International Parity Conditions: Dr. Ch. Venkata Krishna Reddy Associate Professor

Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance
International Parity conditions

Dr. Ch. Venkata Krishna Reddy
Associate Professor
Session Plan
International Parity conditions

– International Parity-An Overview
– Exchange Rate Determination
– Measuring Exchange Rate Movements
– Parity Conditions
• The Purchasing Power Parity Theory
• Interest Rate Parity Theory
• The Fisher Effect
Ch. Venkata Krishna Reddy
International Financial
Management
International Parity-An Overview
In international exchange, parity refers to the exchange

rate between the currencies of two countries making the
purchasing power of both currencies substantially equal.
Theoretically, exchange rates of currencies can be set at a
parity or par level and adjusted to maintain parity as
economic conditions change.
International Financial
Management
Foreign Exchange Rate Determination.

• Foreign Exchange Rate is the amount of
domestic currency that must be paid in order
to get a unit of foreign currency.

International
Method of Quotation
• Direct
• Indirect
• Cross

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Transactions Costs
Bid-Ask Spread
used to calculate the fee
charged by the bank
• Bid = the price at which the bank is willing to buy
• Ask = the price at which the bank is willing to sell the
currency
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Transactions Costs
Percent Spread Formula:
Ask  Bid
PS  x 100
Ask
International
Measuring Exchange Rate Movements

Predicting Exchange Rates
• On arbitrage and speculation
• Purchasing Power Parity (PPP)
• Interest Rate Parity (IRP)
• The International Fisher Effect (IFE)

International
Arbitrage
Business operation involving the purchase of foreign exchange, gold,

financial securities, or commodities in one market and their almost
simultaneous sale in another market, in order to profit from price
differentials existing between the markets.
Arbitrage generally tends to eliminate price differentials between

markets.

International
Mind the distinction

Arbitrage: attempt at exploiting short-term market inconsistencies in order to
extract risk-free profits.
Speculation: betting that the market will go up or down in the short-term.

Speculators take on tremendous risks.
Whenever there is high risk involved, arbitrage becomes speculation

International
Arbitrage in the foreign exchange market
Uncovered (Speculation)
Covered (True arbitrage)

International
Example of uncovered arbitrage

i(us) = 5%
i(uk) = 8%
s = $1.5
• Borrow in $ at 5%
• Buy pounds and lend at 8%
• At maturity exchange back pounds for $
• Hope that you’ll have enough to repay the loan and make an arbitrage profit
International
Example of covered arbitrage

i(us) = 5%
i(uk) = 8%
s = $1.5
f = $1.48
• Borrow in $ at 5%
• Buy pounds and lend at 8%
• At maturity exchange back pounds for $
• Repay the loan and make an arbitrage profit
International
Arbitrage (Problem with Solution)

• TD Bank (TD) trades on both the Given This
Toronto Stock Exchange (TSX) • 47*1.35= 63.45
and the New York Stock Clearly, there's an opportunity for arbitrage
Exchange (NYSE). Let's say TD is here as, given the exchange rate, TD is
trading for CAD62.50 on the TSX priced differently in both markets. A trader
can purchase TD shares on the TSX for
and USD47.00 on the NYSE. The CAD62.50 and sell the same security on the
exchange rate of USD/CAD is NYSE for USD47.00 (the equivalent of
1.35, which means that 1 U.S. CAD63.45), netting them CAD0.95 per share
dollar = CAD1.35 (63.45 - 62.50) for the transaction.
International
Purchasing Power Parity
Absolute PPP
Goods and services should cost the same regardless of the country
Relative PPP
The exchange rate is expected to adjust in order to reflect expected
relative differences in purchasing power.
International
PPP: Background
The basis for PPP is the "law of one price".
Competitive markets will equalize the price of an identical

good in two countries (expressed in the same currency).
International
Exemplification
A particular DVD player sells for:
C$ 700 in Sherbrooke
US$ 500 in Burlington
Exchange rate: US$ 1.50/C$.
Consequences
Consumers in Burlington would prefer buying it in Sherbrooke.
Result:
The DVD player price in Sherbrooke should increase to C$750

International
Caveats
(1) Transportation costs, barriers to trade, and other can make a difference.
(2) There must be competitive markets for the goods and services in question in
both countries.
(3) The law of one price only applies to tradable goods .

