Chapter Outline


 Interest Rate Parity
 Covered Interest Arbitrage
 Purchasing
 Power Parity
 IRP

 ThePPP and Exchange
Deviations andRate Determination
the Real Exchange Rate
 Fisher Effects
 Reasons

Evidencefor
on Deviations from IRP
 Forecasting
 Exchange Rates Parity
Purchasing Power
 Purchasing

The PowerApproach
Fisher Market
 Efficient Effects Parity
 The
 Fisher Effects
Forecasting
 FundamentalExchange
ApproachRates
 Forecasting Exchange Rates
 Technical Approach

 Performance of the Forecasters

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 Interest Rate Parity
 Interest Rate Parity Defined
 Covered Interest Arbitrage
 Interest Rate Parity & Exchange Rate
Determination
 Reasons for Deviations from Interest Rate Parity

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 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.

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 Interest Rate Parity Carefully Defined
Consider alternative one year investments for $100,000:
1. Invest in the U.S. at i$. Future value = $100,000 × (1 + i$)
2. Trade your $ for £ at the spot rate, invest $100,000/S$/£ in
Britain at i£ while eliminating any exchange rate risk by
selling the future value of the British investment forward.
F$/£
Future value = $100,000(1 + i£)×
S$/£
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$/£
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 Alternative 2: $1,000 IRP
Send your $ on a
round trip to
S$/£
Step 2:
Britain
Invest those
pounds at i£
$1,000 Future Value =
$1,000
 (1+ i£)
S$/£
Step 3: repatriate
Alternative 1: future value to the
invest $1,000 at i$ U.S.A.
$1,000
$1,000×(1 + i$) =  (1+ i£) × F$/£
S$/£
IRP

Since both of these investments have the same risk, they must
have6-5the same future value—otherwise an arbitrage
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 Interest Rate Parity Defined
 The scale of the project is unimportant
$1,000  (1+ i ) × F
$1,000×(1 + i$) = £ $/£
S$/£

F$/£
(1 + i$) = × (1+ i£)
S$/£

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 Interest Rate Parity Defined
Formally,
1 + i$ F$/¥
=
1 + i¥ S$/¥

IRP is sometimes approximated as

i$ – i ¥ ≈ F – S
S

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 Forward Premium
 It’s just the interest rate differential implied by
forward premium or discount.
 For example, suppose the € is appreciating from
S($/€) = 1.25 to F180($/€) = 1.30
 The forward premium is given by:

F180($/€) – S($/€) 360 $1.30 – $1.25

f180,€v$ = × 180 = × 2 = 0.08
S($/€) $1.25

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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

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 IRP and Covered Interest Arbitrage
If IRP failed to hold, an arbitrage would exist. It’s
easiest to see this in the form of an example.
Consider the following set of foreign and domestic
interest rates and spot and forward exchange rates.

Spot exchange rate S($/£) = $1.25/£

360-day forward rate F360($/£) = $1.20/£
U.S. discount rate i$ = 7.10%
British discount rate i£ = 11.56%

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 IRP and Covered Interest Arbitrage
A trader with $1,000 could invest in the U.S. at 7.1%, in one
year his investment will be worth
$1,071 = $1,000  (1+ i$) = $1,000  (1,071)
Alternatively, this trader could
1. Exchange $1,000 for £800 at the prevailing spot rate,
2. Invest £800 for one year at i£ = 11.56%; earn £892.48.
3. Translate £892.48 back into dollars at the forward rate
F360($/£) = $1.20/£, the £892.48 will be exactly $1,071.

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Alternative 2: Arbitrage I
buy pounds £800
£1 Step 2:
£800 = $1,000×
$1.25 Invest £800 at
i£ = 11.56%
$1,000 £892.48 In one year £800
will be worth
Step 3: repatriate £892.48 =
to the U.S.A. at £800 (1+ i£)
F360($/£) =
Alternative 1:
$1.20/£
invest $1,000 $1,071 F£(360)
at 7.1% $1,071 = £892.48 ×
£1
FV = $1,071

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 Interest Rate Parity
& Exchange Rate Determination
According to IRP only one 360-day forward rate,
F360($/£), can exist. It must be the case that

F360($/£) = $1.20/£
Why?
If F360($/£)  $1.20/£, an astute trader could make
money with one of the following strategies:

