AJAFIN 6605-03

Parity Conditions In International Finance

Outline:
* International Arbitrage and the Law of One Price
* Excess Money Supply Growth and Inflation
* The Neutrality of Money
* Inflation and Domestic Currency Depreciation
• Nominal Interest Rates and Real Interest Rates
• International Arbitrage: The Covered Interest Arbitrage
• Parity Conditions: IRP, FRP, PPP, FE & GFE, and IFE.

1
 Parity Conditions In International Finance
These are economic theories linking exchange
rates, price levels, and interest rates.
International Arbitrage and the Law of One Price
In a competitive market characterized by:
i. Many buyers
ii. Many sellers
iii. Cost-less access to information
iv. Lack of government controls
v. Free transportation 2
✦ The price of an identical tradable good and
financial asset must be equalized.
This is the “law of one price."
✦ All goods and financial assets obey the law of one
price or, equivalently, free trade will equalize the
price of an identical product in all countries.
✦ This law is enforced by the international
arbitragers who follow the dictum of “buy low"
and "sell high" to generate profits for themselves.

3
✦ Certain key theoretical economic relationships
result from arbitrage activities, namely:
- Interest Rate Parity (IRP)
- Forward Rate Parity (FRP)
- Purchasing Power Parity (PPP)
- Fisher Equation (FE) & GFE
- International Fisher Equation (IFE)

4
✦ These relationships explain the links between prices, spot
exchange rates, interest rates, and forward exchange rates.
Underlying these parity conditions is the adjustment of
various rates and prices to inflation.
✦ Modern monetary theory posits that an expansion of the
money supply in excess of real output results in a logical
outcome of inflation.
While this view is not universally subscribed to, it has a
solid microeconomic foundation.

✦ The basic precept of price theory is that as the supply

of product A increases relative to others, the price of
A must decrease relative to others.
5
Extraordinary verifications of this theory abound.
✦ The German hyperinflation (1920-23) and the
lessons thereof.
Inflation peaked at 200 billion percent in 1923.
✦ In 1922, Germany’s highest currency denomination
was 50,000 mark.
✦ By 1923, the highest denomination was
100,000,000,000,000 mark.
✦ In December of 1923 one US dollar was equal to
4,000,000,000,000 marks!.

6
✦ The Bolivian hyperinflation (1985).
In the spring 1985 Bolivian hyperinflation was
running at over 100,000% per year.
The government revenue covered only 15% of
spending while the rest was paid for by printing peso
currency notes.
The government fell. Spending cuts were introduced.
Excessive Peso printing stopped.
Inflation returned to 0% that same year.
✦ Greece, in the mid 1940s with 8.55 billion
percent per month.

7
 Yugoslavia, 1993 (500 billion dinar for a gallon of milk!)
✦ Yugoslavia’s Central Bank introduced a 500 billion
dinar bank note around Christmas 1993.

✦ It marked another milestone in the country’s descent

into economic chaos.

✦ In November 1993, inflation topped 600,000 %.

✦ In 1992, the U.S dollar was worth 1,000 dinar.

By Christmas 1993, it took 180 trillion of the same
1,000 dinar notes to equal one dollar!

8
✦ Hungary about the 1940s at 4.19 quintillion (1
plus 18 zeros) percent per month.
✦ Zimbabwe (Aug. 2008). Facing inflation of about 50
million percent per year, Zimbabwe's Reserve Bank knocked
10 zeros off its hyper-inflated currency. 10 billion old
Z$ note becomes one new Z$1 note.
100 billion new Z$ note introduced (still not enough to buy a
loaf of bread!). Gasoline coupon used for currency.
Update: Jan 09: Zimbabwe rolls out Z$100tr note = $33
✦ The widespread use of fiat money created the possibility of
hyperinflation as governments often print large amounts of
money, without actual market demand, to finance spending.

