INTERNATIONAL FINANCE

Theories of FX
Determination
Theories of FX Determination

Introduction to FX Determination
 FX Determination
• Models of Exchange Rate Determination
- We will presents simple models of exchange rate
determination. These models apply arbitrage arguments in
different contexts to obtain equilibrium relations that determine
exchange rates.
- We define arbitrage as the activity that takes advantages of
pricing mistakes in financial instruments in one or more
markets, facing no risk.
- Financial markets are said to be in equilibrium if no arbitrage
opportunities exist.
- The equilibrium relations derived in this chapter are called
parity relations.
- Because of the underlying arbitrage argument, parity relations
establish situations where economic agents are indifferent
between two financial alternatives. Thus, parity relations provide an
“equilibrium” value or a “benchmark.”
 - These benchmarks are very useful. For example, based on a
parity benchmark, investors or policy makers can analyze if a
foreign currency is “overvalued” or “undervalued.”
• Fundamentals that affect FX Rates: Formal Theories
- Inflation rates differentials (ICOP - IFC) PPP
- Interest rate differentials (iCOP - iFC) IFE
- Income growth rates (yCOP - yFC) Monetary Approach
- Trade flows Balance of Trade
- Other: trade barriers, expectations, taxes, etc.
• Objective
- Explain St with a theory, say T1. Then, StT1 = f(.)
- Different theories can produce different f(.)’s.
- Evaluation: How well a theory match the observed behavior of
St, say the mean and/or variance.
=> Eventually, produce a formula to forecast St+T = f(Xt) =>
E[S ].
• We want to have a theory that can match the observed S t. It is not
realistic to expect a perfect match, so we ask the question: On average, is
St ≈ StT1 ? Or, alternatively, is E[St] = E[StT1]?

MXN/USD

18
16
14
12
10
S(t)

8
6
4
2
0
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
• Like many macroeconomic series, exchange rates have a trend –in
statistics the trends in macroeconomic series are called stochastic trends.
It is better to try to match changes, not levels.
• Let’s plot changes of MXN/USD exchange rate. Now, the trend is gone.

Changes in MXN/USD

0.8

0.6

0.4
Changes

0.2

0
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
-0.2

• Our goal is to explain ef,t, the percentage change in St. Again, we will
try to see if the model we are using, say T1, matches, on average, the
observed behavior of ef,t. For example, is E[ef,t] = E[ef,tT1]?
• We will use statistics to formally tests theories.
• Let’s look at the distribution of ef,t for the USD/MXN. –in this case, we
look at monthly percentage changes from 1986-2011.
Changes in USD/MXN - Histogram
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
3 0 6 3 0 6 3 9 6
.3 0 .3 0 .2 0 .2 0 .2 0 .1 0 .1 0 .0 0 .0 0 .0
2 01 04 08 11 15 18 22 25
-0 - - - - - - - - - 0. 0. 0. 0. 0. 0. 0. 0.

• The average (“usual”) monthly percentage change is a 0.9%

appreciation of the USD (annualized -11.31% change). The SD is 4.61%.

• These numbers are the ones to match with our theories for St. A good
theory should predict an average annualized change close to -11% for e f,t
• Descriptive stats for st for the JPY/USD and the USD/MXN.
JPY/USD USD/MXN
Mean -0.0026 -0.0090
Standard Error 0.0014 0.0026
Median -0.0004 -0.0027
Mode 0 0
Standard Deviation 0.0318 0.0460
Sample Variance 0.0010 0.0021
Kurtosis 1.6088 18.0321
Skewness -0.2606 -2.1185
Range 0.2566 0.5833
Minimum -0.1474 -0.3333
Maximum 0.1092 0.2500
Sum -1.2831 -2.7354
Count 491 305

• Developed currencies: less volatile, with smaller means/medians.

International Parity Conditions

Purchasing Power Parity

Interest Rate Parity
International Fisher Effect
 Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP)
PPP is based on the law of one price (LOOP): Goods, once denominated
in the same currency, should have the same price.

If they are not, then some form of arbitrage is possible.

