International Parity Relationships and

Forecasting Foreign Exchange Rates

Chapter Six

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline
 Interest Rate Parity
– Covered Interest Arbitrage
– IRP and Exchange Rate Determination
– Currency Carry Trade
– Reasons for Deviations from IRP
 Purchasing Power Parity
– PPP Deviations and the Real Exchange Rate
– Evidence on Purchasing Power Parity
 The Fisher Effects
 Forecasting Exchange Rates
– Efficient Market Approach
– Fundamental Approach
– Technical Approach
– Performance of the Forecasters
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 Interest Rate Parity Defined
 IRP is a “no arbitrage” condition.
 If IRP did not hold, then it would be
possible for an astute trader to make
unlimited amounts of money by
exploiting the arbitrage opportunity.
 Since we don’t typically observe
persistent arbitrage conditions, we can
safely assume that IRP holds.
…almost all of the time!
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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 and 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£) × = (1 + i$) F$/£ = S$/£ ×
S$/£ (1 + i£)
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Alternative 2: $1,000 IRP
Send your $ on
S$/£ Step 2:
a round trip to
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.
$1,000×(1 + i$) = $1,000
 (1+ i£) × F$/£
S$/£
IRP

Since both of these investments have the same risk, they must have the
same future value—otherwise an arbitrage would exist.
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 Interest Rate Parity Defined
 The scale of the project is unimportant.

$1,000
$1,000×(1 + i$)=  (1+ i£) × F$/£
S$/£

 IRP Form F$/£

× (1+ i£)
(1 + i$) =
S$/£
 IRP is sometimes approximated as:
i$ – i£ ≈ F – S
S
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Interest Rate Parity Carefully Defined
 No matter how you quote the exchange rate
($ per ¥ or ¥ per $) to find a forward rate,
increase the dollars by the dollar rate and the
foreign currency by the foreign currency
rate: (below)v European Term vvv American
1 + i¥ 1 + i$
F¥/$ = S¥/$ or F$/¥ = S$/¥
1 + i$ 1 + i¥
× ×
…be careful—it’s easy to get this wrong.

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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($/£) = $2.0000/£
360-day forward rate F360($/£) = $2.0100/£
U.S. discount rate i$ = 3.00%
British discount rate i£ = 2.49%
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 IRP and Covered Interest Arbitrage

 A trader with $1,000 could invest in the U.S. at

3.00%. In one year his investment will be worth:
$1,030 = $1,000  (1+ i$) = $1,000  (1.03)

 Alternatively, this trader could:

1. Exchange $1,000 for £500 at the prevailing spot rate.
2. Invest £500 for one year at i£ = 2.49%; earn £512.45.
3. Translate £512.45 back into dollars at the forward rate
F360($/£) = $2.01/£. The £512.45 will be worth $1,030.

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Other Choice: Arbitrage I
£500
Buy £500 at $2/£. £1 Step 2:
£500 =
$1,000× $2.00 Invest £500 at
i£ = 2.49%.
$1,000 £512.45 In one year £500
will be worth
Step 3: £512.45 =
Repatriate to the £500  (1+ i£)
U.S. at F360($/£)
One Choice: = $2.01/£
Invest $1,000 at 3%. $1,030 F£(360)
FV = $1,030 $1,030 = £512.45 ×
£1

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IRP& Exchange Rate Determination
 According to IRP only one 360-day
forward rate F360($/£) can exist. It must be
the case that