9
✦Inflation causes a transfer of wealth: It benefits:
-- the asset-rich at the expense of the asset-poor
-- debtors at the expense of creditors
-- non-savers at the expense of savers
It results in less total wealth within the economy than
would have been in its absence.
✦ Deflation is a decrease in the general price level over
a period of time.
It is the opposite of inflation.
With deflation, the demand for liquidity goes up,
in preference to goods or interest.
The purchasing power of money increases.
10
 For consumers, deflation is a delight (the purchasing power
of money increases with time)
 Consumers are encouraged to delay their purchases until the
future when the goods they wish to buy will be cheaper.
 Deflation depresses consumption, leading to lower national
income which further decreases consumption – the vicious
cycle continues.
 Depressed profits for firms translates to less income for
households and this in turn means less income to spend on
goods and services … and decline in investment by firms.
 Deflation is bad for borrowers. The debt continues to grow
– the real value of money owed increases.
 Nominal interest rate may be zero, but real rate may be
several percentage points higher since inflation is negative.
11
✦ Economic values measured in current dollars are
termed nominal while those measured in constant
(adjusted) dollars are termed real.
✦ The relationship between real and nominal is given by:
Real = nominal/deflator.
✦ The deflator adjusts for inflation.
Common deflators are:
 CPI = Consumer price index based on market basket of
consumer goods.
 PPI = Producer price index based on prices of inputs
(labor and capital)
 GDP deflator: takes into account all components of GDP.
12
✦ Another link in the money supply growth, inflation,
interest rates, and exchange rates, is the notion of the
"Neutrality of Money" i.e., money should have no
impact on real variables, such as output, employment
and interest rates.

✦ For example, if money supply (Ms) should increase

by 10% relative to money demand (Md), then prices
should increase by 10%.

13
 The neutrality of money has strong policy
implications.
✦ If money were neutral, there would be an easy way to
reduce inflation if we ever wanted to.
All we would have to do would be to reduce the rate
of growth of money stock.

✦ In practice, however, it is very difficult to change

inflation rate without producing a recession, e.g., in
1979-83, the experiment with lower growth rate of
money in the US first resulted in unemployment, and
only later in lower inflation.
14
 Inflation and Currency Depreciation:
The international analogue to inflation is the
depreciation of domestic currency.
✦ Inflation results in a change in the exchange rate
between domestic currency and domestic goods.
✦ Whereas domestic currency depreciation results in a
change in the exchange rate between domestic
currency and foreign goods.

15
✦ If international arbitrage enforces the law of one
price, then the change in the exchange rate between
domestic currency and domestic goods (inflation)
must equal the change in the exchange rate between
domestic currency and foreign goods.
✦ Therefore if $1.00 buys a loaf of bread in the U.S.,
it should buy the same loaf in Japan, the U.K., or
elsewhere.
✦ For this to happen, foreign exchange rate must
change by the difference between domestic and
foreign rates of inflation.
✦ The theory of Purchasing Power Parity (PPP)
espouses this notion.
16
 Nominal and Real Interest Rates:
✦ The nominal interest rate is the price quoted on
lending and borrowing transactions.
✦ It determines the exchange rate between current and
future dollars.
But the Fisher Equation and International Fisher Equation
emphasize what really matters, i.e., the exchange rate
between current and future purchasing power as measured
by the real interest rate.
✦ Lenders are concerned about how many more goods
can be obtained in the future by foregoing
consumption today and borrowers are concerned
about how much of future consumption must be given
up, or sacrificed, for today's consumption to be paid
for with future earnings. 17
✦ Consequently, if exchange rate between current
and future goods (the real interest rate) varies from
one country to another, arbitrage activities (in the
form of capital flows) will tend to equalize the real
interest rate across countries.
✦ Arbitrage can be defined as "The process of
buying or selling a good or an asset in order to
exploit a price differential so as to make a riskless
profit."

