International Parity

Relationships
 Session Outline:

 Purchasing-Power Parity
 Interest Rate Parity
Purchasing Power Parity
 At a Glance
 The Law of One Price
 Absolute Form of the PPP Condition
 The Relative Form of the PPP
 Evidence on PPP
 The Law of One Price
An Example:
 Suppose a bushel of wheat costs $4 in New York and £2 in
London, which at the current exchange rate of S($/£) = 1.5
translates into $3.
 If we assume
1. there are no restrictions on the sale in the form of tariffs,
2. the transportation costs are negligible in comparison to the price
difference;
then commodity arbitragers will buy wheat in London and
ship it to New York and through their actions remove any
profitable opportunities that may exist
 Under the given assumptions, prices of the same product in
different markets must be equal
 The Law of One Price
There are three caveats with this law of one price
 Transportation costs, barriers to trade, and other
transaction costs, cannot be significant
 There must be competitive markets for the goods
and services in both countries.
 The law of one price only applies to tradeable
goods; immobile goods such as houses, and many
services that are local, are of course not traded
between countries.
 The Law of One Price
Formalization:
 The law of one price states that in the absence of frictions
such as shipping costs, tariffs and so on, the price of a
product when converted into a common currency such as the
US dollar, using the spot exchange rate, is the same in every
country.
pUSwheat = S($/£). pUkwheat …………………………
(1)

 When the law of one price does not hold, buying decisions
help restore the equality.
 Absolute Form of the PPP Condition
 If equation (1) were to hold for each and every
goods and service, we would expect to find that
pUS = S($/£). pUk ………………………… (2)

 Equation (2) is the absolute form of the purchasing-

power parity condition.
 The exchange rate between two currencies should equal the
ratio of the countries’ price levels:
p US
S($/£) =
p uk
HEADLINES
The Big Mac Index
For more than 20 years, The Economist newspaper has
engaged in a whimsical attempt to judge PPP theory based a
well-known, globally uniform consumer good: the McDonald’s
Big Mac. The over- or undervaluation of a currency against
the U.S. dollar is gauged by comparing the relative prices of a Home of the undervalued burger?
burger in a common currency, and expressing the difference
as a percentage deviation from one:

 E P Big Mac

1    1
Big Mac $/local currency local
Big Mac Index  q
 P Big Mac 
 US 
The Big Mac Index The table shows the price of a Big Mac in July 2009 in local
currency (column 1) and converted to U.S. dollars (column 2) using the actual exchange
rate (column 4). The dollar price can then be compared with the average price of a Big
Mac in the United States ($3.22 in column 1, row 1). The difference (column 5) is a
measure of the overvaluation (+) or undervaluation (−) of the local currency against the
U.S. dollar. The exchange rate against the dollar implied by PPP (column 3) is the
hypothetical price of dollars in local currency that would have equalized burger prices,
which may be compared with the actual observed exchange rate (column 4).
The Big Mac Index (continued)
The Big Mac Index (continued)
 Absolute Form of the PPP Condition
Absolute PPP is a deviation from reality!
 The reason is that as tastes and needs differ across countries,
different baskets of goods are used in different countries for
computing price indices.
 For example, Indians consume more rice and less burger than
Americans. If price of rice increases more than burgers, India
would have more inflation than US, even though prices of rice
and burgers increased the same amount in both countries.
 This means that even if the law of one price holds for each
individual good, price indices, which depend on the weights
attached to each good, will not confirm to the law of one price
 The Relative Form of PPP
An alternative form of PPP condition stated in terms of inflation
rates
 If inflation is 12% in the India and 8% in US, then the rupee
must depreciate by about 4% to equalize the price of goods in the
two countries.
 That is the exchange rate change during a period should equal
the inflation differential for that same time period.
 In effect, PPP says that currencies with high rates of inflations
should devalue relative to currencies with lower rates of
inflation.
 PPP Deviations and the Real Exchange Rate
 The real exchange rate (RER) is the nominal exchange rate adjusted
for changes in the relative purchasing power of each currency.
 The real exchange rate at time t, εt, which measures home currency
(HC) per unit of foreign currency (FC), relative to the base period
(specified as time 0) is defined as
εt = St (P*/P)
where S is nominal exchange rate of HC per unit of FC, P* is the
foreign price level and P is the home price level at time t.
 The real exchange rate measures the amount of purchasing power in
US that must be sacrificed for each unit of purchasing power in India.
 The REER is an average of the bilateral RERs between the country and
each of its trading partners, weighted by the respective trade shares
of each partner.
Nominal versus Real Exchange Rate

 one good: Big Mac

 price in US:
P* = $2.5
 price in India:
P = INR 100
 nominal exchange rate
e = 60 Yen/$

To buy a U.S. Big Mac, someone from

India would have to pay an amount
that could buy 1.5 Indian Big Macs.