Example: LOOP for Oil.

Poil-USA = USD 80.
Poil-SWIT = CHF 160.
 StLOOP = USD 80 / CHF 160 = 0.50 USD/CHF.
If St = 0.75 USD/CHF, then a barrel of oil in Switzerland is more
expensive -once denominated in USD- than in the US:
P (USD) = CHF 160 x 0.75 USD/CHF = USD 120 > P
Example (continuation):
Traders will buy oil in the US (and export it to Switzerland) and sell
the US oil in Switzerland. Then, at the end, traders will sell CHF/buy
USD.
This movement of oil from the U.S. to Switzerland will affect prices:
Poil-USA↑; Poil-SWIT↓; & St↓ => StLOOP ↑ (St & StLOOP converge) ¶

LOOP Notes :
⋄ LOOP gives an equilibrium exchange rate.
Equilibrium will be reached when there is no trade
in oil (because of pricing mistakes). That is, when
the LOOP holds for oil.
⋄ LOOP is telling what St should be (in equilibrium). It is not telling
what St is in the market today.
⋄ Using the LOOP we have generated a model for St. We’ll call this
model, when applied to many goods, the PPP model.
Problem: There are many traded goods in the economy.

Solution: Use baskets of goods.

PPP: The price of a basket of goods should be the same across countries,
once denominated in the same currency. That is, USD 1 should buy
the same amounts of goods here (in the U.S.) or in Colombia.
Absolute version of PPP: The FX rate between two currencies is simply
the ratio of the two countries' general price levels:
StPPP = Domestic Price level / Foreign Price level = Pd / Pf

Example: Law of one price for CPIs.

CPI-basketUSA = PUSA = USD 755.3
CPI-basketSWIT = PSWIT = CHF 1241.2
 StPPP = USD 755.3/CHF 1241.2 = 0.6085 USD/CHF.

If St  0.6085 USD/CHF, there will be trade of the goods in the basket

between Switzerland and US.

Suppose St = 0.70 USD/CHF > StPPP.

Then, PSWIT (in USD) = CHF 1241.2*0.70 USD/CHF
= USD 868.70 > PUSA = USD 755.3
Example (continuation):
PSWIT (in USD) = CHF 1241.2*0.70 USD/CHF
= USD 868.70 > PUSA = USD 755.3
Potential profit: USD 868.70 – USD 755.3 = USD 93.40

Traders will do the following arbitrage strategy:

1) Borrow USD
2) Buy the CPI-basket in the US
3) Sell the CPI-basket, purchased in the US, in Switzerland.
4) Sell the CHF/Buy USD
5) Repay the USD loan, keep the profits.

Note: “Equilibrium forces” at work:

2) PUSA ↑ & 3) PSWIT ↓ (=> StPPP↑)
4) St ↓.
• Real v. Nominal Exchange Rates
The absolute version of the PPP theory is expressed in terms of S t, the nominal
exchange rate.

We can modify the absolute version of the PPP relationship in terms of the real
exchange rate, Rt. That is,
R t = S t P f / Pd .

It compares the value of a basket of goods in two different countries expressed

in the same currency

Rt allows us to compare prices, translated to DC:

If Rt > 1, foreign prices (translated to DC) are more expensive
If Rt = 1, prices are equal in both countries –i.e., PPP holds!
If Rt < 1, foreign prices are cheaper
Example: Suppose a basket –the Big Mac- cost in Switzerland and in the
U.S. is CHF 6.23 and USD 3.58, respectively.
Pf = CHF 6.23
Pd = USD 3.58
St = 1.012 USD/CHF => Pf = USD 6.3048

Rt = St PSWIT / PUS =1.012 USD/CHF x CHF 6.23/USD 3.58 = 1.7611.

Taking the Big Mac as our basket, the U.S. is more competitive than
Switzerland. Swiss prices are 76.11% higher than U.S. prices, after
taking into account the nominal exchange rate.
To bring the economy to equilibrium –no trade in Big Macs-, we expect
the USD to appreciate against the CHF.