18
 Covered Interest Arbitrage (CIA):
✦ CIA is a profit seeking activity that takes advantage of
differences in domestic and foreign interest rates in
the presence of forward exchange markets.
✦ Suppose a U.S. investor decides to capitalize on a
relatively higher British interest rates.
The spot exchange rate is known and there exists a
forward market.
✦ The only uncertainty is the future spot exchange rate.
A forward sale can be used to lock-in the rate at
which pounds could be exchanged for dollars.

19
 Hence, the CIA strategy proceeds as follows:
A US investor:
 Converts dollars to pounds
 Deposits pounds in the U.K.
 Sells pound proceeds forward for term to maturity
 At maturity converts pounds proceeds to dollars at

the agreed upon forward rate.

20
Algebraically,
Let A = Amount to be invested, e.g. $1
S = Spot exchange rate (direct)
ius = U.S. interest rate
F = Forward exchange rate
iuk = U.K. interest rate
 Comparing what can be earned at home with
what is possible through CIA we have:
1(1+ius ) vs 1/S(1+iuk )F
 Then arbitrage profit (AP) is given by:
AP = 1/S(1+iuk )F – (1+ius ) 21
 CIA will be profitable if AP > 0. However, market forces
resulting from CIA will cause a price realignments so that
excess profits from arbitrage are no longer possible.
For example, as $ are used to purchase Pounds in the spot
market, S increases, netting fewer £s. The forward sale of
£s puts a downward pressure on the forward rate F,
netting fewer $s.
In addition, as U.S. investors transfer funds to the U.K.,
there will be a decrease in iuk and an increase in ius
 As a result of market forces from CIA a relationship
exists between the forward rate premium(discount) and
the interest rate differentials.
This is the subject matter of Interest Rate Parity Theory.
22
 The Interest Rate Parity:
Let: ius = Interest rate in U.S.
iuk = Interest in U.K.
S = Spot exchange rate (Dollar/ Pound)
F = Forward exchange rate ( Dollar/Pound)
 A U.S. investor can earn (1 + iUS ) in the U.S., or (1/S)(1 +
iUK ) in the U.K.
Since investment proceeds will ultimately be converted
to dollars, but future spot exchange rates are not known
with certainty, the investor can eliminate the uncertainty
regarding the dollar value of the proceeds by covering
with a forward contract.
 The covered return is given by: (1/S)(1 + iUK )F. 23
Arbitrage between the two investments (the domestic and the
foreign) results in parity so that,

or (1 + iUK )F (1)
1 + iUS =
S
1 + iUS F
= (2)
1 + iUK S
Subtracting 1 from both LHS and RHS gives:

F -S
ius - iuk ≈ (3)
S
where (1 + i ) = 1 (approximately.), assuming small values of i .
UK UK

Equation 3 indicates that the interest rate differential between

a comparable U.S. and U.K. investment is equal to the forward
premium (discount) on the pound.
24
Examples:
(1) Spot $/C$ = .80
90 day fwd $/C$ = .79
90 day iCan = 4%
90 day iUS = 2.5% .

(2) Spot $/£ = 1.50

90- day fwd rate = 1.4550
90- day ius = 3%
90- day iuk = 4%.

 Show whether or not IRP holds

 Find the yield to a U.S. investor who executes a CIA.
 Explain the direction of flow and compute arbitrage profits
 Find the 90-day fwd rate on C$ (£) if IRP holds. 25
Solution (1)
1
Yield CIA = (1.04)(.79 ) - 1 = 1.02 7 - 1 = .02 7
.80
For parity, forward rate on C$ rate is given by:

1
(1.04)F = 1.025
.80
from which F = .78846
The currency of the country with a lower interest rate should
be at a forward premium with respect to the currency of the
higher interest rate country.
The interest rate differential should be approximately equal to
the forward rate differential (premium or discount) when
parity exists.
(SEE APPENDIX I) 26
 Interpret points A,B,X,Y.
 In reality the IRP line is a band because transaction
costs arising from the spread on spot and forward
contracts and brokerage fees on security purchases and
sales cause effective yields to be lower than nominal
yields.
 Note that if IRP exists, it does not mean that domestic
and foreign investors earn the same return.
Rather existence of IRP means that investors cannot
use covered interest arbitrage to achieve higher returns
than those possible at home.
 Effective returns are equalized for domestic investors if
IRP holds regardless of where they invest - domestic or
foreign market. 27
 Empirical Evidence:
It is difficult to get quotations that reflect the same point
in time for interest rates and the forward rates.
 Nevertheless IRP theory is well supported empirically in
international finance literature.
 In the Euro-Currency markets the forward rate is
frequently calculated from interest rate differencial
between two countries using the no arbitrage condition.
 The Eurocurrency markets are relatively unregulated.
Deviations from IRP occur due to capital controls,
taxes, transaction costs, political risks etc.
 Note that "default risks" could exit on loan contracts for
which IRP is supposed to apply.
This would create deviation from parity. 28
 Forward Rate Parity (FRP)
(The forward rate is an unbiased predictor of future spot rate)
 The forward exchange rate must be equal to the
expected future spot exchange rate at maturity otherwise
risk-less arbitrage will take place.
 One may argue whether the forward rate should be equal
the expected future spot rate or whether there is a
premium incorporated in the forward rate that serves as
reward for bearing risk in which case the forward would
differ from the expected future spot by this premium.
 Empirical work typically focuses on whether the fwd
rate is an unbiased predicator of future spot rate.
An unbiased predictor is one that is correct on average:
…it is equally likely to guess too high or guess too low
29 .
 Pressure from the forward market is transmitted into the spot
market and vice-versa.
Equilibrium is achieved only when the forward differential equals
the expected change in the future exchange rate (Append II)
 At I, parity prevails as an expected 2% depreciation of the
Pound is matched by a 2% discount on the Pound.
 Point J is a position of dis-equilibrium because a 3% forward
discount on the Pound is more than offset by a 4% expected
depreciation of the Pound.
 Speculators are expected to sell pound forward and replenish or cover
their commitments with 4% fewer units of domestic currency (short
sale). Points L, X, K are also in disequilibrium.
 Formally we can state that the forward rate is an unbiased
predictor of future spot or that the forward differential equals
the expected change in exchange rates as follows:
30
 S0 Sn
|------------------------------------|
t=0 t=n
Fn
Speculative efficiency hypothesis: Ft = E[St]

Sn ≈ Fn
Sn - So F n - So
OR ≈ (4)
So So

(Expected Change ≈ (Forward Differenti al)

in Exchange Rate) [Premium(D iscount)]

31
 Empirical Evidence:
 There are pros and cons for the notion that the forward rate is an
unbiased predictor of the future spot.
It is probably unrealistic to expect a perfect correlation between
forward rates and the realized future spot rates since future spot
rates are influenced by events that cannot be perfectly forecast.
 The rationale for the hypothesis that the fwd rate is unbiased is that
the foreign exchange market is reasonably efficient (semi-strong
form).
The forward market can be said to be efficient if the forward
rate ruling at anytime is equal to the rational expectation of the
future spot when the contract matures, plus the risk premium that
speculators require to in order to compensate them for the
additional risk that they bear in the forward market.

32
 Questions for Discussion:
 Under what conditions would the forward rate be a
biased predictor of future spot?
 What should be expected to happen?
 Currencies trading at a forward premium are expected to
appreciate while currencies trading at a forward discount
are expected to depreciate.

33
 Empirical Verifications (A method)

Consider,
Ft,n = forward rate at n+t

St+n = spot rate at time n+t

Then,
St+n = a0 + b0Ft,n + Ut (5)

