10/15/2021

Chapter 6

International Parity
Condition

International Parity Conditions

 Demonstrate how price levels

and price level changes
(inflation) in countries
determine the exchange rate at
which their currencies are
traded
 Explain how interest rates
 Show how interest rates
for currencies reflect
reflect inflationary forces
expectations held by
within each country and
market participants about
currency
the future spot rate
 Analyze how, in
equilibrium, the spot and
forward currency markets
are aligned with interest
differentials

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International Parity Conditions

• The economic theories which

link exchange rates, price
levels, and interest rates
together are called international
parity conditions

These theories may not

always work out to be “true”
when compared to what
students and practitioners
observe in the real world, but
they are central to any
understanding of how
multinational business is
conducted

1-3

Prices and Exchange Rates

• The Law of one price states that

all else being equal (no transaction
costs) a product’s price should be
the same in all markets
 Even if prices for a particular
product are in different currencies,
the law of one price states that

P$  S = P ¥
 Where the price of the product in US dollars (P$), multiplied
by the spot exchange rate (S, yen per dollar), equals the
price of the product in Japanese yen (P¥)

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Prices and Exchange Rates

• Conversely, if the prices

were stated in local
currencies, and markets
were efficient, the
exchange rate could be
deduced from the
relative local product
prices

P¥
S $
P

1-5

Purchasing Power Parity &

The Law of One Price

 If the Law of One Price were true for all goods, the
purchasing power parity (PPP) exchange rate could be
found from any set of prices
 Through price comparison, prices of individual products
can be determined through the PPP exchange rate
 This is the absolute theory of purchasing power parity
 Absolute PPP states that the spot exchange rate is
determined by the relative prices of similar basket of
goods

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The Big Mac Hamburger Standard

• The Economist developed the

Big Mac Standard to track PPP:
 Assuming that the Big Mac
is identical in all countries,
it serves as a comparison
point as to whether or not
currencies are trading at
market prices
 Big Mac in Switzerland
𝑺𝒇𝒓𝟔.𝟑𝟎
costs Sfr6.30 while the = 𝐒𝐟𝐫2.4803/$
same Big Mac in the US $𝟐.𝟓𝟒𝟓.𝟑𝟎/$
costs $2.54
 The implied PPP of this
exchange rate is

1-7

The Big Mac Hamburger Standard

• However, on the date of the

survey, the actual exchange
rate was Sfr1.73/$,
therefore the Swiss franc is
overvalued by

Sfr2.4803
 1.4337 or   43.37%
Sfr1.73

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The Big Mac Hamburger Standard

Another Example

1-9

The Big Mac Hamburger Standard

Another Example

𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐵𝑖𝑔 𝑀𝑎𝑐 𝑖𝑛 𝐶ℎ𝑖𝑛𝑎,𝑖𝑛 𝑌𝑢𝑎𝑛 𝑌𝑢𝑎𝑛19.8

= 𝑌𝑢𝑎𝑛6.7875 = $2.92
𝑌𝑢𝑎𝑛/$ 𝑆𝑝𝑜𝑡 𝑅𝑎𝑡𝑒

𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐵𝑖𝑔 𝑀𝑎𝑐 𝑖𝑛 𝐶ℎ𝑖𝑛𝑎,𝑖𝑛 𝑌𝑢𝑎𝑛 𝑌𝑢𝑎𝑛19.8

= = Yuan3.7358/$
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐵𝑖𝑔 𝑀𝑎𝑐 𝑖𝑛 𝑈.𝑆.,𝑖𝑛 $ $5.30

𝐼𝑚𝑝𝑙𝑖𝑒𝑑 𝑅𝑎𝑡𝑒 −𝐴𝑐𝑡𝑢𝑎𝑙 𝑅𝑎𝑡𝑒 𝑌𝑢𝑎𝑛3.7358/$−𝑌𝑢𝑎𝑛6.7875/$

= = - 45.0%
𝐴𝑐𝑡𝑢𝑎𝑙 𝑅𝑎𝑡𝑒 𝑌𝑢𝑎𝑛6.7875

What does it mean?

