International Financial

Management (MAF612)
Chapter 1 - International Parity
Conditions
 Parity conditions in international
finance and Currency Forecasting
• Factors affecting exchange rate
– Rate of inflation (PPP)
– Interest rate (IRP)
– Balance of payment
– Foreign exchange reserve
 Interest Rate Parity relationship
• John M. Keynes, in the 1920s
• Premium or discount of one currency against another
country reflects interest rate differential between the
two countries
• Reasons for deviation from IRP
– Capital control
– Transaction cost
 PPP and IP
• Relationship between exchange rates and prices -
Purchasing Power Parity
• PPP is expected to hold when there is no arbitrage
opportunity in goods markets.
• Relationship between exchange rates and interest rates -
Interest Parity
• IP is expected to hold when there is no arbitrage
opportunity in financial markets.
 Interest Rate Parity Defined
• IRP is a “no arbitrage” condition.

• If IRP did not hold, then it would be possible for a 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 … almost all of the
time!
• Conclusion, IRP holds
 Variable Definitions
• iH : Interest Rate in the home country

• iF : Interest Rate in the foreign country

• S = Current spot rate for the foreign currency (in

direct quote)

• F = 1 year forward rate for the foreign currency

(in direct quote)

 Interest Rate Parity Carefully Defined
• Consider two alternative one-year investments for $1

1. You could invest in the US at iH. Future value of this

investment in $ will be: $1 × (1 + iH) = (1 + iH)

2. Or you could convert $1 into the foreign currency at the

going spot rate (S) and invest 1/S in the foreign country at
iF whose future value will be: [1/S × (1 + iF)]. In order to
eliminate any exchange rate risk, you will have to sell this
amount at forward rate (F) to get you money back in $: F x
[1/S × (1 + iH)]
 Interest Rate Parity Carefully Defined

• Since these investments have the same risk, they

must have the same future value (otherwise an
arbitrage would exist)
Interest Rate Parity Carefully Defined
 Interest Rate Parity Carefully Defined

• Depending upon how you quote the exchange rates,

direct (S, F) or indirect (SI, FI), we have:
 Uncovered Interest Rate Parity
• What should be the relation between exchange rates and interest
rates?

• Suppose you have a choice of investing your money in USA at the

eurodollar interest rate, r, or in Japan at the euro-yen interest rate,
r*. Which will you choose?

• Of course, as we have seen before, that if you invested in the

foreign currency and hedged yourself, then the covered interest
rate parity (i.e. by the definition of the forward rate) tells you that,
in either case, you should earn the same amount.

• But what if you did not want to hedge yourself?

 Uncovered Interest Rate Parity
• In the long run, if economies were globally integrated then one
might again expect that it should not matter.

• Suppose S(t) is the current spot rate, and S(t+1) is the spot rate
you expect to hold in the future (so to be precise we should
actually write it as E[S( t+1)]).

• If you invest $1 today in the US, you will get $(1+r) one year
from now.

• If you invest $1 in the foreign currency, you expect to get $(1)

(1+r*)( s(t+1)/s(t) ).
 Uncovered Interest Rate Parity
• So that if in equilibrium you were indifferent between
the two, then you should expect
E[S(t+1)] = S(t)(1 + r)/(1 + r*)
• This is the same equation as we had earlier for the
forward price except that we replaced the forward

price, F, by the expected future spot price, E[S(t+1)].

 Uncovered Interest Rate Parity
• As previously we can rewrite this as:

[E(S(t+1)-S(t)]/S(t) = (r-r*)/(1+r*)
• So that the expected change in spot rate is approximately equal
to the difference in interest rates.
• This suggests that if the domestic interest rate is higher than the
foreign, then investors expect a depreciation of the US$, and if
its lower than the foreign then they expect an appreciation of
the $.
• This is the same as saying that the speculators expect the future
spot rate to be the forward rate.
 Interest Rate Parity (IRP)
Uncovered Interest Rate Parity (UIRP) Condition:
E
(1  i* )  1  i
S

Covered Interest Rate Parity (CIRP) Condition:

F
(1  i* )  1  i E = expected spot
S rate on the future date
F = forward rate
i = domestic interest rate
i* = foreign interest rate
IRP and Covered Interest Arbitrage
• If IRP failed to hold, an arbitrage would exist.
• It is 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.
IRP and Covered Interest Arbitrage
• If IRP failed to hold, an arbitrage would exist.
• It is 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.
IRP and Covered Interest Arbitrage
• If IRP failed to hold, an arbitrage would exist.
• It is 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.
IRP and Covered Interest Arbitrage
• If IRP failed to hold, an arbitrage would exist.
• It is 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.
 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

• Capital Controls

– Governments sometimes restrict import and export of money

through taxes or outright bans.
Reasons for Deviations from IRP
 Purchasing Power Parity (PPP)
• Gustav Cassel, 1918

• Purchasing power of a currency is determined by the amount of

goods/services that can be purchased with one unit of currency.

• Levels of appreciations/depreciation

• Deviations from PPP

– Difference in the components of the index
– Trade barriers
– Disregard capital movement
– Government intervention on the exchange market
 Purchasing Power Parity and Exchange Rate
Determination
• A dollar should buy the same quantities of goods and

services in all countries

• According to absolute PPP, in the long run, currencies

should move towards the rate which equalizes the prices of

an identical basket of goods and services in each country

• The exchange rate (direct quote) between two (S)

currencies should equal the ratio of the countries’ price

levels in the home (PH) and foreign (PF) country: S = (PH / (PF)
Absolute Purchasing Power Parity

• For example, if an ounce of gold costs $1200 in

the U.S. and € 800 in Europe, then the price of
one euro in terms of dollars should be:

• What happens if S = 1.25 or S = 1.75?

