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• • In the real world, there may be deviations from parity due to many reasons. They are: As the PPP theory has its origin in the law of one price, all assumptions that underlie the law of one price are equally applicable to PPP. Non traded items such as immovable goods (land, building), highly perishable (milk, vegetables), and hospitability services may cause departure from PPP. This is because they cannot be moved from one country to another to cash on the price differential between the countries. The limitations of price indices as a measure of price level changes make PPP an approximate measure. Different countries uses different basket of goods and services in the construction of price index. The PPP theory holds only in the long run. In other words, long run changes in exchange rates are in line with long run differences in inflation rates.

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**INTEREST RATE PARITY
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• The interest rate parity theory states that the differences in the interest rates (risk free) on two currencies should be equal to the difference between the forward exchange rate and the spot exchange rate if there are to be no arbitrage opportunities. In other words according to IRP theory, financial products that are equal to each other sells for the same price. • Thus, the currency of a country with a higher/lower interest rate should be at a discount/premium in term of the currency of another country with a lower/higher interest rate.

investing in securities denominated in another currency with the currency risk covered (or hedged) in the forward market. . is known as covered interest arbitrage.ARBITRAGE: • Locational arbitrage Triangular arbitrage Covered interest arbitrage: • Borrowing in one currency and lending in another.

60 and received INR 10 million.82 million. Thus after one year the investor received NRS 17. . repaid the loan amount with interest (NRS 16.80) in exchange for the Nepalese Currency amount at the forward rate of INR/NRS 1. at an interest rate of 8%. • He has invested INR 10 million in the INR denominated bank deposit for one year.65..96 million) and finally made a profit of NRS 0. without commitment of his fund and bearing risk. Simultaneously he sold forward the maturity value of deposit (INR 10. He converted NC 16 million into Indian Currency at an exchange rate of NRS/INR 1.86 million.• Example: Let us assume that an investor borrowed NC 16 million in the Nepal for one year at the interest rate of 6% per annum.

a. In the later case he knows that he must worry about transactions foreign exchange risk. . Either he will invest in dollar deposit or he will invest in pound deposit for one year.53/£ • Which of these deposits provides the higher dollar return? If these were actually market prices.60/£ • 1-year forward exchange rate $1. and suppose he has two investment alternatives.Example • Suppose XYZ has $ 10. • USD interest rate 8% p.000 to invest. so he decided fully hedge his investment. • Spot exchange rate $ 1. a. what you expect to happen. • GBP interest rate 12% p. • Suppose that XYZ has the following data.

convert the pounds to USD at the rate that was agreed upon in the forward contract. Set up a one year deposit account in British bank.• • • • Follow the following process: Convert dollar into pound at the given spot rate. Engage in a forward contract to sell pound 1 year forward. • Compare this amount with the amount which will be received after 1 year if deposited in US bank. . • When the deposit matures.

.• In this example borrowing NRS and investing in INR has resulted in a profit. However. • If inequality exists. there will be profitable arbitrage opportunities. This is possible if and only if: • (1+KNP)t < Ft(INR/NRS)/S0(INR/NRS)*(1+KIN)t • Where. then borrowing in INR and investing in the NRS deposit will be profitable. if inequality of the above equation reverse. KNP=Interest rate on Nepalese currency denominated deposit/investment • KIN= Interest rate on Indian currency denominated deposit/investment.

Furthermore. . Investors will still be indifferent among the available interest rates in two countries because the forward exchange rate sustains equilibrium such that the dollar return on dollar deposits is equal to the dollar return on foreign deposit. When the no-arbitrage condition is satisfied with the use of a forward contract to hedge against exposure to exchange rate risk. interest rate parity is said to be covered. Each form of the parity condition demonstrates a unique relationship with implications for the forecasting of future exchange rates: the forward exchange rate and the future spot exchange rate. covered interest rate parity helps explain the determination of the forward exchange rate.Covered interest rate parity (CIP): covered interest rate parity refers to the condition in which a forward contract has been used to cover (eliminate exposure to) exchange rate risk. thereby eliminating the potential for covered interest arbitrage profits.

• Covered interest rate parity (CIRP) is found to hold when there is open capital mobility and limited capital controls.• The following equation represents covered interest rate parity. • Or Ft/St=( 1 +i$)/ (1 + ic) • Or for small interest rate: • i$ .ic =(F-S)/S • where. . is shown to be equal to the dollar return on euro deposits. • The dollar return on dollar deposits. and this finding is confirmed for all currencies freely traded in the present-day. Ft is the forward exchange rate at time t. .

0068 dollars per Yen.02 * 0. Suppose S = 0.• Example: i$ = 5%. iY = 3%.05 – 0. What should be the 90-day forward rate? • 0.03 = (F – 0.0068)/0.0068 • F = 0.00694 .0068 + 0.0068 = 0.

It hypothesizes that an investor will make his investment decision by comparing the rate of return to assets. . • uncovered interest rate parity holding in the foreign exchange market states that the returns from investing domestically are equal to the returns from investing abroad.Uncovered Interest Rate Parity • The uncovered interest rate parity condition defines a relationship between the interest rates and exchange rates for two countries in equilibrium. Thus. based on his expectation of the depreciation rate. or all investment would flood the country with a higher expected return. the rate or return to assets should be equalized across countries.

