INTERNATIONAL PARITY

CONDITIONS
Dr. Tinaikar
 Topic Outline

• International Parity Conditions

• Purchasing Power Parity
• Law of One Price (LOOP)
• Absolute Purchasing Power Parity
• Relative Purchasing Power Parity
• Covered Interest Parity (CIP)
• Uncovered Interest Parity (UIP)
• Fischer Effect
International Parity Conditions

• International Parity Conditions are

economic theories relations which link:
• Exchange rates
• Price Levels (Inflation)
• Interest Rates
• These linkages may not always work but are
important in understanding the behavior of
international financial markets, especially,
international money and foreign exchange
markets
• These linkages are important for corporate
treasures, forex dealers, exporter/importers
etc.
Purchasing Power Parity
(PPP)
• Prices of identical goods sold in different
countries must be the same when
expressed in the same currency.
• This law applies in competitive markets
under the following assumptions:
• Goods produced by each country are
homogenous i.e. identical in characteristics.
• Goods produced are tradeable.
• There are no impediments to international
trade such as official trade barriers,
transportation costs etc.
 The Law of One Price
• It is PPP applied to a single good or commodity.
• It implies that the dollar price of good i is the
same wherever it is sold:

PiUS = (PiUK) x (E$/£)

where:
PiUS = $ price of good i when sold in
the U.S.
PiUK = £ price of good i when sold in U.K.
E$/£ = dollar/pound exchange rate i.e.
$ per £
The Law of One Price
• Equivalently, the dollar/pound exchange
rate is the ratio of good i’s U.S. and U.K.
money prices.

(E$/£) = (PiUS )/(PiUK)

where:
PiUS = $ price of good i when sold in
the U.S.
PiUK = £ price of good I when sold in U.K.
E$/£ = dollar/pound exchange rate i.e.
$ per £
The Law of One Price
• Law of One Price
• Disequilibrium:
• If PiUS > (PiUK) x (E$/£)  traders will buy the commodity in
UK and sell it in the US   PiUK and  PiUS till equilibrium
is attained.
• Vice-versa if PiUS < (PiUK) x (E$/£)
• Therefore, arbitrage will ensure equilibrium:

PiUS = (PiUK) x (E$/£)  E$/£ = PiUS/PiUK

The Law of One Price
• Law of One Price
• Examples:
1. If a sweater sells for $45 in New York and the
exchange rate is $1.50 per pound, then the sweater
must sell for £30 in London under the assumptions
stated before.
2. If PwheatUS = $4/bushel and PwheatUK= £2.5/bushel
and E$/£ = $1.70/£
Then, PwheatUS (=$4) < PwheatUK x E$/£ (=$4.25)
Arbitrager will buy a bushel of wheat in the US for $4
and sell it in the UK for £2.5 which at the prevailing
exchange rate will fetch him $ 4.25 i.e. profit of $0.25 per
bushel
The Law of One Price
• Law of One Price
• Example (cont..):
Price of wheat in US will increase and that of wheat in
UK will decrease till equilibrium is attained
The Law of One Price
• Problems with Law of One Price
• Goods produced in different countries may not be
homogenous
• Obstacles to equalization of product price across
countries:
• Differentiated products or globally non-traded
products
• Trade barriers such as import duties, tariffs
etc.
• Transaction and Transportation costs
• Non-competitive markets, segmented markets
• Sticky Prices - the nominal prices of many
goods and services do not change often
Absolute Purchasing Power
Parity
• Purchasing Power Parity (PPP)
• It is the application of the law of one price
across countries for all goods and services, or
typically for “baskets” of goods and services.
PUS = (PUK) x (E$/£)
PUS = price level of basket of goods and services in the US
PUK = price level of basket of goods and services in UK
E$/£ = US dollar/pound exchange rate i.e. $ per £
This is known as Absolute Purchasing Power Parity
Absolute Purchasing Power
Parity
• Absolute PPP implies :
E$/£ = PUS/PUK
• The exchange rate between US$ and £ should equal the
ratio of price levels in US and UK for baskets of common
consumption in these two countries
• If the price level in the US is US$200 per basket, while the
price level in UK is £100 per basket, PPP implies that the
US$/£ exchange rate should be:
US$200/£100 = US$ 2/£
• PPP says that each country’s currency has the same
purchasing power : 2 US$ buy the same amount of goods
and services as does 1 £
Absolute Purchasing Power Parity

• Price Level and Price Indexes

• Calculating the price level – cost of living

• Calculating a price index – ratio of price levels at two different

times
Absolute Purchasing Power
Parity
• Problems with Absolute PPP :
• Different baskets used in different countries for
computing price indices
• Even if the baskets are identical, the proportion
of items in the baskets may be different
• Non-tradable goods, services, and perishable
products which may be included in the
consumption basket
• Transaction and transportation costs
• However, PPP-determined exchange rates can
still provide a valuable benchmark
Big Mac Index:
The Economist