International
PPP: Implications
When a country's domestic price level is increasing

(inflation), the exchange rate must depreciated in order to
return to PPP.

International
Relative PPP: Calculation
E(st)/s0 = (1+inflationh)t/(1+inflationf)t
when t=1
E(s1)/s0 = (1+inflationh)/(1+inflationf)
International
PPP (Problem with Solution)

• For example, if the price of a Big Mac is $4.00 in the
U.S. and 2.5 pounds sterling in Britain, we would
expect the exchange rate to be 1.60 (4/2.5 = 1.60). If
the exchange rate of dollars to pounds is any greater,
the Big Mac index would state the pound was
overvalued, any lower and it would be undervalued.
International
The Big Mac Index

International
Food for thought

Jan 7th 1999 From The Economist print edition
For more than a decade, The Economist’s Big Mac index has offered a light-hearted guide to whether currencies are at their “correct” level.
It is based on the theory of purchasing-power parity (PPP)—the notion that a basket of goods and services should cost the same in all countries.
Thus if the price of a Big Mac is lower in one country than in America, this suggests that its currency is undervalued relative to the dollar and vice versa.
The price of a Big Mac varies in the euro area, from euro3.36 in Finland to a bargain euro2.19 in Portugal. The weighted average price in the 11 countries
is euro2.53, or $2.98 at current exchange rates.
In America a Big Mac costs only $2.63 (taking the average of three cities).
So the Euro is 13% overvalued against the dollar.

International
Big Mac Currencies Apr 27th 2000 From The Economist print edition
Some people read tea leaves to predict the future. We prefer hamburgers
Some readers beef that our Big Mac index does not cut the mustard. They are right that hamburgers are a flawed
measure of PPP, because local prices may be distorted by trade barriers on beef, sales taxes or big differences in the
cost of non-traded inputs such as rents. Thus, whereas Big Mac PPPs can be a handy guide to the cost of living in
countries, they may not be a reliable guide to future exchange-rate movements. Yet, curiously, several academic studies
have concluded that the Big Mac index is surprisingly accurate in tracking exchange rates over the longer term.
Indeed, the Big Mac has had several forecasting successes. When the euro was launched at the start of 1999, most
forecasters predicted that it would rise. But the euro has instead tumbled—exactly as the Big Mac index had signaled. At
the start of 1999, euro burgers were much dearer than American ones. Burgernomics is far from perfect, but our mouths
are where our money is.

International
Interest Rate Parity (IRP)

The forward exchange rate reflects expected relative differences in nominal interest rates.
IRP also assumes differences in nominal interest rates are driven by expected relative
differences in inflation.
ft/s0 = (1+nih)t/(1+nif)t
f1/s0 = (1+nih)/(1+nif), when t=1

International
What is the relationship between forward and future expected exchange
rates?
Some believe f = E(s)
Some believe f = E(s) + risk premium

International
IRP (Problem with Solution)

• For example, assume Australian Treasury bills are offering an annual
interest rate of 1.75%, while U.S. Treasury bills are offering an annual
interest rate of 0.5%. If an investor in the United States seeks to take
advantage of the interest rates in Australia, the investor would have to
translate U.S. dollars to Australian dollars to purchase the Treasury bill.
Thereafter, the investor would have to sell a one-year forward contract on
the Australian dollar. However, under the covered interest rate parity, the
transaction would only have a return of 0.5%, or else the no-arbitrage
condition would be violated.
International
The Fisher Effect
The Simple Fisher Effect
The International Fisher Effect

