11/1/2023

Slide 5- International Parity Relationships &

Forecasting Foreign Exchange Rates

Luu Thi Thu Huong

The International School
Duy Tan University
Email: luutthuhuong@duytan.edu.vn
Phone: 0905 889 226

6-0 McGraw-Hill/Irwin Copyright © 2009

2007 by The McGraw-Hill Companies, Inc. All rights reserved.

International Parity
Relationships & Forecasting
Foreign Exchange Rates Chapter Six
6
INTERNATIONAL
Chapter Objective: FINANCIAL
MANAGEMENT
This chapter examines several key international
parity relationships, such as interest rate parity and
Fourth Edition
purchasing power parity.
EUN / RESNICK

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Chapter Outline

 Interest Rate Parity

  Covered Interest
Purchasing PowerArbitrage
Parity

IRP
 PPP
 and Exchange
Deviations andRate Determination
 The Fisher Effects the Real Exchange Rate
Reasons for
 Evidence on Deviations
Purchasing from IRP
Power Parity
 Forecasting Exchange Rates


 Purchasing
 The Power
FisherMarket
 Efficient
Parity
EffectsApproach
 The Fisher
 Forecasting Effects
 FundamentalExchange
ApproachRates
 Forecasting Exchange Rates
 Technical Approach

 Performance of the Forecasters

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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
have6-6the 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$ = × = × 2 = 0.08
S($/€) 180 $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 =
£800 (1+ i£)
Step 4: repatriate
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
your dollar obligationCopyright
6-16 of $1,071.
© 2007 byThe excess isCompanies,
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Arbitrage Strategy II
If F360($/£) < $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

your dollar obligationCopyright
6-18
of £892.48. Keep
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IRP and Hedging Currency Risk

You are a U.S. importer of British woolens and have just ordered next
year’s inventory. Payment of £100M is due in one year.
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%

IRP implies that there are two ways that you fix the cash outflow to a
certain U.S. dollar amount:
a) Put yourself in a position that delivers £100M in one year—a long
forward contract on the pound.
You will pay (£100M)(1.2/£) = $120M in one year.
b) Form a forward market hedge as shown below.
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IRP and a Forward Market Hedge

To form a forward market hedge:
Borrow $112.05 million in the U.S. (in one year you
will owe $120 million).
Translate $112.05 million into pounds at the spot
rate S($/£) = $1.25/£ to receive £89.64 million.
Invest £89.64 million in the UK at i£ = 11.56% for
one year.
In one year your investment will be worth £100
million—exactly enough to pay your supplier.
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Forward Market Hedge

Where do the numbers come from? We owe our supplier
£100 million in one year—so we know that we need to
have an investment with a future value of £100 million.
Since i£ = 11.56% we need to invest £89.64 million at the
start of the year.
£100
£89.64 =
1.1156
How many dollars will it take to acquire £89.64 million at
the start of the year if S($/£) = $1.25/£?
$1.00
$112.05 = £89.64 ×
£1.25
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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
 Thus
(Fb/Sa)(1 + i¥l)  (1 + i¥ b)  0
 Capital Controls
 Governments sometimes restrict import and export of
money through taxes or outright bans.
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Transactions Costs Example

 Will an arbitrageur facing the following prices be
able to make money?
1 + i$ F$/ €
=
1 + i€ S$/ €

Bid Ask
Spot $1.00=€1.00 $1,01=€1,00
Forward $0.99=€1.00 $1.00=€1.00
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Transactions Costs Example

 Try borrowing $1.000 at 5%:
 Trade for € at the ask spot rate $1.01 = €1.00
Invest €990.10 at 5.5%

Now try this backwards



 Hedge this with a forward contract on

€1,044.55 at $0.99 = €1.00
 Receive $1.034.11
 Owe $1,050 on your dollar-based borrowing
 Suffer loss of $15.89
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Questions and Answers

1. Assume: (1) the US annual interest rate = 10%; (2) the
Malaysian annual interest rate = 4%; and (3) the 90-day
forward rate for the Malaysian ringgit = $0.3864. At what
current spot rate will interest rate parity hold?
A. $.3922
B. $.3855
C. $.3807
D. $.3752

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Questions and Answers

2. The theory of purchasing power parity says that .
A. the inflation rates in two countries are unrelated
B. the exchange rate will adjust to reflect changes in the
price levels of two countries
C. the inflation rate is greater than the interest rate
D. the interest rate is greater than the inflation rate

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