Session 3 (iii)

Exchange Rate Determination

International Arbitrage & Parity
Conditions
 The International Parity Conditions

Session Objectives:
The Law of One Price
International Parity Conditions You
Can Trust
Less Reliable International Parity
Conditions
 Symbols and acronyms

Std/f or Ftd/f = spot or forward exchange rates

std/f or ftd/f = changes in exchange rates during period t

itd and itf = nominal interest rates over period t

ptd and ptf = inflation rates over period t
rtd and rtf = real interest rates over period t

E[...] = Expectations operator

(e.g. E[ptf] or E[Std/f])
 The law of one price
(purchasing power parity, or PPP)

“Equivalent assets sell for the same price”

Ptd = price of an asset in domestic currency
Ptf = price of the same asset in foreign currency

Ptd /Ptf = Std/f  Ptd = Ptf Std/f

seldom holds for nontraded assets

may not hold when there are market frictions
can’t be used to compare assets that vary in quality
An example of the law of one price:
The world price of gold

Suppose P$ = $500/oz in New York

P€ = €800/oz in Berlin
The law of one price requires:
Pt$ /Pt € = St$/ €
 ($500/oz)/(€ 800/oz) = $.6250/ €

If this relation does not hold, then there

is an opportunity to lock in a riskless
arbitrage profit.
Another example: The world price of gold

Suppose P£ = £250/oz in London

P€ = €400/oz in Berlin
The law of one price requires:
Pt£ = Pt€ St£/€
 £250/oz /(€400/oz) = (£0.6250/€)
St£/€ =£0.6250/€; St € /£ = €1.6000/£

If this relation does not hold, then there is an

opportunity to lock in a riskless arbitrage profit.
 An example with transactions costs

Gold dealer A Gold dealer B

€401.40/oz Offer

€401.00/oz Bid
Sell high to B
FX dealer
€1.599/£ bid
€1.601/£ ask
Buy low from A
£250.25/oz Offer

£250.00/oz Bid
 Arbitrage profit
Pay £250.25 million to buy 1 million oz from A

+1 million oz

-£250,250,000
oz
Sell 1 million oz to B for €401 million

+€401,000,000 Arbitrage profit

€218,500
-1 million oz

Buy £s with €s at the spot rate

+£250,468,500

-€401,000,000
 Example: The Indian Rupee Perspective

Suppose P$ = $320/10gms in New York

PRs = Rs32000/10gms in Delhi
The law of one price requires:
StRs/$ = PtRs /Pt$
 or 1$ =Rs 100

If this relation does not hold, then there is an

opportunity to lock in a riskless arbitrage profit.
 Arbitrage profit
(suppose Price of Gold in India=Rs31000/10gms)

Alternative A Pay Rs 31000 to buy 10gms of gold

Sell this to buy $320
Convert $320 to Rs 32000.
Alternative B
Sell 10gms of gold for $320
Sell this to buy Rs 32000 at spot
Buy back gold at 31000 and make Rs 1000 profit.
 Law of One Price

In competitive markets free of transportation costs

and barriers to trade (tariffs), identical products sold
in different countries must sell for the same price
when their price is expressed in terms of the same
currency.
Example: US/French exchange rate: $1 = FFr 5. A
jacket selling for $50 in New York should retail for
for FFr 250 in Paris (50x5)
 Purchasing Power Parity

By comparing the prices of identical products in

different currencies, it should be possible to
determine the ‘real’ or PPP exchange rate - if
markets were efficient.
In relatively efficient markets (few impediments to
trade and investment) then a ‘basket of goods’
should be roughly equivalent in each country
 The Big Mac Index
Purchasing Power Parity
Local Currency
% Over(+)
Price in Implied Actual or Under(-)
Local PPP of the Exchange Valuation
Currency Dollar Rate† Against Dollar

United States $ 2.32 (average) ---- ---- ----

Switzerland Fr 5.90 2.54 1.13 +124
Argentina Peso 3.00 1.29 1.00 + 29

Japan ¥ 391 169.00 84.20 +100

Brazil Real 2.42 1.04 .90 +16
Canada C $ 2.77 1.19 1.39 - 14
Hong Kong HK $ 9.50 4.09 7.73 - 47
Russia Ruble 8,100 3,491.00 4,985.00 - 30
 Japanese Big Mac Valuation
(Yens Over (+) or UNDER (-) Valuation Against the Dollar)
120
100
80
60
40 Percent
20
0
-20 1989 90 91 92 93 94 95 96 97 98