F360($/£) = $2.01/£
 Why?
 If F360($/£)  $2.01/£, an astute trader could
make money with one of the following
strategies.
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 Arbitrage Strategy I
 If F360($/£) > $2.01/£:
1. Borrow $1,000 at t = 0 at i$ = 3%.
2. Exchange $1,000 for £500 at the prevailing
spot rate (note that £500 = $1,000 ÷ $2/£.);
invest £500 at 2.49% (i£) for one year to
achieve £512.45.
3. Translate £512.45 back into dollars; if
F360($/£) > $2.01/£, then £512.45 will be more
than enough to repay your debt of $1,030.
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Step 2: Arbitrage I
Buy pounds
£500 Step 3:
£1
£500 = Invest £500 at
$2.00
$1,000× i£ = 2.49%.
$1,000 £512.45 In one year £500
will be worth
£512.45 =
Step 4: Repatriate £500 (1+ i£)
to the U.S.
Step 1:
Borrow $1,000. More F£(360)
Step 5: Repay than $1,030 $1,030 < £512.45 ×
£1
your dollar loan
with $1,030.
If F£(360) > $2.01/£, £512.45 will be more than enough to repay your
dollar obligation of $1,030. The excess is your profit.
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 Arbitrage Strategy II

 If F360($/£) < $2.01/£:

1. Borrow £500 at t = 0 at i£= 2.49%.
2. Exchange £500 for $1,000 at the prevailing
spot rate; invest $1,000 at 3% for one year to
achieve $1,030.
3. Translate $1,030 back into pounds; if
F360($/£) < $2.01/£, then $1,030 will be more
than enough to repay your debt of £512.45.

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 Step 2:
£500
Arbitrage II
Buy dollars $2.00
$1,000 = Step 1:
£500× £1
Borrow £500.
$1,000
More Step 5: Repay
Step 3: your pound loan
Invest $1,000 than
£512.45 with £512.45.
at i$ = 3%.
Step 4:
Repatriate to
the U.K.
In one year $1,000
F£(360)
will be worth $1,030 $1,030 > £512.45 ×
£1

If F£(360) < $2.01/£, $1,030 will be more than enough to repay your
dollar obligation of £512.45. Keep the rest as profit.
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 Currency Carry Trade
 Currency carry trade involves buying a
currency that has a high rate of interest
and funding the purchase by borrowing in
a currency with low rates of interest,
without any hedging.
 The carry trade is profitable as long as the
interest rate differential is greater than the
appreciation of the funding currency
against the investment currency.

6-16
 Currency Carry Trade Example
 Suppose the 1-year borrowing rate in dollars is 1%.
 The 1-year lending rate in pounds is 2½%.
 The direct spot ask exchange rate is $1.60/£.
 A trader who borrows $1m will owe $1,010,000 in one year.
 Trading $1m for pounds today at the spot generates £625,000.
 £625,000 invested for one year at 2½% yields £640,625.
 The currency carry trade will be profitable if the spot bid rate
prevailing in one year is high enough that his £640,625 will
sell for at least $1,010,000 (enough to repay his debt).
 No less expensive than:

b $1,010,000 $1.5766
S360($/£) = =
£640,625 £1.00
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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.
6-18
 Transactions Costs Example
 Will an arbitrageur facing the following prices
be able to make money?
Borrowing Lending
(1 + i$)
$ 5.0% 4.50% F($/ €) = S($/ €) ×
(1 + i€)
€ 5.5% 5.0%
Bid Ask
Spot $1.42 = €1.00 $1.45 = €1,00
Forward $1.415 = €1.00 $1.445 = €1.00

S0a($/€)(1+i$b) S0b($/€)(1+i$l )
F1b($/€) = F1a($/€) =
(1+i€l ) (1+i€b)
6-19
 Step 1
Borrow $1m at i$b b
$1m $1m×(1+i $)