• The following equation represents uncovered interest rate parity. interest rate parity is said to be uncovered. • Investors are indifferent among the available interest rates in two countries because the exchange rate between those countries is expected to adjust such that the dollar return on dollar deposits is equal to the dollar return on foreign deposits. . thereby eliminating the potential for uncovered interest arbitrage profits.• When the no-arbitrage condition is satisfied without the use of a forward contract to hedge against exposure to exchange rate risk. Uncovered interest rate parity helps explain the determination of the spot exchange rate .

• Think of t as the date an investment is made and (t+1) as the date the investment matures. All the variables in equation are known with certainty except s* t+1.• The exact version of the UIRP condition hypothesizes the equalization of the rate of return across countries: • (1 + rh) = (1 + rf )(s*t+1/st) • Where. • rh and rf are the current domestic and foreign interest rates. • t is the current period. • s* t+1 is the expected spot exchange rate in the following period. (t + 1) is the next period. • st is the spot exchange rate. .

. There is an opportunity to make a profit if he can get a forecast closer to the next period’s spot exchange rate. • His expectation of the next period’s exchange rate is often different from the spot exchange rate that is realized in the following period.• The UIRP condition is called uncovered because the investor is uncovered for the risk associated with the uncertainty of s* t+1.

INR 39. The current spot rate between USD and INR is 39. if interest rate parity holds. what is the three month forward rate. • (Ans.Problem-1 • The interest rate in India and the US are 8% and 6% per annum respectively.97%) .6297 & annualized premium 1.4354.

Problem-2 • The spot rate of the NC against the USD is 75.85%) • Ft = So(1+p) (Ans. 1 year forward rate 73. Discount 1. Solution: from the perspective of Nepalese investor.61) . What is the forward rate premium and or discount of the NC with respect to the USD if interest rate parity exists? What is the forward rate (one year) of the USD in terms of the NC. • P = (1 + Kh)/(1 + Kf) -1 (Ans. The interest rate in US is 8% and in Nepal it is 6%.

• ESt(X/Y) = expected spot rate of one unit of currency X in terms of currency Y on the maturity date of the forward contract. • The relationship between the forward exchange rate and the expected future spot rate between two currencies can be stated as: Ft(X/Y) = ESt(X/Y) • Where. • Ft(X/Y) = forward rate of one unit of currency X in terms of currency Y for delivery in t times. In other words. the forward rate of a currency relative to another currency reflects the future spot rate of exchange. .Forward Rate Parity • The Forward Rate Parity states that forward rates are unbiased predictors of future spot exchange rate.

the forward rate will go down until it is no longer greater than the expected future spot rate. When many participants do same. • In this way. • (Ft – So)/So = (E(St) – So)/So . the demand of forward USD increases. speculators would buy USD forward at INR 44 and expects to sell the same at INR 45 to make a profit of INR 1 on each USD. when the forward rate is no longer greater or lower than the expected future spot rate. • Conversely. Ft(X/Y) = INR/USD = 46. that will drive up the forward rate until it is no longer lower than the expected future spot rate. in six month. if the expected spot rate in the six month period is INR 45 and the forward rate for six month is INR 44. Than. • Market participants would sell USD forward at INR 46 and expects to buy the same at INR 45 when they are required to deliver the dollars.• Example: Suppose ESt(X/Y)= INR/USD = 45 & six month. The speculator expects to make profit of INR 1 on each USD traded. the forward rate and expected future spot rate are in equilibrium (Ft=E(St)).

the rate of interest will rise to approximately 8% a year. the real interest rate and the expected rate of inflation in a country. and if inflation is then anticipated to equal 5% a year. interest rate in any country rise by an amount approximately equal to anticipated rate of inflation. or the Fisher equation. • This theory states that.The Fisher Effect: • The Fisher Effect. • This theory argues that weak currencies have higher interest rates because the interest rate differential equals the expected rate of change of the exchange rate. . If the basic interest rate is 3% a year. when there is no inflation. represents the relationship between the nominal interest rate.

the nominal rate of interest (the rate of exchange between the current money and future money) consists of two components: the real rate of interest (measured in purchasing power of money) and the expected rate of inflation. .• This theory argues that weak currencies have higher interest rates because the interest rate differential equals the expected rate of change of the exchange rate. • According to Irving Fisher.

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This condition is known as real interest rate parity (RIRP) and is related to the international Fisher effect. where in changes in expected real interest rates reflect expected changes in the real exchange rate.Real interest rate parity • When both UIRP (particularly in its approximation form) and PPP hold. the two parity conditions together reveal a relationship among expected real interest rates. The following equations demonstrate how to derive the RIRP equation. .

then they can be combined and rearranged as the following: .• Where represents inflation • If the above conditions hold.

and zero change in the expected real exchange rate.• RIRP rests on several assumptions. no country risk. . The parity condition suggests that real interest rates will equalize between countries and that capital mobility will result in capital flows that eliminate opportunities for arbitrage. including efficient markets. The half-life period of deviations from RIRP have been examined by researchers and found to be roughly six or seven months. but between two and three months for certain countries. • There exists strong evidence that RIRP holds tightly among emerging markets in Asia and also Japan. Such variation in the half-lives of deviations may be reflective of differences in the degree of financial integration among the country groups analyzed.

. but empirical evidence has demonstrated that it generally holds well across long time horizons of five to ten years. .• RIRP does not hold over short time horizons.

Examples: .

Answer: .

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