-40
 East Asian Big Mac Valuation

30
20
10
0
S. Korea
-10 1993 94 95 96 97 98
Thailand
-20
Indonesia
-30
Malaysia
-40
-50
-60
-70
 Inflation and the Money Supply

45
Turkey
40
35 Colombia Ecuador
Growth 30 China

in money25 Poland
Portugal
supply, 20 Great Britain
1985 - 15
United States
1989 % 10
5 Japan
0
0 5 10 15 20 25 30 35 40 45 50
Consumer prices, 1984 - 1989 (%)
 Cross exchange rate equilibrium

Sd/e Se/f Sf/d = 1

If Sd/eSe/fSf/d < 1, then either Sd/e, Se/f or Sf/d must rise.

 Buy the currency in the denominator with the
currency in the numerator of each spot rate.

If Sd/eSe/fSf/d > 1, then either Sd/e, Se/f or Sf/d must fall.

 Sell the currency in the denominator for the
currency in the numerator of each spot rate.
Cross exchange rates and triangular arbitrage
(dollars, rubles, and yen)

Suppose:SRbls/$ = Rbls5.000/$  S$/Rbls = $0.2000/Rbl

S$/¥ = $0.01000/¥  S¥/$ = ¥100.0/$
S¥/Rbl = ¥20.20/Ruble  SRbls/¥  Rbls0.04950/¥
SRbls/$ S$/¥ S¥/Rbl = (Rbls5.000/$)($.01000/¥)(¥20.20/Rbl)
= 1.01 > 1
 Currencies in the denominators are too high
relative to the numerators, so
sell dollars for rubles,
sell yen for dollars,
sell rubles for yen.
 An example of triangular arbitrage

SRubles/$ S$/¥ S¥/Ruble

= (Rbls5.000/$)(¥20.20/Rbl)($0.01000/¥)
= 1.01 > 1

Sell $1 million for 5 million rubles

Sell 4.950 million rubles for 100 million yen
Sell 100 million yen for $1 million

 Profit of 50,000 rubles

= $10,000 at Rbls5.000/$
or one percent of the initial amount
 International parity conditions
that span both currencies and time

Interest rate parity Less reliable linkages

Ftd/f / S0d/f = [(1+id)/(1+if)]t = E[Std/f] / S0d/f
= [(1+pd)/(1+pf)]t
where
S0d/f = today’s spot exchange rate
E[Std/f] = expected future spot rate
Ftd/f = forward rate for time t exchange
p = a country’s inflation rate
i = a country’s nominal interest rate
 International parity conditions
International Fisher relation
Interest rates Inflation rates
[(1+id)/(1+if)]t [(1+pd)/(1+pf)]t

Interest Relative
rate parity PPP

Ftd/f / S0d/f E[Std/f] / S0d/f

Forward-spot Expected change
differential in the spot rate
Forward rates as predictors
of future spot rates
 Interest rate parity

Ftd/f/S0d/f = [(1+id)/(1+if)]t

Forward premiums and discounts are entirely

determined by interest rate differentials.

This is a parity condition that you can trust.

Interest rate parity: Which way do you go?

If Ftd/f/S0d/f > [(1+id)/(1+if)]t

then so...

Ftd/f must fall Sell f at Ftd/f

S0d/f must rise Buy f at S0d/f
id must rise Borrow at id
if must fall Lend at if
Interest rate parity: Which way do you go?

If Ftd/f/S0d/f < [(1+id)/(1+if)]t

then so...

Ftd/f must rise Buy f at Ftd/f

S0d/f must fall Sell f at S0d/f
id must fall Lend at id
if must rise Borrow at if
 Interest rate parity is enforced through
“covered interest arbitrage”

An Example:
Given: i$ = 7% i£ = 3%
S0$/£ = $1.20/£ F1$/£ = $1.25/£

F1$/£ / S0$/£ = 1.041667 > (1+i$) / (1+i£) = 1.038835

Foreign exchange and Eurocurrency markets

are not in equilibrium.
 Covered interest arbitrage example (continued)

1. Borrow $1,000,000 +$1,000,000

at i$ = 7% -$1,070,000
2. Convert $s to £s +£833,333
at S0$/£ = $1.20/£ -$1,000,000
3. Invest £s +£858,333
at i£ = 3% -£833,333