The null hypothesis: a0 = 0 ; b0 = 1

34
If the null hypothesis cannot be rejected, the forward rate is an
unbiased predictor of the future spot rate.
However, movements in the spot are expected to be dominated by a
trend.
Therefore the above equation may produce high R2, or low DW
statistic. There is also the danger of spurious regression if the series
are not stationary. The level of forward rate will explain a high
percentage of the variations in the level of future spot. This
relationship may be spurious if the series are not stationary. But
changes in the spot rate about its trend are likely to be nearly random
so that,
(6)
S t+n F t,n
= a1 + b1 + εt
St St
is likely to produce a low R - i.e., the forward premium (or discount)
2

will explain a low percentage of the variation of the changes in the

spot rates.
If the null hypotheses a1 = 0, b1 = 1 cannot be rejected, we can
conclude that the forward premium or discount is an unbiased
predictor of changes in the exchange rates.
35
 The Purchasing Power Parity (PPP)
✦ The PPP was first stated by Gustav Cassel (1918).
He used it as a basis for a new set of official exchange
rates at the end of World War I so that normal trade
relations might resume among nations.
✦ The Absolute Form: The PPP states that equilibrium
exchange rate between the domestic and the foreign
currencies equals the ratio between the domestic and
foreign price levels.
✦ The absolute PPP postulates that perfect commodity
arbitrage [in the absence of transaction or information
cost of other restrictions] ensures that PPP relationship
holds at each point in time. 36
Formally:

0 1 2 3 n
S0 = e0
St = et
Spot rate = domestic currency units per unit of a foreign currency
Pod, Pof = initial aggregate price levels respectively for
domestic and foreign.

Ptd, Ptf = aggregate price levels at time t respectively for

domestic and foreign.

37
Then,

d
P 7(a)
et = f
P
OR

d f
P = et P 7(b)

38
 This means that:
✦ The general level of prices, when converted to a
common currency will be the same in every country.
✦ In other words, a unit of domestic currency should
command the same purchasing power around the world.
✦ This theory rests on the law of one price which states
that free trade will equalize the price of any good (or
asset) in all countries.
✦ The theory however assumes away transportation
cost, tariffs, quotas, product differentiation, and other
restrictions. 39
The Relative Version: is more meaningful and practical.
It modifies the absolute version as follows:

In comparison to a period when equilibrium rates

prevailed, changes in the ratio of domestic and foreign
prices will indicate the necessary adjustment between
domestic and the foreign currencies.
Formally:
d d d f
et P / P P /P
t 0 t t
= = f f d f
(8)
eo P / P P /P
t 0 0 0

where P0d, P0f, Ptd, Ptf are price indices.

40
Let,
Ptd / Pod = 1 + π d
;π d
= Domestic inflation rate

Ptf / Pof = 1 + π f ; π f
= Foreign inflation rate

et 1 + πd
then, =
e0 1 + πf
et 1 + πd
- 1 = - 1
e0 1 + π f
So that,
d f
et e0 π π
- -
= ≈ d
π π- f

e0 1+ π f (9)

assuming that 1 + π f ≃1, for low values of π f .

41
✦ Equation (9) states that the relative (expected)
exchange rate change for two currencies between
t1 and t2 should equal the relative change in price
indices of the two countries between t1 and t2.

Alternatively,
✦ For parity in the purchasing power of two
currencies to obtain over a period of time, the rate
of change of the exchange rate must equal the rate
of change of relative prices. (See Appendix III)

42
 At (A or B) inflation differentials are offset by corresponding
appreciation (depreciation) of the foreign currency. At A, there
exists a 3% more domestic inflation. This is matched by a 3%
increase in exchange rate (a 3% depreciation of domestic currency).
 At B, 1% more π d implies that ex reduces by 1%. At D, π f > π d
by 3%, but exchange rate (d/f) has reduced by only 1%. This means
that domestic residents have a reduced purchasing power on the
foreign goods. They therefore reduce their purchase of foreign
goods but foreigners continue to purchase domestic goods. Foreign
currency depreciates in value relative to domestic currency, so that
D approaches the PPP line.
 Similarly at C, π d > π f by 2% but exchange rate has risen
(domestic currency has depreciated) by only 1%. There is a higher
PP on foreign goods for domestic residents.