“Burgernomics” is based on the theory of PPP. The

Economist's Big Mac Index invented in 1986 is a light-
hearted guide to see whether currencies are at their
“correct” level, the “basket” being McDonalds' Big Mac,
which is produced locally in almost 120 countries.
The “Big Mac Index”
• The “Big Mac Index,” as christened by The Economist is a
prime example of the law of one price:
• Assuming that the “Big Mac” is identical in all countries,
applying PPP theory to Big Mac would mean that
hamburgers cost the same in all countries as in America
when expressed in US dollars
• Comparing the actual (market) exchange rate with “Big
Mac” PPP determined exchange rate indicates whether a
currency is undervalued or overvalued
• Big Mac in China costs Yuan 12.51 (local currency), while
the same Big Mac in the US costs $3.58
• The actual exchange rate is Yuan 6.84/$ at the time
The “Big Mac Index”
• The Economist then calculates the implied purchasing
power parity rate of exchange using the actual price of
the Big Mac in China over the price of the Big Mac in U.S.
dollars:
Yuan
Yuan 12.51
= 3.49/$
$3.58

• The price of a Big Mac in China in U.S. dollar-terms using

market exchange rate is therefore:
The “Big Mac Index”
• Now comparing the implied PPP exchange rate of Yuan
3.49/$, with the actual market rate of exchange at that time,
Yuan 6.84/$, the degree to which the Chinese Yuan is either
undervalued (-) or overvalued (+) versus the U.S. dollar is
calculated:
PPP Rate – Actual Rate = % Under (-) /Over (+)
Actual Rate Valuation of Yuan

Yuan 3.49/$ - Yuan 6.84/$ = -49%

Yuan 6.84/$
The “Big Mac Index”
 Research on “Big Mac Index”

• Research on Big Mac index shows that Big Mac PPP holds in
the long-run but currencies can deviate from it for lengthy
periods. The reasons why the Big Mac index may be flawed:
• It assumes that there are no trade barriers
• Prices are distorted by import duties
• Profit margins may vary according to competition
• Prices of non-traded goods (real estate, utilities, labor) are
also inputs that affect production costs
• The Economist magazine publishes their Big Mac Index twice
a year:
• http://www.economist.com/markets/Bigmac/Index.cfm
A Guide to World Prices: March 2013
How Large is India’s Economy?
Relative Purchasing Power Parity

• If the assumptions of absolute PPP theory

are relaxed, we observe Relative
Purchasing Power Parity:
• 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
Relative Purchasing Power Parity
• Relative PPP :
• Absolute PPP implies:
E$/£ = PUS/PUK
• Relative PPP states :
• Percentage change in exchange rate (‘E’)
during the period ‘t’ to ‘t+1’ is equal to
percentage change in price i.e. inflation
differential between two countries:
(E$/£,t+1 - E$/£,t)/E$/£,t = US - UK

where  = inflation for the period t to t+1

Relative Purchasing Power Parity

• The previous formula can be approximated as:

E   D   F
where, πD and πF refers to domestic and foreign inflation
respectively and E to the percentage change in the
exchange rate.
• If domestic inflation > foreign inflation, PPP
predicts that the domestic currency should
depreciate and if domestic inflation < foreign
inflation domestic currency should appreciate.
Relative PPP Example

• Given the inflation rates of 2% and 5% in US and UK

respectively what is the prediction of PPP with regards to
USD/GBP exchange rate?
Relative PPP
Et 1  Et π D  π F

Et 1

= (0.02 – 0.05)/(1) = - 0.03 = - 3.0%

The general implication of relative PPP is that countries with
high rates of inflation will see their currencies depreciate
against those with low rates of inflation. In the above case
USD should appreciate against GBP
The Real Exchange Rate

 Definition of the real exchange rate: Exchange rate

adjusted for inflation

 Real appreciations and real depreciations – changes in

exchange rate adjusted for inflation
• An increase in the nominal exchange rate S ($/€), holding
$ prices P (t,$) and euro prices P(t,euro) constant
• An increase in the € prices of goods holding the $ prices of
goods constant
• An increase in the $ prices of goods holding the € prices of
goods constant
 Trade-weighted real exchange rates i.e. Real Effective
Exchange Rate – useful when looking at how exchange rate
changes will affect trade balance
Purchasing Power Parity (PPP)
Percent change in the spot exchange
rate for home currency
4
P
3

e
lin
P
PP
2

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

-4
Evidence for PPP in the Long Run

Inflation Differentials and the Exchange Rate, 1975–2005

This scatterplot shows the relationship between the rate of exchange rate
depreciation against the U.S. dollar (the vertical axis) and the inflation differential
against the United States (horizontal axis) over the long run, based on data for a
sample of 82 countries.
Evidence for PPP in the Long Run
(Cont..)

Inflation Differentials and the Exchange Rate, 1975–2005 (continued)