According to PPP, the USD is undervalued against the CHF.

=> Trading signal: Buy USD/Sell CHF.
• The Big Mac (“Burgernomics,” popularized by The Economist) has
become a popular basket for PPP calculations. Why?
1) It is a standardized, common basket: beef, cheese, onion, lettuce,
bread, pickles and special sauce. It is sold in over 120 countries.

Big Mac (Sydney) Big Mac (Tokyo)

2) It is very easy to find out the price.

3) It turns out, it is correlated with more complicated common baskets,
like the based baskets.
• In the previous example, Swiss traders can import US BMs.

From United States to

Switzerland

• This is not realistic. But, the components of a BM are internationally

traded. The LOOP suggests that prices of the components should be the
same in all markets.

The Economist reports the real exchange rate: Rt = StPBigMac,f/PBigMac,d.

For example, for Norway’s crown (NOK): Rt = 7.02/3.58 = 1.9609

=> (96.09%
overvaluation)
Example: (The Economist’s) Big Mac Index (January 2011)
Rt = StPBigMac,f/PBigMac,d (US=domestic) => Rt=1 under Absolute PPP
Example: (The Economist’s) Big Mac Index (July 2015)
=> Rt changes over time!
Example: Iphone 6 (March 2015, taken from seekingalpha.com).
Rt = StPIPhone,f/PIPhone,d (US=domestic) => Rt=1 under Absolute PPP
• Evidence PPP
The PPP has been subject of a series of tests, yielding generally negative
results

Explaining the problems with PPP...

The failure of the empirical evidence to support the PPP and the law of
one price is related to:
- Trade barriers and transport costs
- Non-tradable goods
- Departures from free competition
- International differences in price level measurement

Note: In the short-run, we will not take our cars to Ecuador to be

repaired, but in the long-run, resources (capital, labor) will move. We
can think of the over-/under-valuation as an indicator of movement of
resources.
 Relative Purchasing Power Parity (RPPP)
• If the assumptions of the absolute version of the PPP theory are
relaxed a bit more, we observe what is termed relative purchasing
power parity (RPPP)

• RPPP holds that PPP is not practically helpful in determining what the
spot rate is today, but that the relative change in prices between two
countries over a period of time determines the change in the exchange
rate over that period.
Relative PPP
The rate of change in the prices of products should be similar when
measured in a common currency (as long as trade frictions are unchanged):

S t T  S t (1  I d )
f ,T 
e PPP   1 (Relative PPP)
St (1  I f )
where,
If = foreign inflation rate from t to t+T;
Id = domestic inflation rate from t to t+T.
Note: ef,TPPP is an expectation; what we expect to happen in equilibrium.

• Linear approximation: ef,TPPP  (Id - If)

Example: From t=0 to t=1, prices increase 10% in Mexico relative to

prices in Switzerland. Then, St should also increase 10%; say, from S0=9
MXN/CHF to S1=9.9 MXN/CHF. Suppose S1>9.9 MXN/CHF, then
according to Relative PPP the CHF is overvalued.
Example: Forecasting St (USD/ZAR) using PPP (ZAR=South Africa).
It’s 2013. You have the following information:
CPIUS,2013 = 104.5,
CPISA,2013 = 100.0,
S2011 =.2035 USD/ZAR.
You are given the 2014 CPI’s forecast for the U.S. and SA:
E[CPIUS,2014] = 110.8
E[CPISA,2014] = 102.5.

You want to forecast S2014 using the relative version of PPP.

E[IUS-2014] = (110.8/104.5) - 1 = .06029
E[ISA-2014] = (102.5/100) - 1 = .025

E[S2014] = S2013 x (1 + ef,TPPP ) = S2013 x (1 + E[IUS]- E[ISA])

= .2035 USD/ZAR x (1 + .06029 - .025) = .2107 USD/ZAR.
RPPP Evidence:
• Relative PPP tends to be rejected in the short-run (like in the example
above). In the long-run, there is a debate about its validity. Researchers
find that currencies with high inflation rate differentials tend to depreciate.
• The long-run interpretation for PPP is the one that economist like and
use. PPP is seen as a benchmark, a figure towards which the current
exchange rate should move.

