M-1 Ch 2

International Parity Relationship &

Forecasting Foreign Exchange rate
International Parity Relationship
 This chapter examines several key international
parity relationships, such as interest rate parity and
purchasing power parity that have profound
implications for international financial management.
 The term arbitrage can be defined as the act of

simultaneously buying and selling the same or

equivalent assets or commodities for the purpose of
making certain, guaranteed profits. As long as there
are profitable arbitrage opportunities, the market
cannot be in equilibrium.
 The market can be said to be in equilibrium when no

profitable arbitrage opportunities exist.

Interest rate parity (IRP)
 Interest rate parity (IRP) is an arbitrage
condition that must hold when international
financial markets are in equilibrium.
 Interest rate parity (IRP) holds forward
premium or discount should be equal to the
interest rate differential between two countries.
 If IRP is violated, one can make profit by
borrowing in one currency and lending in
another with exchange risk hedged via forward
contract
Purchasing power parity (PPP)
 When the law of one price is applied
internationally to a standard commodity
basket, we obtain the theory of purchasing
power parity (PPP).
 This theory states that the exchange rate

between currencies of two countries should

be equal to the ratio of the countries' price
levels.
 Ph=home currency
 Pf= foreign currency
Video links
 https://
www.youtube.com/watch?v=7lJxSMawhfI
 https://
www.youtube.com/watch?v=iOxYbH5XyG8
International Parity Relationship &
Forecasting Foreign Exchange rate

 Calculation of Purchasing Power Parity (Step

by Step)
 Step 1: Firstly, try to figure out a good basket
or commodity which is easily available in both
the countries under consideration.
 Step 2: Next, determine the cost of the good
 basket in the first country in its own
currency. The cost will be reflective of the cost
of living in the country.

NJSMTI_ABHANI DHARA K.
 Step 3: Next, determine the cost of the good
basket in the other country in its own
currency.
 Step 4: Finally, the PPP formula of country 1

w.r.t country 2 can be computed by dividing

the cost of the good basket in country 1 in
currency 1 by the cost of the same good in
country 2 in currency 2 as shown below.

NJSMTI_ABHANI DHARA K.
 Purchasing power parity = Cost of good X in
currency 1 / Cost of good X in currency

NJSMTI_ABHANI DHARA K.