You are on page 1of 56

International Parity Conditions:

1) PPP
2) Fisher effect
3) Interest rate parity
1. Purchasing Power Parity
Prices and Exchange Rates
• If the identical product or service can be
sold in two different markets, and no
restrictions exist on the sale or
transportation costs of moving the product
between markets, the products price should
be the same in both markets.
• This is called the law of one price.
Prices and Exchange Rates
• A primary principle of competitive markets is that
prices will equalize across markets if frictions
(transportation costs) do not exist.
• Comparing prices then, would require only a
conversion from one currency to the other:
P$ x S = P¥
Where the product price in US dollars is (P$), the spot
exchange rate is (S) and the price in Yen is (P¥).
Prices and Exchange Rates
• If the law of one price were true for all goods and
services, the exchange rate could be found from any
individual set of prices.
• A weaker version of the law of one price is known as
Purchasing Power Parity (PPP). The PPP states that
the price of a basket of goods should be the same in
all markets. By comparing the prices of a basket of
goods denominated in different currencies, we could
determine the PPP exchange rate that should exist if
markets were efficient. This is the absolute version of
the PPP theory.
Purchasing Power Parity

P$
S($/£) = P
£
Prices and Exchange Rates
If the assumptions of the absolute version of the PPP
theory are relaxed a bit more, we observe what is
termed relative purchasing power parity (RPPP).
RPPP holds that PPP is not particularly helpful in
determining what the spot rate is today, but that
the relative change in prices between two
countries over a period of time determines the
change in the exchange rate over that period.
Prices and Exchange Rates
• More specifically, with regard to RPPP, if
the spot exchange rate between two
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
exchange rate.
Relative Purchasing Power Parity
• Relative PPP states that the rate of change in
the exchange rate is equal to the differences in
the rates of inflation:

S1 − S 0 (π $ – π £)
= e= ≈π $– π £
S0 (1 + π £ )
• If U.S. inflation is 5% and U.K. inflation is 8%,
the pound should depreciate by 2.78% or around
3%.
Evidence on PPP
• PPP probably doesn’t hold precisely in the real
world for a variety of reasons.
– Haircuts cost 10 times as much in the developed world
as in the developing world.
– AAA batteries, on the other hand, is a highly
standardized commodity that is actively traded across
borders.
– Shipping costs, as well as tariffs and quotas can lead to
deviations from the PPP.
• Relative PPP usually holds.
2. Interest Rate Parity
FX and Eurocurrency markets

Now Future

FC
FX and Eurocurrency markets

Now Future

$
spot exchange
market (S $/FC)

FC
FX and Eurocurrency markets

Now Future

$
forward
exchange
market (F $/FC)
FC
FX and Eurocurrency markets

Now Future
$
i (or i )
$

FC
FX and Eurocurrency markets

Now Future

i*
FC
FX and Eurocurrency markets

Now Future
i
$

S F

i*
FC
• FX and money markets create multiple
ways of moving money around:
– Across currencies
– Across time
• This mobility constrains relative prices in
the spot market, the forward market, and the
Eurocurrency markets in any two currencies
(interest rate parity)
Example: Two riskfree dollar investments
Investment #1: Eurodollar deposit

Now Future
i
$

Final Amount - 1 = i
Return =
Initial Amount
FC
Investment #1: Eurodollar deposit

Now Future
i
$ R1 = i

FC
Investment #2: Covered investment in
foreign currency

• Buy pounds (or other FC) spot


• Deposit in an interest-bearing Euro-FC account
• Contract now to convert principal + interest (in FC)
back to dollars @ forward rate F
Investment #2: Covered investment in foreign currency
1) Buy FC spot @ S $/FC

Now Future

$
S $/FC

FC
1/S units of FC
per $ invested
Investment #2: Covered investment in foreign currency
2) Invest @ Euro-rate i*

Now Future

$
S $/FC

i*
FC
1/S units of FC (1/S) (1+i*)
units of FC
Investment #2: Covered investment in foreign currency
3) Sell principal+interest at (precontracted) forward rate F

Now Future

$ (1/S) (1+i*)F
dollars
S $/FC F $/FC

i*
FC
1/S units of FC (1/S) (1+i*)
units of FC
Investment #2: Covered investment in foreign currency

Now Future

$ (1/S) (1+i*)F R2
dollars
S F

i*
FC
R2 = (F/S)(1+i*) - 1
Investment #2: Covered investment in foreign currency
Investment #1: Eurodollar investment

Now i Future
R1 = i
$ R2
S F

i*
FC
R2 = (F/S)(1+i*) - 1
Interest rate parity
• Since both investments have known
(riskfree) returns, those returns must be
identical: R1 = R2
• Reason: all markets are two-way; can
invest or borrow at R1 & R2
• A divergence between R1 & R2 creates a
money pump: borrow low, invest high
Example: R1 = 5%, R 2 = 6%