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 Arbitrage Strategy I
If F360($/£) > $1.20/£
i. Borrow $1,000 at t = 0 at i$ = 7.1%.
ii. Exchange $1,000 for £800 at the prevailing spot
rate, (note that £800 = $1,000÷$1.25/£) invest
£800 at 11.56% (i£) for one year to achieve £892.48
iii. Translate £892.48 back into dollars, if
F360($/£) > $1.20/£, then £892.48 will be more than
enough to repay your debt of $1,071.
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 Step 2: Arbitrage I
buy pounds
£800
£1 Step 3:
£800 = $1,000×
$1.25 Invest £800 at
i£ = 11.56%
$1,000 £892.48 In one year £800
will be worth
£892.48 =
Step 4: repatriate £800 (1+ i£)
to the U.S.A.
Step 1:
borrow $1,000 More F£(360)
Step 5: Repay than $1,071 $1,071 < £892.48 ×
£1
your dollar loan
with $1,071.
If F£(360) > $1.20/£ , £892.48 will be more than enough to repay
6-15your dollar obligation of $1,071.
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 Arbitrage Strategy II
If F360($/£) < $1.20/£
i. Borrow £800 at t = 0 at i£= 11.56% .
ii. Exchange £800 for $1,000 at the prevailing
spot rate, invest $1,000 at 7.1% for one year to
achieve $1,071.
iii. Translate $1,071 back into pounds, if
F360($/£) < $1.20/£, then $1,071 will be more than
enough to repay your debt of £892.48.
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 Step 2:
buy dollars Arbitrage II
£800
$1.25
$1,000 = £800× Step 1:
£1
borrow £800
$1,000 Step 5: Repay
Step 3: More
than your pound loan
Invest $1,000
£892.48 with £892.48 .
at i$
Step 4:
repatriate to
the U.K.
In one year $1,000
F£(360)
will be worth $1,071 $1,071 > £892.48 ×
£1

If F£(360) < $1.20/£ , $1,071 will be more than enough to repay

6-17your dollar obligation of £892.48.
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 Purchasing Power Parity
 Purchasing Power Parity and Exchange Rate
Determination
 PPP Deviations and the Real Exchange Rate
 Evidence on PPP

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 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 $300 in
the U.S. and £150 in the U.K., then the price of
one pound in terms of dollars should be:
P$ $300
S($/£) = = = $2/£
P£ £150
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 Purchasing Power Parity and
Exchange Rate Determination
 Suppose the spot exchange rate is $1.25 = €1.00
 If the inflation rate in the U.S. is expected to be
3% in the next year and 5% in the euro zone,
 Then the expected exchange rate in one year
should be $1.25×(1.03) = €1.00×(1.05)

F($/€) = $1.25×(1.03) = $1.23

€1.00×(1.05) €1.00

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 Purchasing Power Parity and
Exchange Rate Determination
 The euro will trade at a 1.90% discount in the forward
market:
$1.25×(1.03)
F($/€) €1.00×(1.05) 1.03 1 + $
= = =
S($/€) $1.25 1.05 1 + €
€1.00

Relative PPP states that the rate of change in the

exchange rate is equal to differences in the rates of
inflation—roughly 2%
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 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($/€)

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

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

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

F($/€) – S($/€) i$ – i€
E(e) = = ≈ i$ – i€
S($/€) 1 + i€

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 Quick and Dirty Short Cut
 Given the difficulty in measuring expected
inflation, managers often use
$ – € ≈ i $ – i €

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 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.
 For the U.S., the Fisher effect is written as:
1 + i$ = (1 + $ ) × E(1 + $)
Where
$ is the equilibrium expected “real” U.S. interest rate
E($) is the expected rate of U.S. inflation
i$ is the equilibrium expected nominal U.S. interest rate
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 International Fisher Effect
If the Fisher effect holds in the U.S.
1 + i$ = (1 + $ ) × E(1 + $)
and the Fisher effect holds in Japan,
1 + i¥ = (1 + ¥ ) × E(1 + ¥)
and if the real rates are the same in each country
$ = ¥
then we get the 1 + i¥ E(1 + ¥)
=
International Fisher Effect: 1 + i$ E(1 + $)
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 INTERNATIONAL FISHER EFFECT:suggest
nominal interest rate differential reflects the
expected change in exchange rate.that is :
 If interest rate is 5 % in USA AND 7 %in UK.
 DOLLAR is expected to appreciate against pound
by 2 % every year.

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 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 holds: =
S¥/$ E(1 + $)
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