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1. The Law of One Price (Parity Conditions)

A. Law States:
Identical goods must be sold at the same
price worldwide
B. 5 Parity Conditions Results From These
Arbitrage Activities:
 Purchasing Power Parity (PPP)
 The Fisher Effect (FE)
 The International Fisher Effect (IFE)
 Interest Rate Parity (IRP)
 Unbiased Forward Rate (UFR)

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C. Five Parity Conditions Linked by:
1. The adjustment of various rates and prices to
inflation
2. The notion that money should have no effect on
real variables (since they have been adjusted for
price changes)

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D. Inflation and home currency depreciation:
1. Jointly determined by the growth of domestic
money supply:
2. Relative to the growth of domestic money
demand

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 States that spot exchange rates between
currencies will change to the differential in
inflation rates between countries
 In other words, currencies with high inflation

rates should depreciate relative to the

currencies with lower inflation rates.

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1. PPP states future exchange rates between 2
countries should change according to the changes in
the price levels of these 2 countries.
The equation is:
et = (1 + ihc)t
e0 (1 + ifc)t
Where: et = future spot rate
e0 = spot rate
ihc = home inflation
ifc = foreign inflation
t = time period

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2. If PPP is expected to hold, then the future
spot exchange rate is:
e1 = e0 (1 + ihc)t
(1 + ifc)t
3. If measure in terms of percentage
form:
PPP = (ihc - ifc) x 100
(1 + ifc)t

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 Assume that the spot exchange rate of British
pound is RM5.5600. How would the spot rate
adjust according to purchasing power parity
(PPP) if UK experiences an inflation rate of 5%
while Malaysia experiences an inflation of
3.5%?

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A. THE FISHER EFFECT

◦ Explain the relationship between interest rates

& inflation rates of two countries
◦ States that nominal interest rates (r) should be
equal to the investors required rate of return (a)
plus the expected rate of inflation (i)

r=a+i

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B. REAL RATES OF INTEREST
◦ Should tend toward equality everywhere through
arbitrage
◦ Without government interference nominal rates
vary by inflation differential or

rhc – rfc = ihc - ifc

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C. According to FE, countries with higher

inflation rates have higher interest rates.

D. Due to capital market integration

globally, interest rate differentials are
eroding as real interest rates are
determined by the global supply and
demand for funds

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 Explain the relationship between interest rate
& future spot rate
 The future exchange value of two currencies

depends on the combination impact of

inflation & interest rate differences between
two countries
i.e IFE = PPP + FE

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 Fisher postulated:
1. The nominal interest rate differential should reflect
the inflation rate differential
2. Expected rates of return are equal in the absence of
government intervention:

Simplified IFE equation:-

rh – rf = e1 – e0
e0
OR
e1 = e0 (1 + rhc)t
(1 + rfc)t

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Formula:

e1 = e0 (1 + rhc)t
(1 + rfc)t

Where: et = future spot rate

e0 = spot rate
rhc = home interest rate
rfc = foreign interest rate
t = time period

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 Fisher’s Conclusion:
◦ In parity conditions, the currency with lower
interest rate is expected to appreciate relative
to the one with a higher rate & vise versa
◦ Country with higher inflation rate, its currency
value will depreciate but its interest rate will be
higher

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 In July, the one-year interest rate is 10% on the
pound sterling and 8% on US dollar.
 i) If the current exchange rate is
USD1.5625/£, what is the expected future
exchange rate in one year?
 ii) Suppose a change in the expectation
regarding future US inflation causes the
expected future spot rate to decline to
USD1.5572, what is the US interest rate in one
year’s time?

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1. INTRODUCTION
◦ Explain the relationship between spot rate &
forward rate
◦ Sates that the forward rate differs from the spot
rate at equilibrium by an amount equal to the
interest differential between 2 countries.
◦ If there is a disparity/ disequilibrium between the
interest rate differences & the forward premium or
discount on the currency, covered interest
arbitrage will exist

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2. The forward premium or discount equals the
interest rate differential i.e.
Forward premium/ discount = rhc – rfc

3. In equilibrium, returns on currencies will be the

same i.e. no profit will be realized, and interest
parity exist. This can be written as:
F = (1 + rhc)t
S (1 + rfc)t

Where: F = future spot rate

S = spot rate
rhc = home interest rate
rfc = foreign interest rate
t = time period 20
4. If interest rate differential does not equal
the forward premium or discount
(disequilibrium), then covered interest
arbitrage would exist

4. If this is the case, to determine a covered

interest arbitrage & to make investment
decision, the 2 following steps are
recommended:-

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 Step 1: Determine the existence of a covered
interest arbitrage
 Step 2: Decide whether to invest home or

abroad
(1 + rhc)t = (1 + rfc)t F
S
 If (1 + rhc)t > (1 + rfc) F : invest at home & borrow abroad
S
 If (1 + rhc)t < (1 + rfc) F : invest abroad & borrow at
home
S
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 Summary:
◦ Higher interest rate on a currency offset by forward
discount
◦ Lower interest rates are offset by forward premiums

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 An investor will invest his funds in any market to
maximize profit. The one-year Malaysian interest
rate and US interest rate is 6% per annum and
10% per annum, respectively. The spot rate for
RM3.5600/3.5620/USD and the one year
forward rate is RM3.6400/3.6440/USD.
1) Are there any interest arbitrage opportunities?
2) Assist the investor on where he should borrow
and invest?
3) Explain how the investor can profit from the
situation. (Assume the initial investment by
Malaysian investor is RM10,000,000)
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 Step 1: Determine the existence of a covered
interest arbitrage
Forward premium @ discount annualized = Interest difference
Forward rate – Spot rate x 360 x 100 = rhc - rfc
Spot rate Fwd contract days
[(3.6400 – 3.5600)/3.5600] x 360/360 x 100 = 6% -10%
2.25% ≠ -4% , Therefore CIA exist

 Step 2: Decide whether to invest home or abroad

(1 + rhc)t = (1 + rfc)t F
S
(1 + 0.06) = (1 + 0.10) (3.6400/3.5600)
1.06 < 1.12 , Borrow HC; Invest FC

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 RM USD

T = Now

1) Borrow HC @ 6% 10,000,000

2) Convert to FC @ RM3.5620 (Buy (10,000,000) 2,807,411.57

USD, Bank Sell)
3) Invest FC @ 10% (2,807,411.57)
Enter forward rate @ RM3.6400

T = 1 year

4) Return from investment 3,088,152.73

2,807,411.57 x (1 + 0.1)
5) Convert to RM @ RM3.6400 11,240,875.93

6) Pay borrowings 10,600,000

10,000,000 x (1+ 0.06)
PROFIT 640,875.93

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 Explains the relationship between forward rate &
future spot rate that are heavily influenced by current
expectations of future events

 States that if the forward rate is unbiased, then it

should reflect the expected future spot rate

 This is stated as:-

ft = et

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 FORECASTING MODEL

◦ Have been created to forecast exchange rates in

addition to parity conditions.
◦ Two types of forecast:
1. Market- based
2. Model based

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1. Market- based (derive from market indicators)
◦ The current forward rate contains implicit
information about exchange rate changes for one
year
◦ Interest rate differential may be used to predict
exchange rates beyond one year .

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2. Model based
 Fundamental relies on key macroeconomics
variables and policies which most like affect
exchange rates
 Technical relies on use of
 Historical volume and price data
 Charting and trend analysis

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