4. Convert £s to $s +$1,072,920
at F1$/£ = $1.25/£ -£858,333

5. Take your profit:

 $1,072,920-$1,070,000 = $2,920
 Interest Rates
and Exchange Rates
The theory of Interest Rate Parity (IRP) provides
the linkage between the foreign exchange markets
and the international money markets.
The theory states: The difference in the national
interest rates for securities of similar risk and
maturity should be equal to, but opposite in sign to,
the forward rate discount or premium for the
foreign currency, except for transaction costs.
 Currency Yield Curves
& The Forward Premium
Interest
yield Eurodollar
10.0 % yield curve

9.0 %
8.0 %
7.0 %
Forward premium is the
6.0 % percentage difference of 3.96%
5.0 % Euro Swiss franc
yield curve
4.0 %
3.0 %
2.0 %
1.0 %

30 60 90 120 150 180

Days Forward
 Interest Rate Parity (IRP)
i $ = 8.00 % per annum
(2.00 % per 90 days)
Start End
$1,000,000 x 1.02 $1,020,000
$1,019,993*
Dollar money market

S = SF 1.4800/$ 90 days F90 = SF 1.4655/$

Swiss franc money market

SF 1,480,000 x 1.01 SF 1,494,800

i SF = 4.00 % per annum

(1.00 % per 90 days)

•Note that the Swiss franc investment yields $1,019,993, $7 less on a $1 million investment.
 Interest Rates
and Exchange Rates
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).
 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

 Interest Rates
and Exchange Rates

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 not 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.
 Uncovered Interest Arbitrage (UIA):
The Yen Carry Trade
Investors borrow yen at 0.40% per annum
Start End
¥ 10,000,000 x 1.004 ¥ 10,040,000 Repay
¥ 10,500,000 Earn
Japanese yen money market ¥ 460,000 Profit

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

US dollar money market

$ 83,333,333 x 1.05 $ 87,500,000

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.
-4.00
-3.00
-2.00
-1.00
0.00
1.00
2.00
3.00
4.00
01/01/04

01/02/04

01/03/04

01/04/04

01/05/04

01/06/04

01/07/04

01/08/04

01/09/04

01/10/04

01/11/04

01/12/04

01/01/05

01/02/05
FORWARD PREM IUM VS. INT DIFF.

01/03/05

01/04/05

01/05/05
DIFF.

DISC.
USD-INR

INT DIFF.
PREMIUM

USD-EURO
USD-EURO
USD-INR INT
Forward rates as predictors of future spot rates

Ftd/f = E[Std/f] or Ftd/f / S0d/f = E[Std/f] / S0d/f

“Forward rates are unbiased estimates of
future spot rates of exchange.”

Speculators will force this relation to hold on average.

For daily exchange rate changes, the best estimate
of tomorrow's spot rate is the current spot rate
As the sampling interval is lengthened, the
performance of forward rates as predictors of
future spot rates improves.
Forward rates as predictors of future spot rates
(quarterly pound per dollar rates)
20%
Actual change in the spot rate
15%

10%

5% Forward premium
or discount
0%

-5%

-10%

-15%
0% 1% 2%
 Relative purchasing power parity (RPPP)

Let Pt = consumer price index level at time t.

Then inflation pt = (Pt - Pt-1)/Pt-1.
The expected change in the spot exchange rate should reflect
the difference in inflation between two currencies:

E[Std/f] / S0d/f = (E[Ptd] / E[Ptf]) / (P0d / P0f)

= (E[Ptd]/P0d) / (E[Ptf]/P0f)
= (1+E[pd])t / (1+E[pf])t

where pd and pf are geometric mean inflation rates.

This relation only holds over the long run.

Relative purchasing power parity (RPPP)

Mean annual percentage change

in the spot exchange rate (f/$)
S. Africa

4%

Italy

Spain
2% U.K.

Canada
Sweden Hong Kong

France

-2% Norway 2% 4% 5%
Malaysia
Denmark
Belgium Difference in mean annual
inflation rates
Netherlands -2% (relative to the $)
Singapore
Austria
Germany Japan

Switzerland
-4%
 International Fisher relation
(Fisher Open hypothesis)

[(1+id)/(1+if)]t = [(1+pd)/(1+pf)]t
Recall the Fisher relation: (1+i) = (1+r)(1+p)
If real rates of interest are equal across countries (rd=rf),
then interest rate differentials reflect inflation differentials:

[(1+id)/(1+if)]t = [(1+rd)(1+pd)]t / [(1+rf)(1+pf)]t

= [(1+pd)/(1+pf)]t

This relation does not hold at any particular

point in time, but does hold in the long run.
 International Fisher relation
(Fisher Open hypothesis)
10%
Difference in realized quarterly inflation
(1+p£)/(1+p$)-1

