Parity Conditions

 Purchasing Power Parity

 Interest Rate Parity

 International Fisher Effect

 Purchasing Power Parity

 The long run connection between inflation and exchange

rate is known by purchasing power parity principle which
was popularized by Gustav Casell in the 1920s.

 Eg. the dollar equivalent price of wheat in Britain is

P wheat = S ($/£) . P wheat

US UK

 P wheat in US =$4/b, P wheat in UK= ￡ 2.5/b, S($/ ￡ )=1.70, $

equivalent price of wheat in Britain is $1.70/ ￡ * ￡ 2.5/bushel=$4.25/b,
wheat buyers will buy from US& not UK forcing up the US price & forcing
down UK price.
 Law of one price – the connection
between exchange rates and
commodity prices is known as the
law of one price. In other words, in
the absence of frictions such as
shipping costs, tariffs,

 & so on, the price of a product when

converted into a common currency
such as the US dollar, using the spot
exchange rate, is the same in every
country. This holds due to commodity
arbitrage.
 Absolute Form of PPP condition
 If the previous eqn were to hold for each
& every good & service, & we compute
the cost of the same basket of goods &
services in Britain & the US and have
the following eqn.
PUS = S ($/£) . PUk
 The condition can be rearranged to give
the spot exchange rate in terms of the
relative costs of the basket in the two
countries;

 S ($/£) = PUS /PUk= $1000/$600=$1.67/£

 Relative Form of PPP

If PPP condition holds in its absolute form at some

moment in time that is,
PUS = S ($/£) . PUk -----------(1)

 Then at the end of 1 year for PPP to hold it is required

PUS (1+P'US)=S($/£)[1+S'($/£)].PUk(1+P'Uk) ----------(2)
‘ represents %age changeover the year.

Taking the ratios of eqn. 2 to eqn 1 we get

 (1+P'US)= [1+S'($/£)].(1+P'Uk) => S'($/£)= (1+P'US) -1

-----------(3)

(1+P'Uk)
 Or S'($/£)= P'US - P'Uk -------(4) = 0.05 - 0.10 = 0.045 the £ falls by 4.5%
1+P'Uk 1.10

If values reversed 0.10 - 0.05 = 0.48 ie pound rises by 4.8% in approximate form the
1.05
eqn can be written as S'($/£)= P'US - P'Uk -----------(5) ( holds when inflation is low)
Static form does not explain future changes
in exchange rate: need for dynamic form
Relative form of PPP
 Relative form of PPP in the presence of
shipping costs or taxes
The relative form is not necessarily violated by sales tax or
shipping costs that make prices higher than their static –form
PPP levels. For eg say British VAT or shipping costs of principal
commodity imports to Britain is higher than to US.US prices
are consistentlly; lower than British prices by the proportion t.
PUS = S ($/£) . PUk (1-t) ----(6)

If the same holds true next yr.

PUS (1+P'US)=S($/£)[1+S'($/£)].PUk(1+P'Uk)(1-t) ----(7)
Taking the ratio of eqn 7 to 6 we get the eqn 3
(1+P'US)= [1+S'($/£)].(1+P'Uk) -----(3)

eqn 4, 5 that follow from 3 are unaffected by t. The relative form of PPP
can hold even if the absolute form of PPP is consistently violated.
 Speculative form of PPP (older edition)
 The PPP condition derived from commodity arbitrage
considerations can be derived by considering the
behaviour of speculators.
 The expected return in terms of dollars from buying and
holding the basket of commodities in the US is P us’*- the
US expected rate of inflation in this basket of
commodities.
 The expected return in terms of dollars from buying and
holding the same basket of commodities in Britain is
 PUk ’* + S’* ($/£) --------(8)
 If we ignore risk and the markets are efficient, the
expected returns to buying and holding the common
basket of commodities in the two countries will be driven
to equality
 Pus’* = PUk ’*+ S’* ($/£) or S’* ($/£) =Pus’* - PUk ’* ---(9)
Speculative form of PPP
Speculative form of PPP
Speculative form of PPP
 Reasons for departures from PPP
 Restriction on movement of goods-
presence of shipping costs and import
tariffs explains departures only in its
absolute or static form. Quotas provide a
reason for persistent departures from
PPP.