Now Future

FC
Example: R1 = 5%, R 2 = 6%

Now Future
R1 = 5%
$

FC
Example: R1 = 5%, R 2 = 6%

Now Future
R1 = 5%
$ R2 = 6%

FC
R2 = (F/S)(1+i*) - 1
Example: R1 = 5%, R 2 = 6%
Borrow @ R 1 , invest @ R2
Now Future
R1 = 5%
$ R2 = 6%

FC
R2 = (F/S)(1+i*) - 1 = 6%
Example #2: R 1 = 6%, R 2 = 5%

Now Future
R1 = 6%
$ R2 = 5%

FC
R2 = (F/S)(1+i*) - 1 = 5%
Example #2: R 1 = 6%, R 2 = 5%
Borrow FC with forward cover @ 5%, invest Euro-$ @6%
Now Future
R1 = 6%
$ R2 = 5%

FC
R2 = (F/S)(1+i*) - 1
Arbitrageurs eliminate divergences
between R1 and R2

R1 = R2

i = (F/S)(1 + i*) - 1

1 + i = (F/S)(1 + i*)
F = 1+i
S 1 + i*
Interest Rate Parity

F = 1+i
S 1 + i*

(for S and F in $/FC)


Caution: the formula depends on
how exchange rates are quoted
• Rule of thumb: the interest rate ordering
mimics the exchange rate quotations
• If exchange rates are quoted SF/$
(European convention), it’s a SF interest
rate in the numerator and a $ interest rate in
the denominator
Interest Rate Parity
F = 1+i
S 1 + i*
(for S and F in $/FC)
Interest Rate Parity
F = 1+i
S 1 + i*
(for S and F in $/FC)
SF/$
F = 1+i SF

SF/$
S 1+i $

(for S and F in SF/$)


General investment strategies

Lend $
$1 $(1+i)t
$F0,t (1+i*)t/S

Buy £ Deliver on
Short £ futures short £ futures
Lend £
£1/S £(1+i*)t/S
Practice problem
Assume the current $/£ exchange rate is 0.6 $/£ and 1-year futures exchange
rate is 0.61$/£. The risk-free interest rate in US is 4%. Find the risk-free
interest rate in UK.
Practice problem
Assume the current $/£ exchange rate is 0.6 $/£ and 1-year futures exchange
rate is 0.61$/£. The risk-free interest rate in US is 4%. Find the risk-free
interest rate in UK.

Solution:
F 0.61 1 + i 1.04
= = =
S 0.6 1 + i * 1 + i *

0.6
i * = 1.04 − 1 = 0.023 or 2.3%
0.61
Practice problem

Assume the current $/£ exchange rate is 0.6 $/£ and 1-


year futures exchange rate is 0.61$/£. The risk-free
interest rates in US and UK are 4% and 3%
respectively. Is there an arbitrage opportunity?
Practice problem
Assume the current $/£ exchange rate is 0.6 $/£ and 1-year futures exchange rate is
0.61$/£. The risk-free interest rates in US and UK are 4% and 3% respectively. Is
there an arbitrage opportunity?

Solution:
Direct investment of $s gives you 4%
Indirect investment gives (1/0.6)*1.03*0.61-1 =0.0472 or 4.72%

Thus, arbitrage is possible. Strategy:


Today: Borrow $1 at 4%, buy £(1/0.6), invest them at 3%, sell £(1/0.6)*1.03 futures
(note: your portfolio worth zero)
1-year from now: Collect £(1/0.6)*1.03 from your investment, sell £(1/0.6)*1.03 trough
previously bought futures contract to collect (1/0.6)*1.03*0.61 =$1.0472. Repay
your debt of 1.04. Profit = $0.0072

Question: why should we sell futures today? Why we cannot simply wait for one year to
sell our £s at a future spot rate?
Answer: because future spot rate will not be necessary equal to today’s futures rate.
Practice problem

Assume the current $/£ exchange rate is 0.6 $/£ and 1-year futures exchange
rate is 0.61$/£. The risk-free interest rates in US and UK are 4% and 2%
respectively. Is there an arbitrage opportunity?
Practice problem
Assume the current $/£ exchange rate is 0.6 $/£ and 1-year futures exchange
rate is 0.61$/£. The risk-free interest rates in US and UK are 4% and 2%
respectively. Is there an arbitrage opportunity?

Solution:
Direct investment of $s gives you 4%
Indirect investment gives (1/0.6)*1.02*0.61-1 =0.037 or 3.7%

Thus, arbitrage is possible. Strategy:


Today: Buy $1 for £(1/0.6) and invest this $1 at 4%. Borrow, £(1/0.6) at 2%
and buy £(1/0.6)*1.02 futures
1-year from now: Collect $1.04 from your investment, buy £(1/0.6)*1.02
trough previously bought futures contract to repay your debt. Profit =
1.04-(1/0.6)*1.02*0.61= $0.003
Practice problem
Assume the current $/£ exchange rate is 1.7 $/£ and 1-year futures exchange
rate is 1.68$/£. The risk-free interest rates in US and UK are 4% and 6%
respectively. Is there an arbitrage opportunity?