16
 Nominal versus Real Exchange Rate
 In the real world:
We can think of ε as the relative price of a basket of foreign
goods in terms of a basket of Indian goods
ε  Foreign goods become more expensive relative to Indian goods
 IM, EX
 NX

 The net exports function reflects this direct relationship between

NX and ε : NX = NX (ε )

17
 Evidence on PPP
 PPP probably doesn’t hold precisely in the real world for a variety of
reasons. PPP-determined exchange rates still provide a
valuable benchmark.
 One can use the PPP-determined exchange rate as a benchmark
in deciding if a country’s currency is undervalued or overvalued
against other currencies
 One can often make more meaningful international comparisons
of economic data using PPP-determined rather than market-
determined exchange rates
 Suppose we want to rank countries in terms of gross national
income (GNI). If we use market exchange rates, one can
either underestimate or overestimate the true GNI values.
 In the example for the year 2005, India ranks 10th when
market exchange rate is used. However, when the PPP
exchange rate is used, India moves to 4th position
How can you explain this divergence between two rankings?
Interest Rate Parity
 At a Glance
 Interest Rate Parity Defined
 Covered Interest Arbitrage
 Interest Rate Parity & Exchange Rate Determination
 Reasons for Deviations from Interest Rate Parity
 Interest Rate Parity Defined
 The purchasing-power parity condition applies to goods and
services markets.
 There is an important parallel condition that applies to financial
markets, interest rate parity condition.
 IRP states that when steps have been taken to avoid foreign
exchange risk, costs of borrowing and rates of return on
financial instruments will be equal irrespective of the currency
of investment or currency borrowed.
 IRP is thus a no-arbitrage condition.
 If IRP did not hold, then it would be possible for an astute
trader to make unlimited amounts of money exploiting the
arbitrage opportunity
 Determining the Currency of Investment
The Problem

Suppose an Indian firm X has Rs.1,00,000 which it wants to invest in

the money market for one year. It has two alternatives: either
purchase securities denominated in its own currency, or invest in
foreign currency-denominated securities.
Question
Should it buy money-market securities denominated in domestic or in
foreign currency?
Remember
• Realized yields on foreign currency-denominated securities depend on
what happens to exchange rates as well as on interest rates
• If the value of the foreign currency in which the firm X’s investments
are denominated happens to fall unexpectedly before maturity, then
there will be a foreign exchange loss when converted into rupees.
 Determining the Currency of Investment
Solution:
 Invest in an INR investment such as a bank deposit at iRs.
Future value = Rs.1,00,000 × (1 + iRs.)

 Invest in a dollar-denominated bank deposit at i$ and that the

spot Rs./$ exchange rate is denoted by S(Rs./$). Future value
= $1,00,000(1 + i$)/S(Rs./$).

 For example, if S(Rs./$) = 40 and i$ = 0.065, then Rs.

1,00,000 invested in dollar-denominated bank deposits will
provide after 1 year = $2662.5
 Determining the Currency of Investment
 This certain amount of dollars represents an uncertain number of
rupees. So a forward contract can offer a complete hedge and
guarantee the number of rupees that will be finally received.
 If at the time of buying the one year dollar-denominated deposit, firm X
sells forward the amount of dollars to be received at maturity, then the
number of rupees that will be obtained is set by the forward contract.
 After 1 year, firm X delivers the US dollars and receives the amount of
rupees stated in the forward contract.
 Thus, if the 360 day forward rate at the time of investment is
F360(Rs./$), then future value = $1,00,000(1 + i$) x F360/S(Rs./$).
 In our example, if F360=38, then the number of dollars $2662.5 will
provide Rs.2662.5 x 38 = Rs.1,01,175, when sold forward for rupees.
This implies an annual rate of return of approximately (1,01,175-
1,00,000)/1,00,000 = 0.01175 or 1.75%
 The yield on dollar-denominated deposits when the proceeds are sold
forward is called the covered or hedged yield
 Determining the Currency of Investment
Rule for deciding the currency in which to invest
 If (1 + iRs.)> (1 + i$) x F360 (Rs./$)/S(Rs./$), investor should
choose a one-year INR deposit, rather than a dollar deposit.
 If (1 + iRs.)< (1 + i$) x F360 (Rs./$)/S(Rs./$), investor should
select a dollar deposit, rather than the INR deposit.
 If (1 + iRs.)= (1 + i$) x F360 (Rs./$)/S(Rs./$), the investor
should be indifferent, since the same amount will be received
from a rupee invested in securities denominated in either
currency.
 Borrowing and Investing for Arbitrage Profit
What will happen if the firm need to borrow for three months?
 Suppose that a firm can borrow rupees for 3 months at an annualized
interest rate of iRs. For each rupee it borrows, it must repay Rs. (1+
iRs/4)
 Using each borrowed rupee, the firm can buy 1/S(Rs./$) dollars
 If these dollars are invested for 3 months at i$ per annum, and if the
resulting receipts are sold forward, the firm will receive
Rs. (1 + i$/4)x F90 (Rs./$)/S(Rs./$)
 Borrowing in rupees and simultaneously investing in dollars will result in
a profit, if
(1 + iRs/4)< (1 + i$/4)x F90 (Rs./$)/S(Rs./$)
 The reverse activity, i.e., borrowing in dollars and investing in rupees
will be profitable if the reverse inequality holds.
 As long as inequality holds, it pays to borrow in one currency and
lend/invest in another. Borrowing and investing in this way with
exchange-rate risk hedged in the forward market is known as covered
interest arbitrage.
 The Covered Interest Parity Condition
 Investors and borrowers would be indifferent between rupees
and dollars if
(1 + iRs)=(1 + i$) x Fn (Rs./$)/S(Rs./$)