International
The Fisher Effect

Simple Fisher Effect:
Nominal interest rates equal real interest rates plus inflation premium:
(1+ni) = (1+ ri)(1+inflation)
ni = ri + inflation + (ri)(inflation),
When (ri)(inflation) is a very small number:
ni = ri + inflation
International
International Fisher Effect (IFE)

The exchange is expected to change in order to reflect expected relative differences in
nominal interest rates.
IFE assumes differences in nominal interest rates are driven by expected relative
differences in inflation.
E(st)/s0 = (1+nih)t/(1+nif)t
E(s1)/s0 = (1+nih)/(1+nif), when t=1

International
IFE (Problem with Solution)

• For example, suppose the GBP/USD spot exchange rate is 1.5339 and the current
interest rate is 5% in the U.S. and 7% in Great Britain. The IFE predicts the country
with the higher nominal interest rate (Great Britain in this case) will see its
currency depreciate. The expected future spot rate is calculated by multiplying the
spot rate by a ratio of the foreign interest rate to domestic interest rate: 1.5339 x
(1.05/1.07) = 1.5052. The IFE expects the GBP to depreciate against USD (it will
only cost $1.5052 to purchase one GBP compared to $1.5339 before) so investors
in either currency will achieve the same average return (i.e. an investor in USD will
earn a lower interest rate of 5% but will also gain from appreciation of the USD).

International
Summary
The Law of One Price - the arbitrage argument - says that goods and
services should be worth the same when compared across borders
An increase in inflation and the resulting increase in the nominal

interest rate should cause the domestic currency to depreciate.
And vice-versa.
International
Next Topic
• Management of Foreign Exchange Exposure
and Risk

International
Thank you

International

International Parity Conditions: Dr. Ch. Venkata Krishna Reddy Associate Professor

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Ethiopian Civil Service University, Addis Ababa

MSc. In Accounting and Finance

International Parity conditions

International Parity conditions

International Parity-An Overview

In international exchange, parity refers to the exchange

Foreign Exchange Rate Determination.

Ch. Venkata Krishna Reddy

Ch. Venkata Krishna Reddy

Measuring Exchange Rate Movements

Ch. Venkata Krishna Reddy

Business operation involving the purchase of foreign exchange, gold,

Arbitrage generally tends to eliminate price differentials between

Ch. Venkata Krishna Reddy

Mind the distinction

Speculation: betting that the market will go up or down in the short-term.

Whenever there is high risk involved, arbitrage becomes speculation

Arbitrage in the foreign exchange market

Covered (True arbitrage)

Ch. Venkata Krishna Reddy

Example of uncovered arbitrage

Example of covered arbitrage

Arbitrage (Problem with Solution)

Purchasing Power Parity

The basis for PPP is the "law of one price".

Competitive markets will equalize the price of an identical

Exchange rate: US$ 1.50/C$.

The DVD player price in Sherbrooke should increase to C$750

Ch. Venkata Krishna Reddy

(3) The law of one price only applies to tradable goods .

When a country's domestic price level is increasing

Ch. Venkata Krishna Reddy

Relative PPP: Calculation

PPP (Problem with Solution)

The Big Mac Index

Food for thought

So the Euro is 13% overvalued against the dollar.

Ch. Venkata Krishna Reddy

Ch. Venkata Krishna Reddy

Interest Rate Parity (IRP)

f1/s0 = (1+nih)/(1+nif), when t=1

What is the relationship between forward and future expected exchange

Some believe f = E(s)

Some believe f = E(s) + risk premium

Ch. Venkata Krishna Reddy

IRP (Problem with Solution)

The Fisher Effect

The Simple Fisher Effect

The International Fisher Effect

Ch. Venkata Krishna Reddy

The Fisher Effect

(1+ni) = (1+ ri)(1+inflation)

When (ri)(inflation) is a very small number:

International Fisher Effect (IFE)

E(s1)/s0 = (1+nih)/(1+nif), when t=1

IFE (Problem with Solution)

Ch. Venkata Krishna Reddy

An increase in inflation and the resulting increase in the nominal

Ch. Venkata Krishna Reddy

Ch. Venkata Krishna Reddy

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