 Price Indexes and Non-traded Outputs

 Statistical problems of evaluating PPP.

Condensing the whole explanation
in a formula
Interest Parity holds
 Interest Rate Parity
 In equilibrium the forward rate differs from the
spot rate by a sufficient amount to offset the
interest rate differential between two
currencies.

 Once the market forces cause the interest rates

and exchange rates to be such that covered
interest arbitrage is no longer feasible, we are
in an equilibrium state referred to as interest
rate parity (IRP).

 If the home interest rate exceeds the foreign

rate by 2 percent the forward premium on
foreign currency should be 2 % to offset the
lower rate of interest in the foreign market.
 IRP ------contd.
 There is a parallel condition that applies to financial
markets the covered interest parity, similar to PPP that
applies to goods & services markets.

 It states that when steps have been taken to avoid

foreign exchange risk, costs of borrowing & rates of
return on financial investments will be equal irrespective
of the currency of investment or the currency borrowed.

 The frictions that must be absent for covered interest

parity to hold include restrictions on the movement of
capital, transaction costs and taxes.

 Focus will be on currency of denomination rather than

the country in which a security is issued
 Determining the currency of investment
 A co. has funds to place in the money market for 3 months either in
security denominated in its own domestic currency or foreign currency
denominated security.

 If it puts in a $ investment such as a bank deposit for 3 months

each $ gives

 $ (1 + r$) where r$ is annualized $ interest rate.

4
 If Co. considers investing in a £ denominated bank
deposit. The exchange rate is S ($/£).The Co. gets for
1$
* 1/S($/ £) in pounds assuming no transaction costs
If the annualized interest rate on 3 month £ bank
deposit is r£.
* The Co. will get 1 (1 + r£) pounds -----(10)
S($/ £) 4

(1 / 1.4780 )( 1+ 0.0644 )= £ 0.6875.

4
These certain no. of £ represent an uncertain no. of $.
 Determining the currency of investment
contd--
 If the co. sells forward at the time of buying 3
month £ denominated bank deposit, the
amount of pounds to be received at maturity
i.e. £0.6875, the no. of $ that will be obtained is
set by the forward contract.

 $ F1/4 ($/£) (1 + r£) ------(11)

 S($/ £) 4
 If 3 month forward rate isF1/4 ($/£)=1.4725
 we get $1.4725/££0.6875=$1.0123.

 This implies an annual rate of return of approx

4(1.0123 - 1) = 4.93%
 1.000
 The rule for deciding the currency in
which to invest
 A 3 month $ deposit will be chosen if

 (1+ r$) > F1/4 ($/£) (1 + r£) ------(11)

4 S($/ £) 4

 £ deposit will be chosen if

 (1+ r$) < F1/4 ($/£) (1 + r£) ------(12)
4 S($/ £) 4

Only if (1+ r$)=F1/4 ($/£) (1 + r£) --------(13)

4 S($/ £) 4

investor would be indifferent since the same amount is received from dollar invested
in securities denominated in either currency.

Converting eqn 13 into a more meaningful equality if we subtract (1 + r£/ 4) from both
sides.

(1+ r$)- (1 + r£) = F1/4($/£) (1 + r£)-(1 + r£)

4 4 S($/£) 4 4
 With cancellation & rearrangement following is obtained
 r$ = r£+ 4 ( F1/4($/£)- S($/£ )( 1+ r£ ) ---------(14)
S($/£) 4
 r$ = r£ + 4 ( F1/4($/£)- S($/£ )( 1+ r£ ) ---------(14)
S($/£) 4

.
The first term on the right is the annualized pound interest rate. The second
right hand term is the annualized (because of the 4) forward premium on
pounds.

The part of the second right hand term in eqn. involves the multiplication of
two small numbers, the forward pound premium and r £ /4. This product is
very small.

Eg. if the forward premium is 5% and British interest rate is 8% per

annum , the cross-product term will be 0.001 i.e.0.05 * 0.02
or one tenth of 1% therefore we can temporarily drop the term formed from
this product.