 If this equation holds, no covered arbitrage is profitable. This

is the covered interest parity condition.
 When this condition holds, there is no advantage to covered
borrowing or investing in any particular currency or from
covered interest arbitrage.
The Covered Interest Parity Condition
Formally

1 + iRs. FRs./$
=
1 + i$ SRs./$
or,
iRs. – i$ FRs./$ - SRs./$
=
1+i$ SRs./$

which is sometimes approximated as

FRs./$ - SRs./$
iRs. – i$ ≈
SRs./$
 Implications for Exchange Rate Determination
 Being an arbitrage equilibrium condition involving the (spot)
exchange rate, IRP has an immediate implication for exchange
rate determination.
 Reformulate the IRP relationship as
S(Rs./$)=[1+i$/1+iRs.]F(Rs./$)
 This equation shows that given the forward exchange rate, the
spot exchange rate depends on relative interest rates.
 All else equal, an increase in the Indian interest rate will lead
to a higher foreign exchange value of rupee
 This is so because a higher interest rate in India will attract
capital to the country, increasing the demand for rupees.
 Implications for Exchange Rate Determination
 In addition to relative interest rates, the forward exchange
rate is an important factor in spot exchange rate
determination.
 Under certain conditions the forward exchange rate can be
viewed as the expected future spot exchange rate conditional
on all relevant information available now, that is, F = E(St+1|It)

 Thus we may write

S=[1+i$/1+IRs.]E(St+1|It)
 Implications for Exchange Rate Determination
Observations
 Expected future exchange rate is a major determinant of current
exchange rate; when people “expect” the exchange rate to go up in
the future, it goes up now. People's expectations thus become self-
fulfilling.
 Exchange rate behaviour will be driven by news events. People form
their expectations based on the set of information (It) they possess.
As they receive news continuously, they are going to update their
expectations regularly.
 Thus the exchange rate will tend to exhibit a dynamic and volatile
short-term behaviour, responding to various news events.
 Since news events are unpredictable, forecasting future exchange
rates is an arduous task
 The Uncovered Interest Parity Condition
 When the forward exchange rate F is replaced by the expected
future spot exchange rate E(St+1), the IRP condition, derived
earlier, becomes
(iRs.– i$)/(1+i$) =[E(St+1) – St]/ St
or, (iRs.– i$)/(1+i$) = E (e) ,
or, (iRs.– i$) ≈ E (e)
where, E (e) = expected rate of change in exchange rate
 Thus the interest rate differential between a pair of countries is
(approximately) equal to the expected rate of change in exchange
rates.
 This relationship is known as the uncovered interest rate parity.
 Uncovered Interest Arbitrage
 A deviation from covered interest arbitrage is uncovered
interest arbitrage (UIA).
 In this case, investors borrow in countries and currencies
exhibiting relatively low interest rates and convert the proceed
into currencies that offer much higher interest rates.
 The transaction is “uncovered” because the investor does not
sell the higher yielding currency proceeds forward, choosing 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 Arbitrage
 In the yen carry trade, the investor borrows Japanese yen at
relatively low interest rates, converts the proceeds to another
currency such as the U.S. dollar where the funds are invested
at a higher interest rate for a term.
 At the end of the period, the investor exchanges the dollars
back to yen to repay the loan, pocketing the difference as
arbitrage profit.
 If the spot rate at the end of the period is roughly the same as
at the start, or the yen has fallen in value against the dollar,
the investor profits. If, however, the yen were to appreciate
versus the dollar over the period, the “uncovered” investment
may result in significant loss.
Uncovered Interest Arbitrage
Investors borrow yen at 0.40% per annum
Start End
x 1.004 ¥ 10,040,000 Repay
¥ 10,000,000 ¥ 10,500,000 Earn
Japanese yen money market
¥ 460,000 Profit

360 days S360 = ¥ 120.00/$

S =¥ 120.00/$

US dollar money market

x 1.05 $ 87,500,000
$ 83,333,333

Invest dollars at 5.00% per annum

 Combining PPP and IRP
 PPP (relative form) is written as: p Rs.  p $  S ( Rs. / $)

* * 
 Taking expectations on both sides, we get p Rs.  p $  E [ S ( Rs. / $)]  E (e)

 The (uncovered) IRP condition states that (iRs.– i$) ≈ E (e)

 Thus we get p *Rs.  p $*  i Rs.  i$

* *
Or,  
i Rs.  p Rs.  i$  p$
Combining PPP and IRP

The interest rate minus expected inflation is the

real interest rate and the condition is known as
the Fisher-open condition

The Fisher-open condition is the condition that the

real rates of interest are equal in different
countries.
Because each of the three parity conditions are
derived from the other two, any one condition
must be correct if the other two are correct.