• PPP Summary of Applications:

⋄ Equilibrium (“long-run”) exchange rates. A CB can use StPPP to
determine intervention bands.
⋄ Explanation of St movements (“currencies with high inflation rate
differentials tend to depreciate”).
⋄ Indicator of competitiveness or under/over-valuation: Rt > 1 => FC is
overvalued (& Foreign prices are not competitive).
⋄ International GDP comparisons: Instead of using St, StPPP is used. For
example, per capita GDP.
 BRIEF ASSESMENT
1. If the actual exchange rate for the euro value of the British pound is
less than the exchange that would satisfy absolute PPP, which of the
currencies is overvalued and which undervalued? Why?
2. Suppose that the rate of inflation in Japan is 2% in 2018. if the rate
of inflation in Germany is 5% during 2018, by how much would the
yen strengthen relative to the euro if relative PPP is satisfied during
2018?
3. One of your colleagues thinks that the dollar is severely undervalued
relative to the yen. He has calculated that the PPP exchange is 140
yen per dollar, whereas the current exchange rate is 105 yen per
dollar. Because interest rates are 3% p.a. lower in Japan than in the
US, he thinks that this is a good time to speculate by borrowing yen
and lending dollars. What do you think?
International Parity Conditions

Purchasing Power Parity

Interest Rate Parity
International Fisher Effect
 Covered Interest Arbitrage
• Example:
- EUR/USD 1.2762
1 month 1.2786
3 months 1.2836
6 months 1.2905
- Forward rates are often expressed as (annualized) percentage
differences from the current spot rate – called the forward
premium/discount
- Formula: FP = [(F – St) / St](360 / n)
e = nominal exchange rate = domestic currency / foreign exchange
- FP(1 month) = [(F – e) / e](360 / n) = [(1.2786 –
1.2762) / 1.2762](360/30) = 0.0226
The 30 Day EUR is selling at a premium of 2.26%
- Calculate forward premium for 3/6 months
• Example (continuation):
- Currency markets
USD/EUR 1.2762 The Euro 1 month forward is
1 month 1.2786 selling at a 2.26% premium
3 months 1.2836
6 months 1.2905

- Money markets
LIBOR (Dollar denominated)
1 month 5.08%
3 months 5.21%
6 months 5.31%

- Money markets
LIBOR (Euro denominated) (i – i*) = (5.08 – 2.82) = 2.26%
1 month 2.82%
3 months 3.00% IS THIS JUST A CRAZY
6 months 3.09% COINCIDENCE??
• Example (continuation):
- Currency markets
USD/EUR 1.2762 The Euro 3 month forward is
1 month 1.2786 selling at a 2.32% premium
3 months 1.2836
6 months 1.2905

- Money markets
LIBOR (Dollar denominated)
1 month 5.08%
3 months 5.20%
6 months 5.31%

- Money markets
LIBOR (Euro denominated) (i – i*) = (5.20 – 3.00) = 2.20%
1 month 2.82%
3 months 3.00% CAN WE PROFIT OFF
6 months 3.09% THIS INFORMATION?
• Example (continuation):
- Consider the following (covered) strategy to take “advantage”:
1. Borrow $1 in the US for 3 months (i = 1.30%)
2. Convert the $1 to Euros: 1 / 1.2762 = 0.7836
3. Invest the 0.7836 Euros for 3 months (i = 0.75%) =>
0.7836(1.0075) = 0.7895
4. Convert the proceeds back to dollars and repay your
loan: 0.7895(1.2836) – (1.0130) = 0.0003
This strategy yields a 3 month return of 3 basis points!!! RISK
FREE!!!
- Now, instead of borrowing $1, we will try to borrow USD 10
billion (and make a USD 3M profit) or more.
- Obviously, no bank will offer a .0232 EUR/USD 3-months
forward contract!