The eqn 14 may be written in an approximate form

r$ = r£ + 4 ( F1/4($/£)- S($/£ ) ---------(15)
S($/£)
Eqn 15 can be interpreted as investors should be indifferent between home
and foreign currency denominated securities if the home currency interest
rate equals the foreign currency rate plus the annualized forward exchange
premium/discount on the foreign currency.
A mere comparison of interest rates is not sufficient for making investment
choices, we must add the foreign currency interest rate to the forward
premium or discount
 Determining the currency in which to
borrow
 A firm should borrow £ whenever the following condition
holds:

 (1+ r$) > F1/4 ($/£) (1 + r£) ------(16)

4 S($/ £) 4
 A firm should borrow $ whenever the following condition
holds:
 (1+ r$) < F1/4 ($/£) (1 + r£) ------(17)
4 S($/ £) 4
The 3 month borrower would be indifferent between $ & £ if

 (1+ r$) = F1/4 ($/£) (1 + r£) ------(18)

4 S($/ £) 4
 Covered IRP- Mathematical Statement

 It was determined that 3 month investors & borroweres

would be indifferent b/w $ & pound if
 (1+ r$) = F1/4 ($/£) (1 + r£) ------(18)
4 S($/ £) 4

If we allow for compound interest as in case for long term

investing & borrowing, investors & borrowers will be
indifferent between the $ and £ for investing & borrowing
when

 (1+ r$)n = Fn ($/£) (1 + r£)n ------(19)

S($/ £)

Eqn. 19 is the covered interest parity condition. Follows from

financial mkt. efficiency.
Market Forces Resulting in Covered Interest Parity

 Mkt forces leading to covered IP as well

as factors which might result in small
deviations from parity conditions can be
illustrated.

 Annualized 3 month forward premium

on pound –on the principal plus interest
–is drawn on vertical axis, & annualized
interest advantage of $vs pound is
shown along Xaxis.

 Diagonal is line of covered IP along

which Investors & borrowers are
indifferent b/w $ & £
borrowing/investing.

 Above the diagonal there is an

incentive to invest in pounds & borrow
dollars.

 Below diagonal there is an incentive to

invest in dollars & borrow pounds.

 In situations off the interest parity line,

forces are at work pushing us back
towards it.
Market Forces Resulting in Covered Interest Parity
 Section above origin represents a £ forward
premium & section below origin represents a £
forward discount.

 Right of origin there is a $ interest advantage,

& to left there is a dollar interest disadvantage.
 Covered interest parity expressed as:

 r$ - r£ = 4
[F1/4($/£)- S($/£ )]( 1+ r£ )
S($/£) 4
If same scale is used on 2 axes this parity
condition is represented by a 45 degree line.
This line traces the points where the 2 sides of
our eqn. are equal.
Suppose instead of equality we have the
following inequlaity
 r$ - r£ < 4 [F1/4($/£)- S($/£ )]( 1+ r£ )
S($/£) 4
This condition means, any pound forward
premium more than compensates for any $
interest advantage.
1. Covered investment in pounds yields more than
in dollars.
2. Borrowing in $s is cheaper than covered
borrowing in pounds.
Market Forces Resulting in Covered Interest Parity

* Consider pt. A, there is an incentive to borrow $s &

invest in pounds, covered.

* Borrowing in $s to profit from arbitrage opportunity

will put upward pressure on $ interest rates.

* If the borrowing is through selling $ money mkt

instrument, efforts to sell them will reduce their
prices. For given coupon or maturity values, this will
raise their yields. T

* Thus r$ will increase. Represented by force pushing

to the right of A toward the parity line.

* The second step in covered interest arbitrage

requires the spot sale of $s for £s.

* This will help bid up spot price of pounds; i.e. S($/

£) will increase. For any given F1/4 ($/ £) this lowers
the value of:
F1/4 ($/ £) - S($/£)
S($/£)
* Purchased pounds used to invest in pound
securities. If there are enough pound security buyers,
the price of pound securities will increase & therefore
pound yield will decrease ie r£ will decrease
Market Forces Resulting in Covered Interest Parity

. * This means increase in r$-r£, which is shown

by an arrow pointing to the right from A.