The correlation between the two variables is strong and bears a close
resemblance to the theoretical prediction of PPP that all data points would appear
on the 45-degree line.
Exchange Rates and Relative
Price Levels: U.S. and U.K.
Exchange Rates and Relative
Price Levels Data for the
United States and United
Kingdom for 1975 to 2009
show that the exchange rate
and relative price levels do
not always move together in
the short run. Relative price
levels tend to change slowly
and have a small range of
movement; exchange rates
move more abruptly and
experience large
fluctuations. Therefore,
relative PPP does not hold in
the short run. However, it is a
better guide to the long run,
and we can see that the two
series do tend to drift
together over the decades.
Purchasing Power Parity:
Empirical Tests
• Empirical tests of both relative and absolute
purchasing power parity show that for the most
part, PPP is not 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
• However PPP can be used as a “benchmark” to
test whether a currency is overvalued or
undervalued against other currencies
Purchasing Power Parity Theory: Utility
• Simple theory of exchange rate determination.
• Provides baseline forecast of future exchange
rates necessary to forecast cash flows in
different currencies when inflation rates differ
across countries
• Plays a fundamental role in corporate decision
making e.g. location of plants, pricing products,
and hedging decisions.
• Helps central bankers to make appropriate
decision on market intervention in response to
overvaluation/undervaluation of home currency
Covered Interest Parity
• CIP provides the linkage or equilibrium condition
between the foreign exchange markets and the
international money markets.
• Covered Interest Parity (CIP) states that
investors earn the same returns regardless of
the two currencies in which they invest when
expressed in the same currency after hedging
exchange rate risk.
• In other words, the theory states: The interest
differential between domestic and foreign
interest rates for securities of similar risk and
maturity should be equal to the premium or
discount of the forward rate for the foreign
currency (except for transaction costs).
Covered Interest Parity
• Covered Interest Parity:
Ft, t+1– St
= i$ - i£
St
• Where i$ and i£ are the interest rates in the US and
UK respectively and St is the spot exchange rate at
time t and Ft,t+1 is the forward exchange rate
quoted at time t for delivery at time t+1 expressed
as Dollars per Pound ($/£)
• If i$ > i£ then Dollar being the high interest
currency must quote at a discount in the forward
market or Pound must quote at a premium
Covered Interest Parity
• Rearranging the terms:
Ft, t+1– St
+ i£ = i$
St
• Return in Pounds on a “covered basis” i.e.
hedging exchange rate risk is equal to return
in Dollars
• Investors must earn the same returns
regardless of the two currencies in which they
invest i.e. Dollars or Pounds
Covered Interest Parity
• If the spot and forward rates are not in a state
of equilibrium described by interest parity,
the potential for “riskless” or arbitrage profit
exists
• The arbitrager will exploit the imbalance by
investing in a currency which offers higher
return on a “covered basis” thus bringing
about equilibrium in the returns between the
two currencies
• Therefore, this is known as Covered Interest
Parity (CIP)
CIP : Assumptions
• No Transaction Costs
• Invest only if covered differential favoring
foreign assets is greater than transactions
costs
• No Cost of gathering and processing information
• Compatibility of Assets
• Assets must be identical in liquidity, maturity,
and risk class
• No Government intervention and regulation
• Capital controls, transfer risk, differential tax
treatment
• Capital market are perfections
 CIP Derivation
Consider alternative one-year investments for $1:
1. Invest in the U.S. at i$. Future Value = $1× (1 + i$)
2. Sell your $ for £ at the spot rate S$/£, and invest £ 1/S$/£ in Britain at i£ while
eliminating any exchange rate risk by selling the FV of the British
investment forward at F$/£

F$/£
Future Value = $1 × (1 + i£) ×
S$/£
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$/£
CIP Derivation
F$/£
If (1 + i£) × > (1 + i$)
S$/£
Dollars will flow from U.S. to U.K. because of higher
return on Pound-denominated securities
Dollar will depreciate against the Pound ( S$/£) in the
spot market or Pound will appreciate against Dollar
Simultaneously, Dollar will appreciate ( F$/£) in the
forward market as investors will sell Pounds and buy
Dollars to hedge exchange rate risk
The demand for Pound-denominated securities will cause
Pound interest rates to fall ( i£) while higher level of
borrowings in the US will cause Dollar interest rates to
rise ( i$)
CIP Derivation

Exploiting the above risk-less arbitrage opportunity by

several investors will equalize the returns between
Dollar and Pound denominated securities

F$/£
If (1 + i$) ×
S$/£ < (1 + i£)
Money will flow from UK to US and rates will move in
opposite direction till returns between Dollar and
Pound denominated securities are equalized

Dollar return on dollar asset = Dollar return on

pound sterling asset.
CIP in Equilibrium

• In equilibrium CIP must hold:

F$/£ × (1+ i )
(1 + i$) = £
S$/£

CIP is approximated as:

F–S
≈ i$ – i £
S

If i$ > i£ then F > S

CIP in Equilibrium

• Depending upon how you quote the exchange

rate (as £ 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.

Multi-Period CIP

• CIP states that the T-period future

exchange rate prevailing today must be:

S × (1+ i$)T
FT($/£) =
(1+ i£)T
i = ‘t’ period domestic interest rate
i*= ‘t’ period foreign interest rate
F = Forward exchange rate, t-periods from now
 Covered Interest Parity: Equilibrium
between Money and Forex Markets
• Deviation from CIP involves the following risk-less
arbitrage between international money and foreign
exchange markets to earn risk-less profit:
1. Borrow 1 unit of domestic currency @ ‘i’ and repay
(1+i) at maturity.
2. Sell 1 unit of domestic currency and buy 1/S units
foreign currency at spot exchange rate ‘S’ (units of
home currency per unit of foreign currency e.g. $
per £ )
3. Invest the foreign currency (1/S) in a deposit @
‘i*’ which will yield 1/S x (1+i*) at maturity and
simultaneously at the time of investment enter
into a forward contract ‘F’ to “lock in” a future
exchange rate at which to convert the foreign
currency proceeds back to the domestic currency.
4. Amount received at maturity of foreign currency
deposit is F/S x (1+i*)) in home currency units
Covered Interest Parity: Equilibrium
between Money and Forex Markets
• Repay the domestic loan with interest with the
amount received when the foreign currency deposit
matures or else there will be risk free arbitrage:

(1 + i) = F × (1+ i*)
Therefore,
S
CIP is approximated as:

F–S ≈ i – i*
S

If i > i* then F > S

Covered Interest Parity:
Equilibrium between Money and
Forex Markets
In Equilibrium:
Home currency return on domestic deposit =
Foreign currency return on foreign currency
deposit measured in home currency after
hedging exchange rate risk.
or
Forward premium/discount on foreign currency
= Interest differential between domestic and
foreign interest rates
Currency Yield Curves & The
Forward
Interest
Premium
yield Eurodollar
10.0 % yield curve

9.0 %
8.0 %
7.0 %
Forward premium is the
6.0 % percentage difference of 3.96%
5.0 % Euro Swiss franc
yield curve
4.0 %
3.0 %
2.0 %
1.0 %

30 60 90 120 150 180

Days Forward
Covered Interest Parity and Equilibrium

• The following exhibit illustrates the conditions

necessary for equilibrium between interest rates
and exchange rates.
• The disequilibrium situation, denoted by point
“U”, is located off the interest rate parity line.
• However, the situation represented by point “U”
is unstable because all investors have an
incentive to execute the same covered interest
arbitrage, which is virtually risk-free.
CIP and Equilibrium
Z
Y
X
Percentage premium on 4
foreign currency (¥) U
= (F-S)/S 3

-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1 4.83

Percent difference between domestic ($)

-2
and foreign (¥) interest rates i.e. (i - i*)
-3

-4
Reasons for Deviation from CIP
• Transaction Costs
• Invest only if covered differential favoring
foreign assets is greater than transactions
costs
• Cost of gathering and processing information
• Non-compatibility of Assets
• Assets must be identical in liquidity, maturity,
and risk class
• Government intervention and regulation
• Capital controls, transfer risk, differential tax
treatment
• Capital market imperfections
Reasons for Deviation from CIP
• 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.
CIP with Transactions Costs

e
F1($/€) –S0($/€)

lin
P
IR
S0($/€)

←Unprofitable “arbitrage”
opportunity

exploitable arbitrage i $ − i¥
opportunity →

Unprofitable
arbitrage
Evidence on Covered Interest Parity

Financial Liberalization and Covered Interest Parity: Arbitrage between the

United Kingdom and Germany The chart shows the difference in monthly pound
returns on deposits in British pounds and German marks using forward cover from
1970 to 1995. In the 1970s, the difference was positive and often large: traders would
have profited from arbitrage by moving money from pound deposits to mark deposits,
but capital controls prevented them from freely doing so.
Evidence on Covered Interest Parity

Financial Liberalization and Covered Interest Parity: Arbitrage between the

United Kingdom and Germany (continued)
After financial liberalization, these profits essentially vanished, and no
arbitrage opportunities remained. The CIP condition held, aside from small
deviations resulting from transactions costs and measurement errors.
Evidence on Covered Interest Parity

• There is strong empirical evidence that the CIP

condition holds for different foreign currency
deposits issued within a single financial centre.
• Currency traders often set the forward exchange
rates they quote by looking at current interest
rates, spot exchange rates using the CIP formula.
• Deviations from CIP can occur when:
• When deposits being compared are located in
different countries.
• When asset holders fear that governments may
impose regulations (political risk) that will
prevent free movement of foreign funds across
national borders.
Covered Interest Parity : Example (1)

• Assume a US dollar-based investor has $1

million to invest for 3 months (90 days) days
and can select from two investments:
• Invest in the U.S. and earn 8.0% p.a.
• Invest in Switzerland and earn 4.0% p.a.
• Problem with Swiss investment:
• Uncertainty about the future spot rate, or
what if the Swiss Franc (SFr) depreciates
against the dollar by more than 4%!!
• The investor will earn a negative return on
his investment when converted to U.S.
dollars
Covered Interest Parity : Example (1)

• Solution for investor:

• Cover the SFr exchange rate risk by selling
the SFr anticipated from the investment at
the 90 days SFr forward rate.
• But what will the 90 days SFr forward rate be
assuming spot exchange rate is SFr 1.48/$?
• In equilibrium, the forward rate must settle at
a rate to offset the interest rate differential
between the two currencies in question
• This is to insure that investments in the two
currencies will yield similar returns to prevent
covered interest arbitrage opportunities!!!
Covered Interest Parity: Example (1) (Cont..)
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)

* Rounding error. In equilibrium, SFr 1,494,800 must be equal to

$1,020,000 i.e. F90 must be SFr 1.4665/$ to prevent covered interest
arbitrage opportunity (CIP must hold)
 CIP: Example (2)
• USD interest rate = 5% p.a.; GBP interest rate = 8% p.a.
Current spot rate = $1.50/£; 1 year forward rate = $1.48/£.
Can arbitrage profits be made?