 Banks will offer forward contracts that produce non-

positive profits for arbitrageurs.
 Interest Rate Parity Theorem
Q: How do banks price FX forward contracts?
A: In such a way that arbitrageurs cannot take advantage of their quotes.
To price a forward contract, banks consider covered arbitrage strategies.

Notation:
id = domestic nominal T days interest rate (annualized).
if = foreign nominal T days interest rate (annualized).
St = time t spot rate (direct quote, for example COP/USD).
Ft,T = forward rate for delivery at date T, at time t.

• Now, consider the following (covered) strategy:

1. At t=0, borrow from a foreign bank 1 unit of a FC for T days.
 At time T, We pay the foreign bank (1+i f x T/360) units of the FC.
2. At t=0, exchange FC 1 = DC St.

3. Deposit DC St in a domestic bank for T days.

 At time T, we receive DC St(1+idxT/360).

4. At t=0, buy a T-day forward contract to exchange DC for FC at a Ft,T.

 At time T, we exchange the DC St(1+idxT/360) for FC, using Ft,T.
 We get St(1+id x T/360)/Ft,T units of foreign currency.

This strategy will not be profitable if, at time T, what we receive in FC is

less or equal to what we have to pay in FC. That is, arbitrage will force: :
St (1 + id x T/360)/Ft,T =S t(1
(1+
 iifd xxT/360).
T/360)
Ft,T 
(1  i f x T/360)
Solving for Ft,T, we get:
 (1  i d x T/360)
Ft,T  St
(1  i f x T/360)
This equation represents the Interest Rate Parity Theorem (IRPT or just
IRP).

It is common to use the following linear CIP approximation:

Ft,T  St [1 + (id - if) x T/360].

This linear approximation is quite accurate for small differences in i d - if.

Notes:
⋄ We get the same IRPT equation if we start the covered strategy by (1)
borrowing DC at id; (2) exchanging DC for FC at St; (3) depositing the
FC at if; and (4) selling the FC forward at Ft,T.
Example: Using IRPT.
St = 106 JPY/USD.
id=JPY = .034.
if=USD = .050.
T = 1 year
=>Ft,1-year = 106 JPY/USD x (1+.034)/(1+.050) = 104.384 JPY/USD.
Using the linear approximation:
Ft,1-year  106 JPY/USD x (1 - .016) = 104.304 JPY/USD.

Note: If Bank A sets FAt,1-year = 104.38 JPY/USD arbitrageurs cannot

profit from Bank A’s quotes.

Arbitrageurs can profit from any violation of IRPT. Bank A can make
two pricing mistakes:
FAt,1-year < Ft,1-year-IRP -i.e., the forward FC is undervalued.
FAt,1-year > Ft,1-year-IRP -i.e., the forward FC is overvalued.
Example 1: Violation of IRPT at work (forward FC undervalued).
St = 106 JPY/USD.
id=JPY = .034.
if=USD = .050.
Ft,one-year-IRP = 106 JPY/USD x (1 - .016) = 104.304 JPY/USD.

Suppose Bank A offers: FAt,1-year= 100 JPY/USD.

FAt,1-year= 100 JPY/USD < Ft,1-year-IRP (a pricing mistake!)

 The forward USD is undervalued against the JPY.

Let’s take advantage of Bank A’s mistake: Buy USD forward.

Sketch of a covered arbitrage strategy:

(1) Borrow USD 1 from a U.S. bank for one year at 5%.
(2) Exchange the USD for JPY at St = 106 JPY/USD
(3) Deposit the JPY in a Japanese bank at 3.4%.
Example 1 (continuation):
t=today T = 1 year
Borrow 1 USD 5% USD 1.05

Deposit JPY 106 3.4% JPY 109.6

Cash flows at time T=1 year,

(i) We get: JPY 106 x (1+.034)/(100 JPY/USD) = USD 1.096
(ii) We pay: USD 1 x (1+.05) = USD 1.05
Profit = USD 1.096 – USD 1.05 = USD .046

That is, after one year, the U.S. investor realizes a risk-free profit of
USD. 046 per USD borrowed (4.6% per unit borrowed).