* Covering the funds moved abroad involves

forward sale of pounds, will lower F1/4($/£).

* For any given value of S($/£) there will be a

lower value of
F1/4 ($/ £) - S($/£) .
S($/£)
* Thus there is a second force that will also
push downward from A toward the parity
line.

* All four steps of arbitrage occur

simultaneously, all forces shown by the
arrows occur simultaneously.

* Pts B & C like A indicate profitable

opportunities for covered borrowing in $s &
investments in pounds.

* Below the parity line forces push us back

up.
Mkt forces resulting in covered IRP

 The amount of adjustment in interest rates vis-à-

vis spot &/or forward ex-rates depends on
‘thinness’ of mkts.

 Spot exchange & securities mkt are generally

more active than the forward mkt.

 It is likely that a large part of adjustment toward

covered IRP occur in forward ex-rate.

 The actual paths followed from pts such as A or E

back toward the parity line will lie closer to the
vertical arrows, than to horizontal one.
 Combining PPP & Interest rate Partiy-The
uncovered IRP condition

 Eqn. 19 is the condition for hedged or covered interest parity as it

involves use of forward rate. The Un-hedged interest parity
condition should hold as speculation will make the forward
exchange rate approx equal to the expected future spot rate.

 Sn* ($/£) =Fn($/£) ---------(20)

 if Sn* ($/£) > Fn($/£)

 speculators buy pounds forward for less than they expect to sell
them.This will force forward rate up.

 if Sn* ($/£) < Fn($/£)

 speculators sell forward pounds for more than they expect to be

able to buy them pushing forward rate down.
 Substituting eqn. 20 in 19 allows us to say that to a close
approximation uncovered interest parity should hold
 (1+ r$)n = S*($/£) (1 + r£)n ------------(21)
S($/ £)

 Eqn.21 can be put in a diff form by noting that by definition

 Sn*($/£) = S($/ £)(1+S’*)n ------------(22)
 where S’* is average annual expected rate of change of the spot exchange
rate. Substituting eqn.22 into eqn. 21 gives
 (1+ r$)n= (1+S’*)n (1+ r£)n
 Taking the nth root of both sides gives

 1+ r$= 1+S’* + r£+ S’*. r£

 Considering the interaction term will be small, a close
approximation is

 r$ - r£ = S’* -------------(23)

 The interest differential should approx equal the expected rate of

change of the spot exchange rate
 The interrelationship of Parity condition
 Expectation form of PPP

 Pus’* - PUk ’* = S’* ----(9)

 Uncovered interest rate Parity
 r$ - r£ = S’* ----(23)

 Rearranging gives
 r$ - Pus’* = r£ - PUk ’*
 The eqn. states that flow of funds will continue until the real
returns in different countries are equalized.

 Popularized by Irving Fisher and is called the Fisher open

condition.

 This condition states that the real rates of interest are equal in
different countries. From purchasing power parity & uncovered
interest parity, an equality b/w real returns is derived.
Interdependence
 Covered Interest Differences Persist

 In actual financial markets:

 Transactions costs

 Political risks

 Potential tax advantages to foreign exchange

gains vs. interest earnings

 Liquidity differences between foreign securities

and domestic securities.
Fischer effect for an economy
 Transactions cost & Interest Parity

 Covered investment or borrowing involve two foreign

exchange transaction costs- one on spot mkt & the other
in forward mkt.

 These two transactions cost discourage foreign currency

denominated investment & borrowing.

 Interest arbitrage also involves two foreign exchange

transactions costs, since the borrowed currency is sold
spot & then bought forward.

 There are additional transaction costs of interest

arbitrage due to interest-rate spreads.

 As borrowing interest rate is likely to exceed investment

interest rates.
Transactions cost & Interest Parity---contd

 Indeed because the cost of covered interest arbitrage

includes the borrowing-investing interest rate spread as
well as foreign exchange transaction costs.

 It might appear that deviations from interest parity could

be relatively large before being sufficient to compensate
for the transaction costs of covered interest arbitrage.

 It has generally become recognized that transaction costs

do not contribute largely to deviations from interest parity.