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Relative Purchasing Power Parity

• If the assumptions of absolute PPP theory

are relaxed, we observe relative purchasing
power parity
 This idea is that PPP is not particularly
helpful in determining what the spot
rate is today, but that the relative
change in prices between countries over
a period of time determines the change
in exchange rates
 Moreover, if the spot rate between 2
countries starts in equilibrium, any
change in the differential rate of
inflation between them tends to be
offset over the long run by an equal but
opposite change in the spot rate

1-11

Relative Purchasing Power Parity

Percent change in the

4 spot
P Exchange rate for
3 foreign currency

-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1
Percent difference in
expected rates of inflation
-2 (foreign relative to
home country)
-3

-4

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Relative Purchasing Power Parity

Empirical tests of both

relative and absolute
purchasing power parity
show that for the most
part, PPP tends to not be
accurate in predicting
future exchange rates

• Two general conclusions can be drawn from the tests:

 PPP holds up well over the very long term but is poor for
short term estimates
 The theory holds better for countries with relatively high
rates of inflation and underdeveloped capital markets

1-13 Slide 4-13

Exchange Rate Indices:

Real and Nominal

In order to evaluate a single

currency’s value against all other
currencies in terms of whether or not
the currency is “over” or
“undervalued,” exchange rate indices
were created
These indices are formed by
trade-weighting the bilateral
exchange rates between the
home country and its trading
partners

• The nominal exchange rate index uses actual

exchange rates to create an index on a weighted
average basis of the value of the subject currency
over a period of time

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Exchange Rate Indices:

Real and Nominal

• The real effective exchange rate index

indicates how the weighted average
purchasing power of the currency has
changed relative to some arbitrarily selected
base period
– Example: The real effective rate for the
US dollar
R
(E$ ) is found by multiplying the
nominal rate index (E N ) by the ratio of
$

US dollar costs (C ) over foreign currency

$

costs (CFC)

C$
E  E x FC
$
R
$
N
C
1-15

Exchange Rate Indices:

Real and Nominal

– If changes in exchange rates just offset differential inflation

rates – if purchasing power parity holds – all the real effective
exchange rate indices would stay at 100
– If a rate strengthened (overvalued) or weakened (undervalue)
then the index value would be ± 100
Exchange Rate of IDR
(2015 – 2019)

Real Effective

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Exchange Rate Pass-Through

• Incomplete exchange rate pass-through is one reason that
country’s real effective exchange rate index can deviate from
it’s PPP equilibrium point
 The degree to which the prices of imported & exported
goods change as a result of exchange rate changes is
termed pass-through
 Example: assume BMW produces a car in Germany and all
costs are incurred in euros. When the car is exported to
the US, the price of the BMW should be the euro value
converted to dollars at the spot rate. Suppose a specific
type of BMW car is EUR 35000
 Where P$ is the BMW price in dollars, P€ is the BMW price in
euros and S is the spot rate

$
PBMW  PBMW
€
x S€/$

1-17

Exchange Rate Pass-Through

 Incomplete exchange rate pass-through is one reason that
a country’s real effective exchange rate index can deviate
for lengthy periods from its PPP-equilibrium level
 If the euro appreciated 20% against the dollar (for example
from USD1=EUR1 to USD1.20=EUR1), but the price of the
BMW in the US market rose to only $40,000, and not
$42,000 as is the case under complete pass-through, the
pass-through is partial
 The degree of pass-through is measured by the proportion
of the exchange rate change reflected in dollar prices

$
PBMW, $40,000
$
2
  1.1429, or  14.29%
PBMW, 1 $35,000
• The degree of pass-through in this case is partial, 14.29% ÷
20.00% or approximately 0.71. Only 71.0% of the change has
been passed through to the US dollar price

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Interest Rates and Exchange Rates

• Prices between countries are related by exchange rates and now we

discuss how exchange rates are linked to interest rates
• The Fisher Effect states that nominal interest rates in each country
are equal to the required real rate of return plus compensation for
expected inflation. As a formula, The Fisher Effect is

i = r + + r

• Where i is the nominal rate, r is the real rate of
interest, and  is the expected rate of inflation
over the period of time
• The cross-product term, r , is usually dropped
due to its relatively minor value

1-19

Interest Rates and Exchange Rates

• Applied to two different countries, like the US and Japan, The

Fisher Effect would be stated as

i$ = r$ + $ ; i¥ = r¥ + ¥

 It should be noted that this

requires a forecast of the future
rate of inflation, not what
inflation has been, and predicting
the future can be difficult!