0 IRP 1
Step 2 1 l b
$1m a ×(1+i ) F b
($/€) = $1m×(1+i $)
Buy € at S0($/€) ×
€ 1
×
spot ask No arbitrage forward bid price (for
customer): b a b
(1+i $ ) S0 ($/€)(1+i $) Step 4
F1($/€) =
b
=
1
×(1+i l
(1+i l
) Sell € at
€ €
S0a($/€) ) forward
= $1.4431/€ bid
1 1 l
$1m a Step 3 invest € at i l
€ $1m a
×(1+i €
S ($/€)
× S0($/€) × 0 )
(All transactions at retail prices.)
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 b l
€1m × Step 3: lend at i$l €1m × bS0($/€) ×
S0($/€) (1+i$)
0 IRP 1
l a b
€1m × S0($/€) × (1+i$) ÷
b
€1m×(1+i€)
F1($/€) =
No arbitrage forward ask price:
S0b($/€)(1+i$l ) Step 4
Step 2: F1a($/€) =
(1+i€b) buy € at
sell €1m at forward
= $1.4065/€ ask
spot bid
€1m Step 1: borrow €1m at i€b €1m×(1+ib€)
(All transactions at retail prices.)
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 Why This May Seem Confusing
 On the last two slides we found “no arbitrage.”
– Forward bid prices of $1.4431/€.
– Forward ask prices of $1.4065/€.
 Normally the dealer sets the ask price above the
bid—recall that this difference is his expected
profit.
 But the prices on the last two slides are the prices of
indifference for the customer, NOT the dealer.
– At these forward bid and ask prices the customer is
indifferent between a forward market hedge and a
money market hedge.

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 Setting Dealer Forward Bid and Ask
 Dealer stands ready to be on the opposite side of every trade.
– Dealer buys foreign currency at the bid price.
– Dealer sells foreign currency at the ask price.
– Dealer borrows (from customer) at the lending rates.
– Dealer lends to his customer at the posted borrowing rates.
il$ = 4.5% and i€l = 5.0%
Borrowing Lending i$b = 5.0%, ib€ = 5.5%.
$ 5.0% 4.50%
€ 5.5% 5.0% Bid Ask
Spot $1.42 = €1.00 $1.45 = €1.00
Forward $1.415 = €1.00 $1.445 = €1.00
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 Setting Dealer Forward Bid Price
Our dealer is indifferent between buying euros today
at the spot bid price and buying euros in 1 year at the
forward bid price.
b
$1m Invest at i$b $1m×(1+i$
)
He is willing to spend He is also willing to buy at

forward bid
spot bid

$1m today and receive b

S0b($/€)(1+i$)
1 F1b($/€) =
$1m b
× S0($/€) (1+i€b)
1 b
Invest at i 1
$1m b € $1m b ×(1+ib €
× S0($/€) × S0($/€) )
6-24
 Setting Dealer Forward Ask Price
Our dealer is indifferent between selling euros today
at the spot ask price and selling euros in 1 year at the
forward ask price.
b
€1m × Sb0($/€) Invest at i$b €1m × b
×(1+i$)
S0($/€)

forward ask
He is willing to spend He is also willing to buy at
spot ask

€1m today and receive b

€1m × Sb0($/€) S0a($/€)(1+i$)
Fa1($/€) =
(1+i€b)

€1m Invest at i€b €1m×(1+ib€)

6-25
PPP and Exchange Rate Determination
 The exchange rate between two currencies should
equal the ratio of the countries’ price levels:
P$
S($/£) =
P£
For example, if an ounce of gold costs $300 in the U.S.
and £150 in the U.K., then the price of one pound in
terms of dollars should be: S($/£) = P$ = $300 = $2/£
P£ £150
Suppose the spot exchange rate is $1.25 = €1.00. If the inflation
rate in the U.S. is expected to be 3% in the next year and 5% in
the euro zone, then the expected exchange rate in one year
should be $1.25×(1.03) = €1.00×(1.05).
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PPP and Exchange Rate Determination
 The euro will trade at a 1.90% discount in the forward
market:
$1.25×(1.03)
F($/€) €1.00×(1.05) 1.03 1 + $
= = =
S($/€) $1.25 1.05 1 + €
€1.00
Relative PPP states that the rate of change in the
exchange rate is equal to differences in the rates of
inflation—roughly 2%.
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 PPP and IRP
 Notice that our two big equations equal
each other:
PPP IRP
F($/€) 1 + $ 1 + i$ F($/€)
= = =
S($/€) 1 + € 1 + i€ S($/€)