 A major reason for this recognition is the realization that

one-way arbitrage circumvents transaction costs in for-ex
& securities mkts.

 Influence of one way arbitrage on IP condition can be

explained better by contrasting it with round trip arbitrage.
Round Trip Arbitrage

 (ai) Borrowing $s & investing in pounds.

 The top leftward pointing arrow from $n

shows the interest rate on $ borrowing
which gives immediate $s, $0 in return for
paying $s back in future $n.

 The left downward pointing arrow shows

the spot exchange rate at which the
borrowed $s are exchanged into pounds:

 the pounds are purchased so the spot rate

is ask rate for pounds, S($/ask£).

 The bottom rightward pointing arrow shows

interest rate earned on pound denominated
investment which converts today’s pounds
£0 into future £n.

 Finally right upward sloping arrow shows

the forward exchange rate at which $s
needed for repaying the $ loan are
purchased with pounds, Fn($/£).
Round Trip Arbitrage---contd.

 Counterclockwise journey in the left hand

diagram in (a) from $n back to $n is seen to
involve foreign exchange transaction costs- the
ask on spot pounds S($/£) vs bid on forward
pounds Fn($/bid£), hence a bid-ask spread-

 Also involving borrowing-investment transaction

costs- borrowing rate on $s,r$b vs investment
rate on pounds, r£I

 Round trip arbitrage is expensive in terms of

facing costs in the currency & security mkts

 The right hand diagram (a) illustrates round

trip arbitrage with borrowing of pounds &
investment in dollars.

 If max possible sizes of deviations from covered

IP due to transaction costs were determined
only by round trip covered interest arbitrage,
the deviations could be considerable.

 This is because for round trip interest arbitrage

to be profitable it is necessary to overcome
transactions costs in for-ex mkts & borrowing &
lending spread on interest rates.
Interest Rate Parity in the presence of TC
 Interest Rates are taken on horizontal
axis as mid pts b/w the borrowing &
lending rates, & ex-rates on vertical
axis as mid pts. b/w bid & ask rates.

 A band around the interest parity line

within which round trip interest
arbitrage is unprofitable.

 This band has a width of

approximately ½ percent on either side
of interest parity line.

 Band reflects that arbitrage must cover

½ % lost in transaction costs.

 Above & to the left of band it is

profitable to borrow in $s & make
covered investments in pounds.

 To the right of band it is profitable to do

the reverse.
 Implications of one way arbitrage on
IRP  Consider one-way arbitrage illustrated by left-hand
diagram.

 This shows an arbitrager (or one who arbitrates)

holding $0 who wants pounds in future £n.

 The arbitrager has two choices.

 $ can be sold for pounds immediately & invested in
pound denominated securities until pounds are
needed,

 represented by downward pointing arrows on left

from $0 to £0 & the righward pointing arrow along
the bottom from £0 to £n

 or dollars can be invested in dollar securities &

forward pounds can be purchased,

 Illustrated by rightward pointing arrow on top from

$o to $n & downward pointing arrow on right from
$n to £n.

 Choice is to pick the route providing pounds at

lower cost.
 Implications of one way arbitrage on
IRP  If choice is to invest in $ securities & buy pounds
forward, each pound purchased will cost
$Fn($/ask£).

 In order to have this many $s in n yrs requires

investing today at r$I :
 $ Fn($/ask£) ----------------- (a)
 (1+r$I)n
 This is cost per pound using dollar-investment,
forward pound route from $0 to £n.

 If other choice is made,i.e to buy pounds

immediately & invest in pound denominated
securities for n yrs,

 the no. of pounds that must be purchased

immediately for each pound to be obtained in n yrs
is:
 £ 1
 (1+r£I)n

 Cost of this no. of pounds at spot price of pounds,

S($/ £) is:

 $ S($/ask£) -----------------(b)
 (1+r£I)n
 Implications of one way arbitrage on
IRP  If eqn (b) gave a lower cost per pound than eqn.
(a), there would be spot purchases of pounds &
funds invested in £ denominated securities.

 This would increase S($/ask£) & reduce r £I.