Ft ,t 1 1.48
1  id   (1  i f ) 1.05   (1.08) ??
St 1.50
1. Borrow $1m @ 5% 1.05 ≠ 1.0656
2. Purchase £666,667 Spot using $1m at $1.50/£
3. Invest £ at 8% (will receive £720,000 in one year’s time)
4. Simultaneously sell £720,000 Forward at $1.48/£ (receive $1,065,600)
5. Repay loan + interest = $1,050,000
6. ARBITRAGE PROFIT = $15,600
7. To eliminate arbitrage, £720,000 = $1.05 m or F = $1.4583/£
CIP: Example (2) (cont..)
i $ = 5.00 % per annum
(5.00 % per 360 days)
Borrow End
$1,000,000  1.05 $1,050,000 Arbitrage
Potential
Dollar money market $1,065,000

S = $ 1.5000/£ 360 days F360 = $1.48/$

Pound Sterling money market

£ 666,667  1.08 £ 720,000

i £ = 8.00 % per annum

(8.00 % per 360 days)

Assume the forward rate is 1.48. Then, the covered Pound investment
yields $1,065,000 which is $15,600 more than the U.S. investment.
CIP: Example-2 (cont..)
i $ = 5.00 % per annum
(5.00 % per 360 days)
Start End
$1,000,000  1.05 $1,050,000

Dollar money market $1,050,000

S = $ 1.5000/£ 360 days F360 = $1.4583/$

Pound Sterling money market

£ 666,667  1.08 £ 720,000

i £ = 8.00 % per annum

(8.00 % per 360 days)

In equilibrium, £720,000 must be equal to $1,050,000 i.e. F360 must

be $1.45833/£ to prevent arbitrage opportunity
 CIP: Example (2) (cont..)
• Cash Flows:
US$ £
At the time of borrowing +1000,000 -
Convert into £ @ $1.50/£ -1000,000 666,667
After 1 year pay (@ 5%)
receive (@ 8%) interest -50,000 53,333
_________ _______
Amount Paid / Received -1,050,000 720,000

No Arbitrage is possible if US$ 1.05 m = £ 0.72 m or

Forward Rate = 1.4583 US$/£

1. Borrow $1m @ 5%
2. Purchase £666,667 Spot using $1m at $1.50/£
3. Invest £ at 8% (will receive £720,000 in one year’s time)
4. Simultaneously sell £720,000 Forward at $1.48/£ (receive $1,065,600)
5. Repay loan + interest = $1,050,000
6. ARBITRAGE PROFIT = $15,600
7. To eliminate arbitrage, £720,000 = $1m or F = $1.3888/£
CIP: Example-2 (cont..)

• Covered interest arbitrage should continue

until interest rate parity is re-established,
because the arbitrageurs are able to earn
risk-free profits by repeating the cycle.
• But their actions nudge the foreign
exchange and money markets back toward
equilibrium:
• Purchase of Pounds in the spot market
and sale of £ in the forward market would
narrow the premium on forward pounds.
• The demand for pound-denominated
securities causes pound interest rates to
fall, while the higher level of borrowing in
U.S. causes dollar interest rates to rise.
CIP: Example-2 (cont..)

• In the previous example, the pound being

higher interest currency will be at a discount
of 3% to the U.S. Dollar being lower interest
currency or the U.S. Dollar will quote at 3%
premium to the Pound
• In other words, when the U.S. investor covers
exchange rate risk, the 8% Pound return is
reduced by the 3% discount, resulting in a
covered return of 5%.
CIP – Example 3

Eurodollar rate = 8.00 % per annum

Start End
$1,000,000 x 1.04 $1,040,000 Arbitrage
$1,044,638 Potential
Dollar money market

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

Yen money market

¥ 106,000,000 x 1.02 ¥ 108,120,000

Euroyen rate = 4.00 % per annum

In equilibrium F180 must be ¥ 103.9615/$ to prevent arbitrage

CIP and Indian Forex Market Example-
1 (Aug26-2016)
• Does CIP hold true in Indian Forex / Money
Markets?
• MIBOR : o/n (Call Money Rate)@ 6.51% p.a.
3-mth @ 6.92% p.a.
• LIBOR (USD) : 3-mth @ 0.83% p.a.
• USD/INR Forward Premium: 3-mth @ 6.25% p.a.

So, (F-S)/S = 6.25% p.a. (3-mth Fwd Premium)

(i-i*) = (6.92% – 0.83%)

= 6.09% p.a.
Therefore, (F-S)/S > (i-i*) or (F-S)/S + i* > i
CIP and Indian Forex Market –
Example-1 (Cont..)
• Borrow 1 INR at 3 mth-MIBOR @ 6.92% p.a.
• “Buy” USD Spot and Sell INR Spot
• Simultaneously, hedge INR-USD exchange rate risk by
“Selling” USD Forward i.e. “Buy-Sell” Swap i.e. receive
premium @ 6.25% p.a.
• Invest in 3 mth USD deposit @ 3 mth L= 0.83% p.a.
• When the USD deposit matures in 3 mths, pay back
the INR loan.
Net Profit = -6.92% + 6.25% + 0.83%
= 0.16% (in INR terms)*

* Does not include statutory costs viz. SLR, CRR etc. After
inclusion of these costs the Net Profit will be lower.
CIP and Indian Forex Market Example-
2 (Aug-2015)
• Does CIP hold true in Indian Forex / Money
Market?
• MIBOR : o/n (Call Money Rate)@ 7.25% p.a.
3-mth @ 7.68% p.a.
• LIBOR (USD) : 3-mth @ 0.329% p.a.
• USD/INR Forward Premium: 3-mth @ 6.71% p.a.