Solution:
Direct investment of $s gives you 4%
Indirect investment gives (1/1.7)*1.06*1.68-1 =0.0475 or 4.75%

Thus, arbitrage is possible. Strategy:


Today: Borrow $1, buy 1/1.7=£0.5882, invest it at 6% (so that you expect to
receive 1.06*(1/1.7)=£0.6235 one year from now) and sell futures
contract for £0.6235

1-year from now: Collect £0.6235 from your investment, sell £0.6235 trough
previously sold futures contract, receive 0.6235*1.68=$1.0475, repay you
debt of 1*1.04=$1.04. Profit = 1.0475-1.04= $0.0075
Practice problem
As in previous problem, assume the current $/£ exchange rate is 1.7 $/£ and 1-year
futures exchange rate is 1.68$/£. The risk-free interest rates at which you can invest
in US and UK are 4% and 6% respectively. However, since you do not have a very
good credit rating, you can borrow funds only at higher rates. Namely, you can
borrow $s at 5% and you can borrow £s at 7%. Is there an arbitrage opportunity?

Solution:
Try both directions
Direction 1: (borrow $s, invest £s)
Today: Borrow $1, buy 1/1.7=£0.5882, invest it at 6% (so that you expect to receive
1.06*(1/1.7)=£0.6235 one year from now) and sell futures contract for £0.6235
1-year from now: Collect £0.6235 from your investment, sell £0.6235 trough
previously sold futures contract, receive 0.6235*1.68=$1.0475, repay you debt of
1*1.04=$1.04. Profit = 1.0475-1.05= -$0.0025<0. No arbitrage this way

Direction 2: (borrow £s, invest $s)


Today: Buy $1 for £(1/1.7) and invest this $1 at 4%. Borrow, £(1/1.7) at 7% and buy
£(1/1.7)*1.07=£0.6294 futures
1-year from now: Collect $1.04 from your investment, buy £0.6294 trough previously
bought futures contract to repay your debt. Profit = 1.04-(1/1.7)*1.07*1.68= 1.04-
1.0574=-$0.0174<0. No arbitrage this way as well

Therefore, there is no arbitrage.


3. Fisher effect
The Fisher Effects
The nominal return i (nominal interest rate i) is the percentage change in the
amount of money you have.
The real return ρ (real interest rate ρ) is the percentage change in the amount of
stuff you can actually buy.

An increase (decrease) in the expected rate of inflation will cause a proportionate


increase (decrease) in the interest rate in the country.
For Canada, the Fisher effect is written as:
1 + i$ = (1+ ρ $)(1 + E[π $]) = 1 + ρ $ + E[π $] + ρ $E[π $]
i$ = ρ $ + E(π $) + ρ $E[π $] ≈ ρ $ + E[π $]
Where
ρ $ is the equilibrium expected “real” Canadian interest rate
E[π $] is the expected rate of Canadian inflation
i$ is the equilibrium expected nominal Canadian interest rate
Expected Inflation
The Fisher effect implies that the expected inflation rate is approximated as the difference between the nominal and real interest rates in each country, i.e.

i$ = ρ $ + (1 + ρ $)E[π $] ≈ ρ $ + E[π $]

(i$ – ρ $)
E[π $] = ≈ i$ – ρ $
(1 + ρ $)
International Fisher Effect
• If the Fisher effect holds in Canada
1+i$ = (1+ ρ $)(1 + E[π $]) ≈ ρ $ + E[π $]
and the Fisher effect holds in Japan,
1+i¥ = (1+ ρ ¥ )(1 + E[π ¥]) ≈ ρ ¥ + E[π ¥]
and if the real rates are the same in each country (i.e.
ρ $ = ρ ¥ ), then, using RPPP, we get the International
Fisher Effect
 S1 − S 0  (i$ – i¥)
E   = E(e) = ≈ i$ – i¥
 S0  (1 + i¥)
International Fisher Effect

(i$ – i¥)
E(e) =
(1 + i¥)
and if IRP also holds
F–S (i$ – i¥)
=
S (1 + i¥)
then forward expectation parity holds.
F–S
E(e) =
S
Forecasting Exchange Rates
Efficient Markets Approach
• Financial Markets are efficient if prices reflect
all available and relevant information.
• If this is so, exchange rates will only change
when new information arrives, thus:
Ft = E[St+1| It]
where Ft can be found from the Interest Rate
Parity
Fundamental Approach
• Involves econometrics to develop models that use a
variety of explanatory variables. This involves three
steps:
– step 1: Estimate the structural model using historical
data
Basic model:
S=α +β 1(m-m*)+β 2(y-y*)+ε
m=expected rate of grows of money
y=expected rate of real economic grows

– step 2: Estimate future parameter values.


– step 3: Use the model to develop forecasts.
Technical Approach
• Technical analysis looks for patterns in the
past behavior of exchange rates.
• Clearly it is based upon the premise that
history repeats itself.
• Thus it is at odds with the EMH