 At the same time the lack of forward purchases

would reduce Fn($/ask£), & the unwillingness to
invest in $ securities would increase r $I

 The choice b/w alternatives would drive them to

the same cost.
 Fn($/ask£) = S($/ask£)
 (1+r£I)n (1+r$I)n
 Can be rewritten as:

 (1+r$I)n = Fn($/ask£) (1+r$I)n

 S($/ask£)
 If the sizes of transactions costs in spot & forward
exchange mkts were same, this eqn is essentially
the same as eqn for interest rate parity.
Implications of one way arbitrage on IRP
 Another form of one-way interest arbitrage is
illustrated by right-hand diagram.

 Choice is b/w 2 way of going from £n to $0.

 A US exporter who is to receive pounds & needs

to borrow dollars would be interested in going
from £n to $0.

 Two way of going involve either going from £n to

£0 by borrowing pounds, & then from £0 to $0 via
the spot mkt.

 Or going from £n to $n via the forward mkt, & from

Sn to $0 by borrowing dollar.

 If route that is taken from £n to $0 that is borrow

pounds & sell them spot for dollars, the no. of
pounds that can be borrowed today for each
pound to be repaid in n yrs is :

 £ 1
 (1+r£B)n
 No. of pounds, when sold spot for dollars,
provides,

 $ S($/bid£) ----------------- c
 (1+r£B)n
Implications of one way arbitrage on IRP
 Alternative route of selling pounds forward &
borrowing $s means receiving in future for
each pound sold:
 $Fn($/bid£).

 No. of $s that can be borrowed today &

repaid with these pounds is:

 $ Fn($/bid£) ----------------- (d)

 (1+r$B)n
 Dollar amounts in eqn c & d show $s
available today, $0 for each pound in future, £n.
The choice b/w alternative ways of obtaining
$s will drive ex-rates & interest rates to the
point that:

 Fn($/bid£) = S($/bid£)
 (1+r£B)n (1+r$B)n
 Can be rewritten as:

 (1+r$B)n = Fn($/bid£) (1+r$B)n

 S($/bid£)

 If forward & spot transaction costs are equal,

this is an exact interest parity line:

 we have borrowing interest rates on both

sides, & both ex-rates are bid rates.
 Comparison b/w round trip & one way arbitrage
 Forward exchange transaction costs are slightly higher than spot costs, & so eqn

(1+r$I)n = Fn($/ask£) (1+r$I)n

S($/ask£)

& eqn(1+r$B)n=Fn($/bid£) (1+r$B)n

S($/bid£)

 might differ a little from the IRP drawn without transactions

cost.

 However, the departures will be much smaller than those

obtained from consideration of round trip interest arbitrage.

 This is because round trip arbitrage involves borrowing-

investment interest rate spread & for-ex transaction costs of
buying spot & selling forward, or of buying forward & selling
spot.

 While one-way arbitrage does not involve interest rate spreads,

& foreign ex transaction costs are faced whatever the choice.
Alternative one way arbitrage
 An arbitrager could buy pounds forward or
alternatively, could borrow dollars, buy pounds
spot & invest the pounds.

 Either way the arbitrager receives pounds in

future & has to deliver dollars.
 Fig illustrates where arbitrager can go from $n to
£n via forward mkt (downward pointing arrow on
right-hand)

 or by borrowing $s (upper leftward-pointing

arrow), buying pounds spot with the borrowed
dollars ( lefthand downward pointing arrow), &
investing in pounds (lower rightward-pointing
arrow).

 This one way arbitrage does make foreign

exchange transaction cost irrelevant or at least
less relevant, because it involves ask rates in
either case.

 However, it does not avoid the borrowing –

iinvesting spread.

 It therefore does not take us close to IRPline as

the type of one-way arbitrage considered earlier.

 We reach same conclusion if we consider the

reverse forward exchange going from £n to $n
Another alternative way of one way arbitrage
Capital gains vs Income tax

 Taxes can affect the investment & borrowing

criteria & IRP condition if investors pay
different effective tax rates on foreign
exchange earnings than on interest earnings.