Note: Arbitrage will force Bank A’s quote to quickly converge to

Ft,1-yr-IRP = 104.3 JPY/USD.
Example 2: Violation of IRPT 2 (forward FC overvalued).
Now, suppose Bank X offers: FXt,1-year= 110 JPY/USD.

FXt,1-year= 110 JPY/USD > Ft,1-year-IRP (a pricing mistake!)

 The forward USD is overvalued against the JPY.

Let’s take advantage of Bank X’s overvaluation: Sell USD forward.

Sketch of a covered arbitrage strategy:

(1) Borrow JPY 1 from for one year at 3.4%.
(2) Exchange the JPY for USD at St = 106 JPY/USD
(3) Deposit the USD at 5% for one year.
(4) Cover. Sell USD forward (Buy forward JPY) at FXt,1-yr=110 JPY/USD.

Cash flows at T=1 year:

(i) We get: USD 1/106 x (1+.05) x (110 JPY/USD) = JPY 1.0896
(ii) We pay: JPY 1 x (1+.034) = JPY 1.034
Profit = JPY1.0896 – JPY 1.034 = JPY .0556
The Forward Premium and the IRPT
Reconsider the linear approximation of CIP. That is,
Ft,T  St [1 + (id - if) x T/360].
A little algebra gives us:
(Ft,T-St)/St x 360/T  (id - if)
Let T=360. Then,
FP  id - if.

Equilibrium: FP exactly compensates (id - if) → No arbitrage

→ No capital flows.

Example: Go back to Example 1

FP = [(Ft,T-St)/St] x 360/T = [(100 – 106)/106] x 360/360 = - 0.0566

FP = - 0.0566 < (id - if) = - 0.016 => Arbitrage (pricing mistake!)

=> Capital flows
 Brief Assessment
1. Suppose that the treasurer of IBM has an extra cash reserve of
$100,000,000 to invest for six months. The six-month interest rate is
8 percent per annum in the United States and 7 percent per annum in
Germany. Currently, the spot exchange rate is €1.01 per dollar and
the six-month forward exchange rate is €0.99 per dollar. The
treasurer of IBM does not wish to bear any exchange risk. Where
should he or she invest to maximize the return?
2. While you were visiting London, you purchased a Jaguar for
£35,000, payable in three months. You have enough cash at your
bank in New York City, which pays 0.35 percent interest per month,
compounding monthly, to pay for the car. Currently, the spot
exchange rate is $1.45/£ and the three-month forward exchange rate
is $1.40/£. In London, the money market interest rate is 2.0 percent
for a three-month investment.
 There are two alternative ways of paying for your Jaguar.
a. Keep the funds at your bank in the United States and
buy £35,000 forward.
b. Buy a certain pound amount spot today and invest the
amount in the U.K. for three months so that the
maturity value becomes equal to £35,000. Evaluate each
payment method. Which method would you prefer?
Why?
3. Currently, the spot exchange rate is $1.50/£ and the three-month
forward exchange rate is $1.52/£. The three-month interest rate is 8.0
percent per annum in the U.S. and 5.8 percent per annum in the U.K.
Assume that you can borrow as much as $1,500,000 or £1,000,000.
a. Determine whether interest rate parity is currently
holding.
b. If IRP is not holding, how would you carry out
covered interest arbitrage? Show all the steps and
determine the arbitrage profit.
 c. Explain how IRP will be restored as a result of covered
arbitrage activities.
4. Suppose that the current spot exchange rate is €0.80/$ and the three-
month forward exchange rate is €0.7813/$. The three-month interest
rate is 5.6 percent per annum in the United States and 5.40 percent
per annum in France. Assume that you can borrow up to $1,000,000
or €800,000.
a. Show how to realize a certain profit via covered
interest arbitrage, assuming that you want to realize
profit in terms of U.S. dollars. Also determine the size
of your arbitrage profit.
b. Assume that you want to realize profit in terms of
euros. Show the covered arbitrage process and determine the
arbitrage profit in euros.
International Parity Conditions

Purchasing Power Parity

Interest Rate Parities
International Fisher Effect
 International Fisher Effect (IFE)

• IFE builds on the law of one price, but for financial transactions.