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Interest Rates and Exchange Rates

• The international Fisher effect, or Fisher-open,

states that the spot exchange rate should change in an
amount equal to but in the opposite direction of the
difference in interest rates between countries
 if we were to use the US dollar and the Japanese yen, the
expected change in the spot exchange rate between the
dollar and yen should be (in approximate form)

S1  S2
x 100  i $  i¥
S2

1-21

Interest Rates and Exchange Rates

• Justification for the international Fisher effect is that

investors must be rewarded or penalized to offset the
expected change in exchange rates
 For example, if a dollar-based investor buys a 10-year
yen bond earning 4% interest, instead of a 10-year
dollar bond earning 6% interest, the investor must be
expecting the yen to appreciate vis-à-vis the dollar by
at least 2% per year during the 10 years. If not, the
dollar-based investor would be better off remaining in
dollars. If the yen appreciates 3% during the 10-year
period, the dollar-based investor would earn a bonus of
1% higher return
• The international Fisher effect predicts that with
unrestricted capital flows, an investor should be
indifferent between investing in dollar or yen bonds, since
investors worldwide would see the same opportunity and
compete it away
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Interest Rates and Exchange Rates

• The Forward Rate

 A forward rate is an exchange rate quoted
today for settlement at some future date
 The forward exchange agreement between
currencies states the rate of exchange at which
a foreign currency will be bought or sold
forward at a specific date in the future
(typically 30, 60, 90, 180, 270 or 360 days)
 The forward rate is calculated by adjusting the
current spot rate by the ratio of euro currency
interest rates of the same maturity for the two
subject currencies

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Interest Rates and Exchange Rates

• The Forward Rate

 The forward rate is calculated for any specific maturity by
adjusting the current spot exchange rate by the ratio of euro
currency interest rates of the same maturity for the two
subject currencies.

  FC 90 
 1  i x 
  360 
F90FC/$  SFC/$ x
  $ 90 
 1  i x 
  360 

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Interest Rates and Exchange Rates

• For example, the 90-day forward rate for the Swiss franc/U.S.
dollar exchange rate (FSF/$) is found by multiplying the current
spot rate (SSF/$) by the ratio of the 90-day euro-Swiss franc
deposit rate (iSF) over the 90-day eurodollar deposit rate.
• The Forward Rate example with spot rate of Sfr1.4800/$, a 90-
day euro Swiss franc deposit rate of 4.00% p.a. and a 90-day
euro-dollar deposit rate of 8.00% p.a.

  90  
1   0.400 x 
  360  
Sfr/$
F90  Sfr1.4800 x
  Sfr1.4800 x
1.01
 Sfr1.4655/ $
  90   1.02
 1   0.800 x 360 
 

1-25

Interest Rates and Exchange Rates

• The forward premium or discount is the percentage difference

between the spot and forward rates stated in annual percentage
terms
– When stated in indirect terms (foreign currency per home
currency units, FC/$) then formula is

Spot - Foward 360

f FC  x x 100
Foward days
1.4800 - 1.4655 360
Using the previous
f FC  x x 100
example:
1.4655 90
 3.96 % p.a

• For direct quotes ($/FC), then F-S/S should be applied

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Interest Rates and Exchange Rates

Interest
Yield (%)

Eurodollar
yield curve

8.0
Forward premium
Is the percentage
Difference of 3.96%
Euro Swiss Franc
yield curve
4.0

1 2 3 4 5 6
Months
1-27

Interest Rate Parity (IRP)

• Interest rate parity theory provides the linkage between

foreign exchange markets and international money markets
• The theory states that the difference in the national interest
rates for securities of similar risk and maturity should be equal
to, but opposite sign to, the forward rate discount or premium
for the foreign currency, except for transaction costs