 If tax rate on capital gains is lower than that

on ordinary income, this affects the slope of
the IPline.
Capital gains vs Income taxes
 Eg-
 Let US investor’s tax rate on capital gains be ‫ז‬k & US
tax rate on income as ‫ז‬y & ‫ז‬k < ‫ז‬y

 All interest earnings are considered to be income

after paying taxes & ignoring transaction costs the
US investor will receive from each $ invested in
dollar denominated securities for one year
1+(1- ‫ז‬y )r$ ------------ (1)

 The investor will lose a fraction on the interest

earned.
Capital Gains vs Income taxes
 If invested in pound securities, then before taxes the US $ receipts
will be
 F1 ($/£) (1+r£) = [ F1($/£) – S($/£) ] (1+r£) + (1+r£)
 S($/£) S( $/£)

 Total return has been expanded into earnings from ex-rates- first
term on the right side & the principal plus interest ( second term on
right side).

 After taxes, if capital gains taxes are paid even on hedged foreign
exchange earnings, the investor will receive only 1- ‫ז‬y of the interest
& 1- ‫ז‬k of any gain from a forward premium, that is
 1+(1- ‫ז‬y )r£ + (1- ‫ז‬k ) = [ F1($/£) – S($/£) ] (1+r£) + (1+r£) ---------(2)
S( $/£)
 We have used the income tax rate ‫ז‬y on r£, since all interest,
whatever the currency or country of source, is s.t. that rate.
Capital gains vs. Income Taxes
 We can show the effect of taxes in terms of graphical presentation of IP
if we proceed the same way as we did when we included transaction
costs.

 The US investor for whom we have assumed ‫ז‬k < ‫ז‬y

 Will be indifferent b/w investing in $ or £ securities if amounts in eqn 1

and 2 are equal, which requires that
 r$ -r£ = (1- ‫ז‬k ) [ F1($/£) – S($/£) ] (1+r£) ---------- (3)
(1- ‫ז‬y ) S( $/£)

 In comparing eqn. 3 with the eqn for IP line in figure drawn for 1 year
investments, which is
 r$ -r£ = [ F1($/£) – S($/£) ] (1+r£)
S( $/£)
 We see that differential taxes on income vs capital gains/ losses adds
the ratio

 (1- ‫ז‬k ) / (1- ‫ז‬y ) to the front forward premium/discount term. When the capital
gains tax rate is lower than the income tax rate,
Capital gains vs income taxes
 (1- ‫ז‬k ) >1
(1- ‫ז‬y )

 For eg, ‫ז‬k =0.10 & ‫ז‬y =0.25, then

 (1- ‫ז‬k ) = 1.20

(1- ‫ז‬y )

 This means that the line of indifference for investors who

face lower taxes on foreign exchange earnings than on
interest income is flatter than a 45 – degree IP line in
the figure considered earlier (drawn for one year
investments) is associated with more than a 1% change
in (r$- r£) on horizontal axis.
Capital gains vs income taxes
 Some investors may enjoy a lower tax rate on
foreign exchange than on interest earnings,
banks & other major players do not; such
investors, for whom
 Instruments of international trade
 Trade Draft- when an exporter gives credit to a
foreign buyer by issuing a bill of exchange
drawn up by the exporter or the exporter’s bank
stipulating the payment after the receipt of the
credit advice.

 Banker’s Acceptance: When the draft is

stamped “accepted by the importer’s bank it
becomes a banker’s acceptance. The draft is
only a commercial obligation rather than a bank
obligation, the draft will face a higher discount
than would a banker’s acceptance.

 Consignment sales-payment is not made until

after the buyer has sold the goods.
 Letter of Credit
The L/C is a guarantee by importer’s bank

that if all the relevant documents are presented

in exact conformity with the terms of the L/C
(Credit letter ) the exporter will be paid.

Eg.Importer- Aviva, US co., Exporter- British

cotton mills ;Order – 1 million yards of cloth at
£ 4/yard, shipment in 10 months & payment in
2 months after the delivery.

Aviva goes to Citibank in New York and buys

forward ( 12 months ahead) the £ 4 million,
requests an L/C, Citibank issues the letter if
satisfied with creditworthiness of Aviva for a
fee.
 Copy of the L/C sent to Citibank in London which
informs the British exporter’s bank, Britbank (advising
bank) which in turn informs the Britcorp of the credit
advice.