5%

Difference in 3-month Eurocurrency

interest rates (1+i£)/(1+i$)-1
0%

-5%
-5% 0% 5% 10% 15%
 International parity conditions
International Fisher relation
Interest rates Inflation rates
[(1+id)/(1+if)]t [(1+pd)/(1+pf)]t

Interest Relative
rate parity PPP

Ftd/f / S0d/f E[Std/f] / S0d/f

Forward-spot Expected change
differential in the spot rate

Forward rates as predictors of future spot rates

 NEER

The unadjusted weighted average value of a

country's currency relative to all major currencies
being traded within an index or pool of currencies.
The weights are determined by the importance a
home country places on all other currencies traded
within the pool, as measured by the balance of
trade.
 NEER

The actual calculation method of the indicator is as

follows:
(i) The weighted average of the Rupee's exchange
rates versus other major currencies are calculated
using the value of India's trade with the respective
countries and areas as its weights.

(ii) It is then converted into a single index using a

base period. This type of indicator is called the
"nominal effective exchange rate."
 NEER
The NEER represents the relative value of a home
country's currency compared to the other major
currencies being traded (U.S. dollar, Japanese yen,
euro, etc.).
A higher NEER coefficient (above 1) means that
the home country's currency will usually be worth
more than an imported currency, and a lower
coefficient (below 1) means that the home currency
will usually be worth less than the imported
currency.
The NEER also represents the approximate relative
price a consumer will pay for an imported good.
 The REER Index

The weighted average of a country's currency

relative to an index or basket of other major
currencies adjusted for the effects of inflation.
The weights are determined by comparing the
relative trade balances, in terms of one country's
currency, with each other country within the index.
 REER
The calculation method of the real effective
exchange rate is as follows:
(i) Each of the Rupee's exchange rates versus other
major currencies (nominal exchange rates) is
deflated by the price indices of India and the
corresponding country and area to get the real
exchange rate.
(ii) Then, weighted average of the real exchange
rates is calculated using the value of India's trade
with the respective countries and areas as its
weights. Then it is converted into a single index
using a base period.
 REER

This exchange rate is used to determine an

individual country's currency value relative to the
other major currencies in the index, as adjusted for
the effects of inflation. All currencies within the
said index are the major currencies being traded
today: U.S. dollar, Japanese yen, euro, etc.

This is also the value that an individual consumer

will pay for an imported good at the consumer
level. This price will include any tariffs and
transactions costs associated with importing the
good.
 Change in the nominal exchange rate
EXAMPLE S0¥/$ = ¥100/$, E[p¥] = 0%, E[p$] = 10%
RPPP  E[S1¥/$] = S0¥/$ (1+ p¥)/(1+ p$) = ¥90.91/$
¥130/$
¥120/$
St¥/$
¥110/$ Actual S1¥/$ = ¥110/$
¥100/$
¥90/$ E[S1¥/$] = ¥90.91/$
¥80/$

t=0 t=1

In real (purchasing power) terms, the dollar has

appreciated by (¥110/$)/(¥90.91/$)-1 = +.21,
or 21 percent more than expected.
 The real exchange rate
The real exchange rate adjusts the nominal
exchange rate for differential inflation since an
arbitrarily defined base period.
Change in the real exchange rate is defined by:

1+xtd/f = (Std/f / St-1d/f) [(1+ptf)/(1+ptd)]

where
xtd/f = % change in the real exchange rate
Std/f = the nominal spot rate at time t
ptc = inflation in currency c during period t
Percentage changes in real exchange rates
Xtd/f= level of the real exchange rate
xtd/f = (Std/f / St-1d/f) [(1+ptf)/(1+ptd)]-1
= [(¥110/$)/(¥100/$)][(1.10)/(1.00)] = 1.21, or a 21% increase
130%
120% X1¥/$ = X0¥/$ (1+ x1¥/$) = 1.21 = 121%
110%
Xt¥/$ 100% Base: X0¥/$ = 1.00 = 100%
90%
80%

t=0 t=1

Real value of the dollar has appreciated by 21 percent.

 Real value of the dollar
(1970-1998)
200%

Germany
Japan
150%
U.K.

100%

50%

0%

Jan 1970 Jan 1975 Jan 1980 Jan 1985 Jan 1990 Jan 1995

Mean level = 100 for each series