05) = $1×(1.03)

F(₹ /$) = ₹81.40 ×(1.05) =

₹82.98
$1×(1.03) $
 Purchasing Power Parity and Exchange Rate
Determination
 The INR will trade at a 1.90% premium in the forward
market:
₹81.40 ×(1.05)
F(₹/$) $×(1.03) 1.05 1 + ₹
= = =
S (₹/$) ₹81.40 / $ 1.03 1 +  $

Relative PPP states that the rate of change in the exchange

rate is equal to differences in the rates of inflation—roughly
2%
Purchasing Power Parity and Interest Rate
Parity
 Notice that our two big equations today equal each
other:

PPP IRP
F(₹/$) 1 + ₹ 1 + i₹ F(₹/$)
= = =
S(₹/$) 1 + $ 1 + i $ S($/₹)
Expected Rate of Change in Exchange Rate as Inflation Differential
 We could also reformulate our equations as inflation or
interest rate differentials:
F(₹/$) 1 + ₹
=
S(₹/$) 1 + $

F(₹/$) – S(₹/$) 1 + ₹ 1 + ₹ 1 + $
= – 1 = 1+ 1+–
S(₹/$) 1 + $ $ $

F(₹/$) – S(₹/$)  ₹ – $
E(e) = = ≈ ₹ – $
S(₹/$) 1 + $
Expected Rate of Change in Exchange Rate as Interest
Rate Differential

F(₹/$) – S(₹/$) i₹ – i$
= ≈ i₹ – i $
E( e ) = 1 + i$
S(₹/$)
Quick and Dirty Short Cut
 Given the difficulty in measuring expected inflation,
managers often use

₹ – $ ≈ i₹ – i$
Evidence on PPP
 PPP probably doesn’t hold precisely in the real
world for a variety of reasons.
 Haircuts cost 10 times as much in the developed world as
in the developing world.

 Film, on the other hand, is a highly standardized

commodity that is actively traded across borders.

 Shipping costs, as well as tariffs and quotas can lead to

deviations from PPP.

 PPP-determined exchange rates still provide a

valuable benchmark.
Approximate Equilibrium Exchange Rate
Relationships

E( e )
≈ IFE ≈ FEP

≈ PPP
F–S
(i₹ – i $) ≈ IRP
S
≈ FE ≈ FPPP

E(₹ –  $)
 The Exact Fisher Effects
 An increase (decrease) in the expected rate of inflation
will cause a proportionate increase (decrease) in the
interest rate in the country.
 The Fisher effect is written as:
1 + i₹ = (1 + ₹ ) × E(1 + ₹)
Where
₹ is the equilibrium expected “real” interest rate
E(₹) is the expected rate of inflation
i₹ is the equilibrium expected nominal interest rate
 International Fisher Effect

If the Fisher effect holds in the India.

1 + i₹ = (1 + ₹ ) × E(1 + ₹)
and the Fisher effect holds in the USA,
1 + i$ = (1 + $ ) × E(1 + $)
and if the real rates are the same in each country
₹ = $
then we get the
International Fisher Effect:
1 + i$ = E(1 + $)
1 + i₹ E(1 + ₹)
International Fisher Effect

If the International Fisher Effect holds,

1 + i$ E(1 + $)
=
1 + i₹ E(1 + ₹)

and if IRP also holds

1 + i$ F$/₹
=
1 + i₹ S$/₹
F$/₹ E(1 + $)
then forward rate PPP =
S$/₹ E(1 + ₹)
holds:
Exact Equilibrium Exchange Rate Relationships

E (S ¥ / $ )
IFE S¥ /$ FEP

PPP
1 + i$ F¥ / $
IRP
1 + i₹ S¥ /$
FE FRPPP
E(1 + $)
E(1 + ₹)
Forecasting Exchange Rates
 Efficient Markets Approach
 Fundamental Approach
 Technical Approach
 Performance of the Forecasters
Efficient Markets Approach
 Financial Markets are efficient if prices reflect all
available and relevant information.
 If this is so, exchange rates will only change when
new information arrives, thus:
St = E[St+1]
and
Ft = E[St+1| It]
 Predicting exchange rates using the efficient markets
approach is affordable and is hard to beat.
 Fundamental Approach
 Involves econometrics to develop models that use a
variety of explanatory variables. This involves three
steps:
 step 1: Estimate the structural model.
 step 2: Estimate future parameter values.
 step 3: Use the model to develop forecasts.
 The downside is that fundamental models do not work
any better than the forward rate model or the random
walk model.
Technical Approach
 Technical analysis looks for patterns in the past
behavior of exchange rates.
 Clearly it is based upon the premise that history
repeats itself.
 Thus it is at odds with the EMH
 Performance of the Forecasters
 Forecasting is difficult, especially with regard to the
future.
 As a whole, forecasters cannot do a better job of
forecasting future exchange rates than the forward
rate.
 The founder of Forbes Magazine once said:
“You can make more money selling financial advice
than following it.”