6-28
Expected Rate of Change in Exchange
Rate as Inflation Differential
 We could also reformulate
our equations as inflation or F($/€) 1 + $
=
interest rate differentials: S($/€) 1 + €

F($/€) – S($/€) 1 + $ 1 + $ 1 + €
= –1= –
S($/€) 1 + € 1 + € 1 + €

F($/€) – S($/€)  $ – €
E(e) = = ≈ $ – €
S($/€) 1 + €
6-29
Expected Rate of Change in Exchange
Rate as Interest Rate Differential

F($/€) – S($/€) i$ – i€
E(e) = = ≈ i$ – i€
S($/€) 1 + i€
 Given the difficulty in measuring expected
inflation, managers often use a “quick and dirty”
shortcut:
$ – € ≈ i$ – i€

6-30
 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.
– Film, 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 PPP.
 PPP-determined exchange rates still
provide a valuable benchmark.
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Approximate Equilibrium Exchange
Rate Relationships
E(e)
≈ IFE ≈ FEP
≈ PPP F–S
(i$ – i¥) ≈ IRP
S
≈ FE ≈ FRPPP
E($ – £)

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 The Exact Fisher Effects
 An increase (decrease) in the expected rate of inflation
will cause a proportionate increase (decrease) in the
interest rate in the country.
 For the U.S., the Fisher effect is written as:
1 + i$ = (1 + $ ) × E(1 + $)
Where:
$ is the equilibrium expected “real” U.S. interest rate.
E($) is the expected rate of U.S. inflation.
i$ is the equilibrium expected nominal U.S. interest rate.

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 International Fisher Effect
If the Fisher effect holds in the U.S.,
1 + i$ = (1 + $ ) × E(1 + $)
and the Fisher effect holds in Japan,
1 + i¥ = (1 + ¥ ) × E(1 + ¥)
and if the real rates are the same in each country,
$ = ¥
then we get the International Fisher Effect:

1 + i¥ E(1 + ¥)
=
1 + i$ E(1 + $)
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 International Fisher Effect
If the International Fisher Effect holds,
1 + i¥ E(1 + ¥)
=
1 + i$ E(1 + $)
and if IRP also holds,
1 + i¥ F¥/$
=
1 + i$ S¥/$
then forward rate PPP holds:
F¥/$ E(1 + ¥)
=
S¥/$ E(1 + $)
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Exact Equilibrium Exchange Rate
Relationships
E (S ¥ / $ )
IFE S¥ /$ FEP

1 + i¥ PPP F¥ / $
IRP
1 + i$ S¥ /$
FE FRPPP
E(1 + ¥)
E(1 + $)

6-36
 Forecasting Exchange Rates:
Efficient Markets Approach
 Financial markets are efficient if prices reflect
all available and relevant information.
 If this is true, exchange rates will only change
when new information arrives, thus:
St = E[St+1]
and
Ft = E[St+1| It]
 Predicting exchange rates using the efficient
markets approach is affordable and is hard to
beat.
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 Forecasting Exchange Rates:
Fundamental Approach
 Involves econometrics to develop models
that use a variety of explanatory variables.
This involves three steps:
– Step 1: Estimate the structural model.
– Step 2: Estimate future parameter values.
– Step 3: Use the model to develop forecasts.
 The downside is that fundamental models
do not work any better than the forward
rate model or the random walk model.

6-38
 Forecasting Exchange Rates:
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.

6-39
 Performance of the Forecasters
 Forecasting is difficult, especially with
regard to the future.
 As a whole, forecasters cannot do a better
job of forecasting future exchange rates
than the forecast implied by the forward
rate.
 The founder of Forbes Magazine once said,
“You can make more money selling
financial advice than following it.”

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