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Interest Rate Parity (IRP)

 In the diagram in the following slide, a US dollar-based investor

with $1 million to invest, is shown indifferent between dollar-
denominated securities for 90 days earning 8.00% per annum, or
Swiss franc-denominated securities of similar risk and maturity
earning 4.00% per annum, when “cover” against currency risk is
obtained with a forward contract

1-29

Interest Rate Parity (IRP)

i $ = 8.00 % per annum

(2.00 % per 90 days)
Start End
$1,000,000  1.02 $1,020,000

Dollar money market $1,019,993*

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

Swiss franc money market

SF 1,480,000  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.
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Covered Interest Arbitrage (CIA)

• Because the spot and forward markets are not always in a

state of equilibrium as described by IRP, the opportunity for
arbitrage exists
• The arbitrageur who recognizes this imbalance can invest in
the currency that offers the higher return on a covered basis
• This is known as covered interest arbitrage (CIA)
• The following slide describes a CIA transaction in much the
same way as IRP was transacted

1-31

Covered Interest Arbitrage

(CIA)/exhibit 6.7
Eurodollar rate = 8.00 % per annum
Start End
$1,000,000  1.04 $1,040,000 Arbitrage
$1,044,638 Potential
U.S. Dollar money market

S =¥ 106.00/$ 180 days F180 = ¥ 103.50/$

Japanese Yen money market

¥ 106,000,000  1.02 ¥ 108,120,000

Euroyen rate = 4.00 % per annum

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Covered Interest Arbitrage (CIA)

• A deviation from CIA is uncovered interest arbitrage, UIA,

wherein investors borrow in currencies exhibiting relatively
low interest rates and convert the proceeds into currencies
which offer higher interest rates
• The transaction is “uncovered” because the investor does not
sell the currency forward, thus remaining uncovered to any
risk of the currency deviating

1-33

Uncovered Interest Arbitrage (UIA):

The Yen Carry Trade

Investors borrow yen at 0.40% per annum

Start End
¥ 10,000,000  1.004 ¥ 10,040,000 Repay
¥ 10,500,000 Earn
Then exchanges Japanese yen money market ¥ 460,000 Profit
the yen proceeds
for US dollars,

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

investing in US
dollar money
markets for US dollar money market
one year
$ 83,333,333  1.05 $ 87,500,000

Invest dollars at 5.00% per annum

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Interest Rate Parity (IRP) and Equilibrium

2 Percentage premium on
foreign currency (¥)
1
4.83

-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1
106.00/$ - 103.50/$ 360
fY  x x 100
-2 103.50/$ 180
 4.83 % p.a (exhibit 6.7)
Percent difference -3
between
foreign (¥) and X U
domestic ($) -4
interest rates
Y
Z

1-35

Forward Rates as an Unbiased

Predictor

• If the foreign exchange markets are thought to be “efficient”

then the forward rate should be an unbiased predictor of the
future spot rate
• This is roughly equivalent to saying that the forward rate can
act as a prediction of the future spot exchange rate, and it
will often “miss” the actual future spot rate, but it will miss
with equal probabilities (directions) and magnitudes
(distances)

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Forward Rates as an Unbiased Predictor

Exchange rate
S2 F2

S1 Error Error F
3

F1 S3 Error

S4
Time
t 1 t 2 t 3 t 4

The forward rate available today (Ft,t+1), time t, for delivery at future time t+1, is used as a
“predictor” of the spot rate that will exist at that day in the future. Therefore, the forecast
spot rate for time St2 is F1; the actual spot rate turns out to be S2. The vertical distance
between the prediction and the actual spot rate is the forecast error. When the forward rate is
termed an “unbiased predictor,” it means that the forward rate over or underestimates the
future spot rate with relatively equal frequency and amount, therefore it misses the mark in a
regular and orderly manner. The sum of the errors equals zero.