• Idea: The return to international investors who invest in money

markets in their home country should be equal to the return they
would get if they invest in foreign money markets once adjusted for
currency fluctuations.

• Exchange rates will be set in such a way that international investors

cannot profit from interest rate differentials --i.e., no profits from
carry trades.
The "effective" T-day return on a foreign bank deposit is:
rd (f) = (1 + if x T/360) (1 + sT) -1.

• While, the effective T-day return on a home bank deposit is:

rd (d) = id x T/360.

• Setting rd (d) = rd (f) and solving for ef,T = (St+T/St - 1) we get:

eIFEf,T =(1 + id x T/360) - 1. (This is the IFE)

(1 + if x T/360)

• Using a linear approximation: eIFEf,T  (id - if) x T/360.

• eIFEf,T represents an expectation. It’s the expected change in St from t to

t+T that makes looking for the “extra yield” in international money
• Since IFE gives us an expectation for a future exchange rate –S t+T-, if
we believe in IFE we can use this expectation as a forecast.

Example: Forecasting St using IFE.

It’s 2018:I. You have the following information:
S2018:I=1.0659 USD/EUR.
iUSD,2018:I=6.5%
iEUR,2018:I=5.0%.
T = 1 quarter = 90 days.
eIFEf,,2018:II = [1+ iUSD,2018:I x (T/360)]/[1+ iEUR,2018:I x (T/360)] - 1 =
= [1+.065*(90/360))/[1+.05*(90/360)] – 1 = 0.003704

E[S2018:II] = S2018:I x (1+eIFEf,,2011:II ) = 1.659 USD/EUR *(1

+ .003704)
= 1.06985 USD/EUR
That is, next quarter, you expect St to change 1.06985 USD/EUR to
• Note: Like PPP, IFE also gives an equilibrium
exchange rate. Equilibrium will be reached when
there is no capital flows from one country to another
to take advantage of interest rate differentials.

IFE: Implications
If IFE holds, the expected cost of borrowing funds is identical across
currencies. Also, the expected return of lending is identical across
currencies.

Carry trades –i.e., borrowing a low interest currency to invest in a high

interest currency- should not be profitable.

If departures from IFE are consistent, investors can profit from them.
Example: Mexican peso depreciated 5% a year during the early 90s.
Annual interest rate differential (iMEX - iUSD) were between 7% and 16%.
The E[ef,T]= -5% > eIFEf,T = -7% => Pseudo-arbitrage is possible
(The MXN at t+T is
overvalued!)

Carry Trade Strategy:

1) Borrow USD funds (at iUSD)
2) Convert to MXN at St
3) Invest in Mexican funds (at iMEX)
4) Wait until T. Then, convert back to USD at St+T.

Expected foreign exchange loss 5% (E[ef,T ]= -5%)

Assume (iUSD – iMXN) = -7%. (Say, iUSD= 5%, iMXN=12%.)
E[e ]= -5% > eIFE =-7% => “on average” strategy (1)-(4) should
Example (continuation):
Expected return (MXN investment):
rd (f) = (1 + iMXNxT/360)(1 + sT) -1 = (1.12)*(1-.05) - 1 = 0.064

Payment for USD borrowing:

rd (d) = id x T/360 = .05

Expected Profit = .014 per year

• Overall expected profits ranged from: 1.4% to 11%.

• You may have noticed that IFE pseudo-arbitrage strategy differs from
covered arbitrage in the final step. Step 4) involves no coverage.

• It’s an uncovered strategy. IFE is also called Uncovered Interest Rate

Parity (UIRP).
• IFE: Evidence
No short-run evidence => Carry trades work (on average).
Some long-run support:
ÞCurrencies with high interest rate differential tend to depreciate.

If the IFE fails there are possible explanations:

- markets are not efficient
- risk premium is missing
- or it could be Central Bank behavior
- or a possible peso problem
- etc.
Q&A