So, (F-S)/S = 6.71% p.a. (3-mth Fwd Premium)

(i-i*) = (7.68% – 0.329%)

= 7.35% p.a.
Therefore, (F-S)/S < (i-i*) or i > (F-S)/S + i*
CIP and Indian Forex Market –
Example-2 (Cont..)
• Borrow 1 USD at 3 mth-LIBOR @ 0.329% p.a.
• “Sell” USD Spot and Buy INR Spot
• Simultaneously hedge USD-INR exchange rate risk by
“buying” USD Forward i.e. “Buy-Sell” Swap i.e. pay
premium @ 6.71% p.a.
• Invest in 3 mth INR deposit @ 7.68% p.a.
• When the INR deposit matures in 3 mths, pay back the
USD loan.
Net Profit = -0.329% - 6.71% + 7.68%
= 0.641% (in USD terms)
ICE LIBOR
CIP – Arbitrage between Offshore USD Market and
INR Market

2013 Taper
Lehman crisis
Tantrum 26 Aug 2016
 10
12

-4
-2
0
2
4
6
8
Aug-15
Jul-15
May-15
Mar-15
Jan-15
Nov-14
Aug-14
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Nov-13
Aug-13
May-13
Mar-13
Dec-12
Sep-12
Jul-12
May-12
Mar-12
Jan-12
Nov-11
Sep-11
Jul-11
1Y GSEC

May-11
Mar-11
Jan-11
Lehman crisis

Nov-10
Sep-10
Jul-10
Jun-10
Market and INR Market

Mar-10
1Y MIFOR

Jan-10
Nov-09
Sep-09
Jul-09
Jun-09
2013

Mar-09
Jan-09
Tantrum

Nov-08
Taper
Arbitrage

Sep-08
Jul-08
May-08
Mar-08
Jan-08
Nov-07
Sep-07
Jul-07
May-07
Mar-07
CIP – Arbitrage between Offshore USD

Jan-07
Nov-06
Sep-06
Jul-06
Jun-06
04 Sep 2015

Apr-06
Uncovered Interest Parity (UIP)
• Uncovered interest parity (UIP) also known
as “Carry Trade”
• In the case of UIP, investors borrow in
currencies with relatively low interest rates
(‘funding currency’) and convert the
proceeds into currencies that offer much
higher interest rates (investment currency’)
without hedging exchange rate risk.
• The investor is “risk neutral” and chooses
to remain uncovered and accept the
currency risk of exchanging the higher yield
currency into the lower yielding currency at
the end of the period.
Uncovered Interest Parity (UIP)

• In Equilibrium UIP:

(1 + i) = S e
× (1+ i *
)
S

UIP is approximated as:

Se – S ≈ i – i*
S
Uncovered Interest Parity (UIP)
• In theory, according to UIP, carry trades should
not be systematically profitable because the
differences in interest rates between two
currencies should be offset by depreciation of
high-interest-rate currency against low-
interest-rate currency i.e. appreciation of low-
interest-rate currency against the high-
interest-rate one.
• In reality, carry trade weakens the currency
which is borrowed because investors sell the
low-interest-rate borrowed currency by
converting (buying) the high-interest-rate
currency causing the high-interest-rate
currency to appreciate.
Uncovered Interest Parity (UIP)

• Carry Trade is profitable as long as

the interest differential between high
interest currency and low interest
currency is greater than the
depreciation of the high interest
currency i.e. the investment
currency.
Uncovered Interest Parity (UIP)
• Yen Carry Trade:
• Over much of 2000s Bank of Japan (BOJ) had
maintained near “zero interest rate policy”
making it profitable to borrow in JPY to fund
high interest rate currencies such as AUD,
NZD, and USD.
• The Yen carry trade collapsed in 2008 following
Lehman shock and appreciation of Yen.
• The 2008-2012 Icelandic financial crisis has its
origin in undisciplined borrowing of Euro
denominated loans to purchase homes and
other assets which defaulted when Icelandic
currency depreciated dramatically making loan
repayments unaffordable and causing banking
crisis
Uncovered Interest Parity (UIP)
Example: The Yen Carry Trade
• Suppose:
• 1 year JPY interest rate ‘i’ is 0.4% p.a.
• 1 year USD interest rate ‘i*’ is 5% p.a.
• Current USD /JPY spot exchange rate ‘S’ is 120.
• USD/JPY exchange rate is expected to remain
stable over next 1 year.
• How much profit can an investor earn in JPY by
borrowing JPY 10 mio, investing in USD deposit
for 1 year and converting the earnings in USD
back into JPY?
 Uncovered Interest Parity (UIP)
Example: 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

Carry Trade Analysis- USD/JPY

USD/JPY (Nov 2012): 82.48

USD/JPY (Nov 2014): 118.63
Currency Return : 22.03% p.a.
UST 2Y Return : 0.24% p.a.
Total Return : 44.54% p.a.
Return based on
investment made
in Nov 2012 &
maturing in Nov
2014
 JGB 5Y Yield UST 5Y Yield Carry Trade Return USD/JPY Spot
80 160

70 Carry Trade
Return 150

60
As of 140
4 Sep
50 2015
USD/JPY Spot
130
40

30 120

20 110

10
100
0
UST 5Y Yield 90
-10 JGB 5Y Yield

80
-20

-30 70
Uncovered Interest Parity (UIP)
• Carry Trade Strategy:
• Choose currency pair with high positive
interest rate difference. AUD/JPY and
NZD/JPY being the most popular currencies
• Select a currency pair which has been stable
or where the high yield currency is likely to
appreciate which would given an opportunity
for an investor to stay as long as possible.
• The interest difference based on over-night
interest rates is paid on a daily basis
Uncovered Interest Parity (UIP)
• Carry Trade Strategy:
• Leverage and Margin:
• You have USD 2,000 and have borrowed
additional USD 50,000 equivalent in JPY
from a bank in Japan
• You have borrowed 25 times your own
capital i.e. leverage ratio of 25
• You conduct carry trade by investing USD
52,000 in the AUD
• The initial capital put up by the investor of
3.8% of the total investment is know as
“margin”
Uncovered Interest Parity (UIP)