1-37 Slide 4-37

Prices, Interest Rates and

Exchange Rates in Equilibrium
• (A) Purchasing power parity
– forecasts the change in the spot rate on the basis of differences
in expected rates of inflation
• (B) Fisher effect
– nominal interest rates in each country are equal to the required
real rate of return (r) plus compensation for expected inflation
()
• (C) International Fisher effect
– the spot exchange rate should change in an amount equal to but
in the opposite direction of the difference in interest rates
between countries
• (D) Interest rate parity
– the difference in the national interest rates should be equal to,
but opposite in sign to, the forward rate discount or premium for
the foreign currency, except for transaction costs
• (E) Forward rate as an unbiased predictor
– the forward rate is an efficient predictor of the future spot rate,
assuming that the foreign exchange market is reasonably
efficient
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Prices, Interest Rates and

Exchange Rates in Equilibrium (exhibit
6.11)

Forecast change in
Forward rate spot exchange rate Purchasing
+4% power
as an unbiased
(yen strengthens)
Predictor ( E ) Parity ( A )

Forward premium International Forecast difference

on foreign currency Fisher Effect (C) in rates of inflation
+4% -4%
(yen strengthens) (less in Japan)

Interest Difference in nominal

rate parity interest rates Fisher effect
(D) -4% (B)
(less in Japan)

1-39

Prices, Interest Rates and

Exchange Rates in Equilibrium (exhibit
6.11)

 Exhibit 6.11 illustrates all of the fundamental parity relations

simultaneously, in equilibrium, using the U.S. dollar and the
Japanese yen. The forecasted inflation rates for Japan and the
United States are 1% and 5%, respectively—a 4%
differential. The nominal interest rate in the U.S. dollar
market (1-year government security) is 8%—a differential of
4% over the Japanese nominal interest rate of 4%. The spot
rate is ¥104/$, and the 1-year forward rate is ¥100/$.
• According to the relative version of purchasing power parity,
the spot exchange rate one year from now, S2, is expected
to be ¥100/$:

1+π¥ This is a 4% change and

S2 = 𝑆 1 𝑥 $
equal, but opposite in sign,
1+π to the difference in expected
= ¥104/$ x (1.01/1.05) rates of inflation (1% - 5%,
= ¥100/$ or -4%).

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Prices, Interest Rates and

Exchange Rates in Equilibrium (exhibit
6.11)

• The Fisher Effect. The real rate of return is the nominal rate of
interest less the expected rate of inflation. Assuming efficient and
open markets, the real rates of return should be equal across
currencies. Here, the real rate is 3% in U.S. dollar markets
(r = i - p = 8% - 5%) and in Japanese yen markets (4% - 1%).
Note that the 3% real rate of return is not in Exhibit 6.11, but rather
the Fisher effect’s relationship—that nominal interest rate differentials
equal the difference in expected rates of inflation, -4%.
• International Fisher Effect. The forecast change in the spot
exchange rate, in this case 4%, is equal to, but opposite in sign to,
the differential between nominal interest rates:

𝑺𝟏−𝑺𝟐
x 100 = i¥- i$
𝑺𝟐
= -4%

1-41

Summary of Learning Objectives

• Parity conditions have traditionally been used by economists to

help explain the long run trend in an exchange rate
• Under conditions of free floating rates, the expected rate of
change in the spot rate, differential interest and inflation rates,
and the forward rate are all directional and proportional to each
other
• If two products are identical across borders and there are no
transaction costs, the product’s price should be the same in
both countries. This is the law of one price
• The absolute theory of PPP states that the spot rate is
determined by the relative prices of similar goods
• The relative theory of PPP states that if the spot rate starts in
equilibrium, any change in the differential inflation rates should
be offset over the long run by an opposite change in the spot
rate

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Summary of Learning Objectives

• The Fisher Effect states that nominal interest rates in each

country are equal to the required real rate of return plus
compensation for expected inflation The international Fisher
Effect states that the spot rate should change in an equal
amount but in the opposite direction to the difference in interest
rates between two countries
• The IRP theory states that the difference between national
interest rates for similar securities should be equal to, but
opposite sign to, the forward discount or premium rate excluding
transaction costs
• When the forward and spot market rates are not in equilibrium,
the opportunity for risk free arbitrage exists. This is termed
covered interest arbitrage
• If markets are believed to be efficient, then the forward rate is
considered an “unbiased predictor” of the future spot rate

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