43
Note that if changes in nominal exchange rates are fully offset by
relative price level changes between two countries, then the real
exchange rates remains unchanged. Alternatively, a change in the
real exchange rate is equivalent to a deviation from PPP.
Algebraically:
Let Real Exchange Rate = RERt then,
$ $
( )
1+ π d
1+ π us $ 1 + π uk
RERt = ≡ = •
BP BP BP 1 + π
us

t
( uk
)
1+ π 1+ π
£ = BP,
et (1 + π f
)
RER t =
(1 + π d )

44
But by PPP,
=
e0 (1 + π )
d
et
(1 + π f )

e0 (1 + π d
) (1 + π )
f
∴ RERt = • = e0
(1 + π )f
(1 + π )
d (10)

This means that there are no real changes in e from

t = 0 to t = t, if PPP holds.
If PPP holds then real return on an identical asset is
equalized for investors worldwide.

45
 Empirical Evidence:
Relative PPP holds fairly in the long-run especially in high
inflation countries. The PPP does not hold consistently for many
reasons:
01. Other factors maybe at work
02. No substitute for traded goods
03. Existence of internationally non-traded goods in the national
price indexes.
04. Changes in Taste
05. Technological Progress
06. Differently constructed price indexes
07. Different "Market Baskets"
08. Different weighing formula for Market Basket
09. Relative price changes (vs changes in general price level)
10. The "best" index cannot be a basis for a perfect representation
of theoretical parity.
46
 Empirical Verifications
Recent empirical tests focus on the L-R behavior of the RER
(regarded as a measure of deviations from PPP)
Examples:
✦ Joseph Whilt [RWK (1991) article #24] reports that inflation
adjusted exchange rates (RER) do not follow a random, but
instead returns, over time, to some L-R equilibrium level posited
by PPP.
✦ Richard Roll (1979), Jacob Frenkel (1981), Michael Adler &
Bruce Lehmann (1983), and others are unable to reject the
hypothesis that the RER follows a RW.
If RER follows a RW, no L-R equilibrium exists to which the
rate tends to return, so that PPP can no longer serve as a gauge of
L-R exchange equilibrium.
47
→ Other studies- Cumby & Obstfeld (1984), Jeffrey Frankel
(1985), John Huizinga (1987) have been able to reject the RW
hypothesis for RER in some instances.
→ However, Hakkio (1984, 1986) is unable to reject the RW
hypothesis.
He demonstrates that, if in fact, the RER differs modestly
from a RW, standard tests are very likely to favor the RW even
if it is false! So tests may be the problem.
→ Sims (1988) proposes a new statistical test that is especially
sensitive in determining whether a variable is a true RW or
whether the variable returns to equilibrium after a long-lag.
→ More recent developments: Cointegration and error correction
models.

48
  A Test of PPP
The exchange rate can be expressed as:
et = ao + a1 (Pt - Pt*) + Ut

where et , Pt , Pt* are in logs.

and a0, a1 can be estimated in a regression equation
with monthly, quarterly, or annual data on et , Pt , Pt*.

However problems exist here!

→ Direction of causality?
→ Estimated residuals, Ut, always exhibit severe positive
autocorrelation.
→ If residuals are autocorrelated, the estimated std. errors of
coefficient will be biased downwards!
→ The usual fix is to difference the data. 49
✦ That means: Construct Zt = Xt - Xt-1 , thus shifting the
focus to changes in the (natural log of) original series Xt
rather than (natural log of) the levels. Thus:
et - et-1 = a1 [(Pt - Pt-1 ) - (Pt* - Pt-1 *)] + Ut - Ut-1
or
∆ et = a1 (∆ Pt - ∆ Pt *) + Zt ,
where Zt is iid (inde. and identically distr.)