On receiving the credit advice the British cotton mills

start producing the denim cloth sure of payment from
Citibank, even in case of default by Aviva.

The actual payment will be made by means of a draft and

this will be drawn by the exporter or the exporter’s bank
after the receipt of the credit advice.

The draft will stipulate that payment is to be made to the

exporter at the exporter’s bank-Britbank & is different
from conventional checks drawn by those making
payment.
The draft is a usance draft if it allows a credit period ( in eg. 60-day
credit )

the bank accepts the draft if the draft and other relevant documents
are presented to the bank in exact conformity with the L/C . If the
draft is stamped and signed by an officer of Citibank, it becomes a
banker’s acceptance.

British Cotton Mills can sell the accepted draft before maturity at a
discount which reflects the interest cost of the money advanced but
not any risk associated with payment by Aviva(importer) as draft
has been guaranteed.

The most imp document that is required before a bank will accept a
draft is the bill of lading- issued by the carrier and shows that the
carrier has originated the shipment of merchandise.

The B/L can serve as the title to the goods which are owned by the
exporter until payment is made. Then, via the participating bank the
bill of lading is sent to the importer to be used for claiming the
merchandise.
Cash in advance & Confirmed Credits
 Cash in advance:Cash is sent to the supplier’s
bank before the goods are shipped.

 Confirmed credits - When an exporter’s lack of

trust concerns the importer’s bank or the
importer’s govt., the exporter asks the importer
for a letter of credit, even though this will be
issued by a bank in the importer’s country.

 The exporter takes this letter to a bank at home

and pays the domestic bank to guarantee , or
confirm the letter of credit.

 The result will be a foreign L/C with a domestic

confirmation. The exporter will than be paid by
the confirming bank regardless of what happens
to the importer’s bank or in the importer’s
country.
 Forfaiting
 A medium term non recourse exporter arranged
financing of importer’s credits.
 It involves the purchase by a bank, the
forfaiter, of a series of promissory notes,
usually due at 6 months intervals for 3to 5 yrs.
Signed by an importer in favor of an exporter.
 These notes are frequently guaranteed by
importer’s bank.
 The promissory notes are sold by the exporter
to the forfaiting bank at a discount.
 The bank pays the exporter immediately
allowing the exporter.
 Forfaiting contd---
 The notes are held by the forfaiter for collection
as they come due, without recourse to the
exporter in whose favour the notes were
originally drawn.
 This absence of recourse distinguishes the
forfaiting of promissory notes from the
discounting of trade drafts, for which the
exporter is open to recourse in case of
nonpayment.
 The discount rate that apply to forfaiting
depend on the terms of the notes, the
currencies in which they are denominated, the
credit rating of the banks avalling the notes &
the country risks of importing entities.
 Counter Trade
 Involves a reciprocal agreement for the
exchange of goods or services to circumvent
the use of a convertible currency or when
prices are kept artificially high or low.

 The parties involved may be firms or govts.

 The reciprocal agreement can take a no. of

forms:
 Barter
 Counter-purchase
 Industrial offset
 Buyback
 Switch trading
 Barter involves direct exchange of goods or
services from one country for the goods or
services of another. No money changes, no
need for L/C or drafts, credit insurance.

 Counter purchase – seller agrees with the

buyer either:

to make purchases from a co. mominated

by the buyer ( the buyer then settles up
with the co. it has nominated.

Take products from the buyer in the future

(i.e.the seller accepts credits in terms of
products)
 Industrial offset- An aircraft manufacturer might
agree to buy engines from a buyer of its aircraft.
This involves reciprocal agreements to buy materials
or components from the buying co. or country.

 Buyback – the seller of the capital equipment

agrees to buy the products made with the
equipment it supplies.

 Switch trading- A British firm sells equipment to

U.S.
 If the British firm finds a French purchase attractive
it might settle the payment by its credit held in US
provided the French co. finds the sales of US
attractive.
 The owner of the credit switches title to its credit to
the co. or country from which it is making a
purchase.