• Carry Trade Strategy:

• Leverage and Margin:
• If you lose 3.8% on the trade you have lost
your initial capital investment but made
good the loss by the returns you have
made on the borrowing of USD 50,000
Uncovered Interest Parity (UIP)
• Carry Trade Strategy (Cont..):
• Example-1:
• Over much of the 2000’s, JPY interest rates were
close to zero while Australia’s interest rates were
comfortably positive climbing to 7% p.a. by spring
2008.
• The average annual interest differential between AUD
and JPY was about 5.50% p.a.
• With many people indulging in carry trade the high
yield currency appreciates. For e.g. between Jan
2001 and Dec 2007 the AUD appreciated by 70%
• The effective return earned by investors was about
75%
Interest Rates on USD and JPY Deposits: 1978-2012
Uncovered Interest Parity (UIP)
• Carry Trade Strategy (Cont..):
• Example-1 (Cont..):
• The graph in the next slide illustrates the
cumulative return of investing JPY 100 in Yen
bonds and in Australian Dollar bonds over a period
from 2003 to 2013 with initial investment being
made at the start of 2003.
• JPY investment yields next to nothing.
• AUD pays off handsome returns not only because
of high interest rate but because of appreciation
of AUD against JPY till mid-2008.
• In mid-2008 the AUD crashed against the JPY,
falling from JPY 104 to JPY 61 between July to
Dec 2008.
• This crash did not wipe out the gains in carry
trade strategy entirely if the strategy had been
initiated early enough!
Cumulative Total Investment Return in
Australian Dollar Compared to Japanese
Yen 2003-2013
Interest Rate Spreads and Exchange Rate
Changes AUD vs. JPY

Carry
trade
loses
money Carry trade makes money
when interest rate spread >
exchange rate change
Uncovered Interest Parity (UIP)
• Carry Trade Strategy (Cont..):
• Example-2:
• As of Jan 2009 the interest rates for most liquid
currencies in the world were as follows:

Australia (AUD)
4.50%
New Zealand (NZD)
2.75%
Eurozone (EUR) 1.00%

Canada (CAD) 0.50%

U.K. (GBP) 0.50%

U.S. (USD) 0.25%

Japanese Yen (JPY) 0.10%

AUD/JPY Carry Trade: Jan 2009 to Jan
2010
USD
/JPY

88.00

55.50

Jan 2009 Jan 2010

 From Jan’09 to Jan’10, JPY/AUD moved from 55.50 to 88.00 i.e.

JPY depreciated by 59.5% (AUD appreciated by 59.5%)
 With interest differential of 4.40% p.a. between AUD & JPY the
investor would have earned an effective return of about 64%
Forward Rates and Future Spot Rates

• If the forward rate equals the expected spot rate,

then the expected rate of depreciation
(between today and the future period) equals the
forward premium (the proportional difference
between the forward and spot rates):
F-S = Se - S
S S
(Forward premium) (Expected rate of depreciation)

• While the left-hand side is easily observed, the

expectations on the right-hand side are typically
unobserved.
Forward Rates as Unbiased Predictors
of Future Spot Rates
• If foreign exchange markets are “efficient”
then forward exchange rates should be
unbiased predictors of future spot exchange
rates.
• The unbiased forward rate (UFR) concept
states that the forward exchange rate, quoted
at time t for delivery at time t+1, is equal to
the expected value of the spot exchange rate
at time t+1:

Ft, t+1 = Et[St+1]

Forward Rates as Unbiased Predictors
of Future Spot Rates
• Unbiased predictor does not mean that the
future spot rate will actually be equal to the
forward rate
• Unbiased prediction simply means that the
forward rate will, on average, overestimate
and underestimate the actual future spot rate
with equal frequencies and magnitudes such
that the sum of errors (deviations) is equal to
zero
• Therefore you can either make a speculative
profit or a speculative loss. However, if you
were to conduct such uncovered arbitrage
time and again, on an average you would not
make any return
Forward Rates: Unbiased Predictor
Exchange rate

S2 F2

Error Error
S1 F3

F1 S3 Error

S4

Time
t1 t2 t3 t4
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. Over time, the sum of the errors equals zero.
Empirical Evidence on Uncovered
Interest Parity
Evidence on Interest Parity
When UIP and CIP hold,
the 12-month forward
premium should equal the
12-month expected rate of
depreciation. A scatterplot
showing these two
variables should be close
to the diagonal 45-degree
line.
Using evidence from
surveys of individual forex
traders’ expectations over
the period 1988 to 1993, UIP
finds some support, as the
line of best fit is close to
the diagonal.
Empirical Tests of UFR

• Empirical tests of efficient market hypothesis

are not conclusive
• It appears that the forward rate may not be
an unbiased predictor of the future spot rate
and that it does pay to use resources in an
attempt to forecast exchange rates.
• The existence and success of foreign
exchange forecasting services suggest that
managers are willing to pay a price for
forecast information even though they can
use the forward rate to forecast at no cost.
 Fischer Effect
• The Fisher effect states that nominal interest rates in each
country are equal to the required real interest rate plus
compensation for expected inflation.
• This equation reduces to (in approximate form):
i=r+