✦ Another problem: PPP is an "equality" relationship

not "causal".
Empirical evidence shows as much impact of exchange
rates on prices as of prices on exchange rates.
The usefulness of PPP, however, depends on existence of
a lag between price level changes and exchange rates
changes. 50
 Demand-pull Vs Cost Push Inflation:
✦ The cost-push view of inflation relates inflation rate to
factors such as changes in wage rate, and productivity
gains (compared to Demand-pull which views
inflation as a monetary phenomenon).
✦ A synthesis is possible so that,
∆ ex = f(∆ in wage rates, ∆ in productivity gains,
∆ in price levels)
Economies with relatively stable wage rates and
higher productivity gains more than the US, for
example, will experience currency appreciation
against the US dollar. 51
 Other Issues About PPP:
- Is the PPP expected to hold in the S-R and L-R?
Too many market imperfections exist in the S-R that
allow S-R deviations from parity.
- In certain circumstances, the PPP might serve as an
indicator of L-R equilibrium relationship among
currencies.
- New econometric designs may improve tests of PPP
e.g. cointegration & error correction models.
- The selection of the reference currency (country) may
be critical.
- Differential speed of adjustment between financial
prices (very fast) and goods prices (relatively slow).52
 In general, a validity for PPP (the necessary condition)
can be established by showing that the series et, Ptd, Ptf,
share a common LR equilibrium relationship - i.e. they
are bound in a LR equal relationship. (that means that
the series are cointergrated)
 PPP is important because it is the centerpiece of many
exchange rate models and also because of its policy
implications.
 Itprovides a benchmark exchange rate for policy
makers and exchange rate arbitragers.
 Check significance of coefficients, explanatory power,
and residuals.
53
 The U.S.
Dollar
Price of a
Big Mac
around the
world in
May 2004

54
 The Fisher Equation:
There is a distinction between the real and nominal
interest rates.
✦ The nominal interest rate is the rate quoted or observed
in the market.
✦ The real rate measures the return after adjusting for
inflation.
✦ The real rate is the rate at which current goods are being
converted into future goods.
✦ It is the net increase in wealth that people expect to
achieve when they save and invest their current income.
✦ It is the added future consumption promised by a
borrower to a lender.
55
Since virtually all financial contracts are stated in
nominal terms, nominal interest rates will tend to
incorporate inflation expectation in order to provide
lenders with a real return.
The Fisher Equation (named after Irving Fisher) states
that the nominal interest rate, i, is made up of a real
required rate of return, r and inflation premium (the
expected rate of inflation),
This equation is given by (Approx)

i ≈ r +π (11)

56
The exact relationship is given by:
1 + i = (1 + r) ( 1 + π )
= 1 + π + r + rπ
and, i ≈ r + π , if rπ → 0
Thus an increase in π will tend to increase i.

Example: If r = 3% and π = 5%, find the:

✦ exact nominal rate:

i = r + π +rπ = .03+.05+ (.03)(.05) = .08+.0015 = 8.15%

✦ approximate nominal rate

i ≈ r + π =.03+.05 = 8%

57
 In the U.S. for example, we have the following
experiences:
✦ In the 1950's and the 60's low inflation rates were
accompanied by low nominal rates.
✦ In the 1970's and 80's high inflation rates were
accompanied by high nominal rates.
✦ In the 90's the experience was low inflation rates
with low interest rates!
✦ So far in the 20s, the experience has been
historically low inflation with low interest rates!
58
The Generalized Fisher Equation (GFE):
This theory asserts that real returns are equalized across
countries through arbitrage.
If rd > rf capital inflows will ensue and continue until rd = rf.
Hence if we express the FE for both domestic (d) and foreign (f)
countries, we have:
id ≈ rd + π d
i f ≈ rf + π f
And if rd = rf then,
id - i f ≈ π d - π f (12)

This is the Generalized Fisher Equation.

It asserts that "the nominal interest rates id and if differ solely
by expected inflation differential.
(SEE APPENDIX IV) 59
 At C, there is equilibrium. A 2% increase in πf is offset by
a 2% increase in if .

 At D, there is a 5% increase in if but only 3% increase in

πf which implies that real return is higher in foreign
country.
Funds should flow from domestic to foreign country to
take advantage of this real difference until expected real
returns are equalized.
 Empirical evidence tends to support this hypothesis if we
abstract from the effects of tax differences, government
controls, political risks, and risk premia.