 Evidence on Absolute PPP
• Absolute PPP probably doesn’t hold precisely in the real world
for a variety of reasons:

• Tradable and non-tradable factors of production

• Haircuts cost 10 times as much in the developed world as in the

developing world.

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

deviations from PPP.

• Relative PPP-determined exchange rates can provide a more

valuable benchmark.
Does PPP Hold? The Case of Big Mac
 Relative Purchasing Power Parity
• Even if the dollar does not buy the same basket of goods in
other countries, the purchasing power of the dollar in
these countries could remain stable over time.

• We can show that according to Relative PPP:

– If two countries have different inflation rates, then the exchange
rates between the two countries will adjust to maintain equality
of relative purchasing power for the citizens of both countries.

– The “real” exchange rate will remain constant

 Variable Definition
• S= Current spot rate (price of foreign currency) in direct quote

• S1 = Actual spot rate, 1 year from now

• F = 1-year forward rate

• FP = the forward premium = [(F-S) / S] = [(F/S) - 1]

– = Inflation rate in the home country

– = Inflation rate in the foreign country

• E(S1) = Expected spot rate, 1 year from now, based on PPP

• E(e) = [E(S1)/S] – 1 = The expected percentage change, or rate of change, in the

spot rate, based on PPP

• e = (S1/S) – 1 = The actual percentage change, or rate of change, in the spot rate

• Sr= real spot rate

 Absolute Purchasing Power Parity and
Exchange Rate Determination

• For example, if an ounce of gold costs $1200 in the

U.S. and € 800 in Europe, then the price of one euro
in terms of dollars should be:

• What happens if S = 1.25 or S = 1.75?

 Purchasing Power Parity and
Exchange Rate Determination
• Suppose the spot exchange rate (S) is $1.50 = €1.00
• If the inflation rate in the U.S. ( ) is expected to be 5% in the
next year and 3% in the euro zone( ),
• Then the expected exchange rate in one year E(S) should be such
that $1.50×(1.05) = €1.00×(1.03)
 Purchasing Power Parity and
Exchange Rate Determination
• Because of the inflation differential, the euro is expected to appreciate
by 1.94% in the spot market by the end of the year:

• Relative PPP states that the rate of change in the exchange rate is equal
to differences in the rates of inflation—roughly 2%

• Also remember that E(S1) = F

• So that: expected rate of change in the exchange rate = forward

premium, or E(e) = FP
 Relative Purchasing Power Parity
• According to Relative PPP:
 “Real” Exchange Rate
• Real exchange rate is the spot rate adjusted for

inflation, let us call it Sr . It is supposed to tell us if a

foreign currency has appreciated or depreciated, after

adjusting for inflation.

• Under PPP, real exchange rates should remain constant

 “Real” Exchange Rate
• Suppose the US the current spot rate for € is 1.50 and US

inflation rate is 5% while the inflation rate is 3% in the euro

zone If the spot rate next year turns out to be 1 52 the real

zone. 1.52, exchange rate is: 1.52*(1.03/1.05) = $1.491

• We can say that although the spot rate for € appreciated in

“nominal” terms from $1.50 to $1.54, it actually depreciated

in “real” terms from $1.50 to $1.491

• This would weaken the US’s competitive position against Europe

 PPP & Competitiveness
• We can also use PPP to determine the competitiveness
of the home country’s currency

• q = 1: Competitiveness of home country is unchanged

• q < 1: Competitiveness of home country has improved
• q > 1: Competitiveness of home country has deteriorated
PPP Conditions Summarized
 The 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

 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 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 ¥/$

then forward rate PPP holds: F E(1 + ¥)

=
¥/$

S ¥/$ E(1 + $)

Equilibrium Exchange Rate Relationships

E (S ¥ / $ )
S¥ /$
IFE FEP
1 + i¥ PPP F¥ / $
1 + i$ IRP S¥ /$
FE FRPPP
E(1 + ¥)
E(1 + $)
 Exchange rate and BoP
• When a country is importing more than it exports, the
demand for foreign currency increases leading to
deprecation of local currency
• Conversely, when a country exports more than it imports,
the demand for foreign currency exceeds the supply
leading to appreciation of local currency
• In this process, apart from the trade flow, capital flow
plays a role.
 Exchange rate & foreign exchange reserve
• Reserves are kept to meet obligations; namely debt service and
import payments
• The relationship can be explained by the “perception” of
economic agents
• Depletion of reserve below some level may be perceived as signs
of some sort of problem, subsequently leading to depreciation of
domestic currency
• Building up of reserve may lead to a positive perception and is
likely to harden the domestic currency
 Official Vs. Parallel Market Rates
• Official market - a controlled foreign exchange market by central
bank/government
• Parallel/Black markets—exists when people are willing to pay
more for dollars than the official rate
• Closely approximate a price based on supply and demand
for a currency instead of a government-controlled price
• The less flexible a country’s exchange-rate arrangements,
the more there will be a thriving black market
 Forecasting Exchange Rate Movement
• Parity forecasting - already covered

• Fundamental forecasting - uses trends in economic variables to

predict future rates

• Use econometric model or more subjective bases

• Technical forecasting - uses past trends to spot future trends

• Assumes that if current exchange rates reflect all facts in

the market, then under similar circumstances future rates

will follow the same patterns

End