Where i = nominal interest rate, r = real interest rate and
= expected inflation.
• 
Empirical tests (using ex-post) of national inflation rates have
shown the Fisher effect usually exists for short-maturity
government securities (T-bills and notes).
Fischer Effect The Fisher Effect
• The international Fisher relation is inspired by the domestic
relation postulated by Irving Fisher (1930).
• The Fisher effect (also called Fisher-closed) states:

1  i   1  r  1     i  r    r
 This relation is often presented as a linear
approximation stating that the nominal interest rate is
equal to a real interest rate plus expected inflation:

i  r 
 Fischer Effect
• Applied to two different countries, home country and
foreign country, “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 in the
past.
• In equilibrium:
r r*

or

i  i*    *
 Fischer Effect
• Applied to two different countries, like U.S. 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 in the
past.
• In equilibrium:
r$ r¥
or
i$ i ¥   $  ¥
 Prices, Interest Rates and
Exchange Rates in Equilibrium
• (A) Purchasing Power Parity
• Percentage change in spot exchange rate is equal to expected
inflation differential between the two countries

(St+1 - St)/St =  - *

• (B) Covered Interest Parity

• Interest differential between home and foreign currency is equal
to premium / discount of foreign currency

F–S ≈ i – i*
S
Prices, Interest Rates and
Exchange Rates in Equilibrium
• (C) Uncovered Interest Parity (“Carry Trade”)
• Interest differential between home and foreign currency is equal
to change in expected future spot rate

(Set+1 - St)/St ≈ i – i*

• (D) Forward Rate as an Unbiased Predictor

• Forward rate is an unbiased predictor of future spot rate
assuming that the foreign exchange market is reasonably
efficient

F = Se
Prices, Interest Rates and
Exchange Rates in Equilibrium

• (E) Fisher Effect

• Nominal interest differential between two currencies is equal to
expected inflation differential between the two countries

i i *   *
Prices, Interest Rates and
Exchange Rates in Equilibrium

(Set+1 - St) /St =  - * = i – i* = (Ft+1 – St) /St

(1) (2) (3) (4)

• (1) – (2) : PPP

• (1) – (3) : UIP
• (1) – (4) : Forward Rate = Expected Future Spot Rate
• (2) – (3) : Fisher Effect
• (3) – (4) : CIP
International Parity Conditions in
Equilibrium (Approximate Form)
Forward rate Forecast change in Purchasing
as an unbiased spot exchange rate power
predictor +4% parity
(yen strengthens)
(E) (A)

Forward premium Uncovered Forecast difference

on foreign currency Interest Parity in rates of inflation
+4% +4%
(yen strengthens)
(C) (less in Japan)

Covered
Difference in nominal Fisher
Interest interest rates effect
Parity +4% (B)
(D) (less in Japan)
International Parity Conditions in
Equilibrium (Approximate Form)
Forward rate Forecast change in Purchasing
as an unbiased spot exchange rate power
predictor +4% parity
(USD strengthens)
(E) (A)

Forward premium Uncovered Forecast difference

on foreign currency Interest Parity in rates of inflation
+4% +4%
(USD strengthens)
(C) (less in US)

Covered
Difference in nominal Fisher
Interest interest rates effect
Parity +4% (B)
(D) (less in US)
Covered Interest Parity
• Covered Interest Parity:
Ft, t+1– St
St = i$ - iSF
• Where i$ and iSF are the interest rates in the US and
Switzerland respectively and St is the spot exchange rate at
time t and Ft,t+1 is the forward exchange rate quoted at
time t for delivery at time t+1 expressed as Dollars per
Swiss Francs ($/SF)
• Investors must earn the same returns regardless of the
two currencies in which they invest i.e. Dollars or Swiss
Francs
Carry Trade Analysis- USD /JPY

USD/JPY (Nov 2012): 82.48

USD/JPY (Nov 2014): 118.63
Currency Return : 22.03% p.a. Return based on
UST 2Y Return : 0.24% p.a. investment made in
Total Return : 44.54% p.a. Nov 2012 &
maturing in Nov
2014
Carry Trade Analysis- USD /JPY
CIP – Arbitrage between Offshore USD
Market and INR Market

2013 Taper
Lehman crisis
Tantrum 26 Aug 2016
CIP – Arbitrage between Offshore USD
Market and INR Market
CIP – Arbitrage between Offshore USD
Market and INR Market
Business Promotion (NJP)

Treasury Opportunity

Investing
Investing in
in Rupee
Rupee Bonds
Bonds to
to widen
widen product
product offering
offering and
and enhance
enhance customer
customer relationship
relationship

1Y AAA Bond Yield, 1Y Implied Forward, Yield Difference on Hedged Basis since 2006
QE End
Expectation
s
Start

Mar 15
Lehman
Yield

10
 Business Promotion (NJP)

Treasury Opportunity

Investing
Investing in
in Rupee
Rupee Bonds
Bonds to
to widen
widen product
product offering
offering and
and enhance
enhance customer
customer relationship
relationship

1Y GSEC Yield, 1Y Implied Forward, Yield Difference on Hedged Basis since 2006
QE End
Expectation
s
Start Mar 15

Lehman
Yield

10