60
We can summarize the link between interest, inflation and
exchange rates by combining the Interest Rate Parity and the
Generalized Fisher Equation, so that,

F-S
id - i f ≈ π - π ≈
d f (13)
S
i.e., real interest rates are equalized across countries when the
Fisher Equation and Interest Rate Parity hold and nominal
interest rates differ by expected inflation differential between
domestic and foreign.

In the real world, the above inter-relationship are determined

simultaneously because interest rates, inflation expectation,
and exchange rates are jointly affected by the arrival of new
information (events).
61
The International Fisher Equation (IFE):
The IFE expresses the relationship between interest rate
differential and the expected change in exchange rates.
This relationship can be derived by combining the PPP with
the GFE.
The IFE is based on nominal interest differentials which are
influenced by expected inflation.
Algebraically, the IFE states that:
et 1 + id
=
e0 1 + if (14)

or et - e0 id - i f
= ≈ id - i f
e0 1 + if
62
Alternatively, we can combine PPP and GFE as follows:
(15) et - e0
PPP : ≈ πd - π f
e0
(16)
GFE : id - i f ≈ π d - π f
Combining (15) and (16) we have:
(17)
et - e0
id - i f ≈
e0
(17) states that the spot exchange rates will change in accordance
with the difference in interest rates (on comparable securities)
between countries.
Hence the return on foreign uncovered money market securities
will, on an average, be no higher than return on domestic money
market securities from the point of view of a domestic resident.

63
This notion can be expressed as:
1
1 + id = (1 + i f ) et
e0
or
et 1 + id
=
e0 1 + if
which reduces to (17).
IFE states that arbitrage between financial markets in the form
of capital flows should ensure that id - if is an unbiased predictor
of the expected change in spot exchange rates between domestic
and foreign currencies; or that spot exchange rate should change
to adjust for differences in interest rates between two countries.

(SEE APPENDIX V) 64
 At E, if > id by 3%, foreign currency depreciates by
3% to offset the interest difference so that parity holds.
 At F parity also obtains as a 2% higher domestic
interest is offset by a 2% increase in exchange rates.
 Points along IFE reflect exchange rates adjusting to offset
interest rate differentials.
 Points below the IFE line implies an increase in return on
foreign assets owned by domestic investors.
 Points above the IFE line implies a reduction in return on
foreign assets owned by domestic investors.

65
 Empirical Evidence:
Evidence exists that currencies with high interest rates
like the Peso, Real, etc tend to depreciate, while those
with low interest rates like the Yen, Swiss Franc, tend to
appreciate.
In the long-run interest rate differentials tend to offset
exchange rate changes.

Problems with IFE:

Determining the effects of the change in i on exchange
rates is complicated by the Fisher Equation which says:
i≃r+π .
However, a change in i can be due to a change in
r or a change in π .
These two possibilities have opposite effects.
66
 When a parity condition fails to hold, the structure
of international financial markets may influence
investor’s strategy of borrowing, investing, hedging,
speculating, or making investment location decisions.
 If absolute PPP does not hold, sellers have the power
to price discriminate across countries and buyers have
incentives to overcome barriers to access lower cost
goods.
 If IRP does not hold, the cost of borrowing or return
on investment (with forward cover) differs depending
on which currency is used … therefore it is possible
to find superior investment or lower cost funds
without incurring foreign exchange risk.
67
 If IFE does not hold, investments with higher
expected returns and funds with lower expected costs
are possible but these contain exposure to currency
risk.
 Rational for the IFE is that a country with a higher
interest rate will tend to have a higher inflation rate.
This increased level of inflation should cause the
currency in the country with the high interest rate to
depreciate against a country with lower interest rate.

 Internet Resources:
www.oecd.org/std/nadata/html
www.ft.com/cgi-bin/pft/intcrates.p1/report 68