International Parity Relations

 International parity relations are important tools

that provide insights into: i) how exchange rates
are determined; ii) how to forecast exchange rates.
 These parity relations are in fact manifestations of
the law of one price in the setting of international
finance, which must hold when the markets are
free of arbitrage opportunities.

1
 Outline
 Purchasing Power Parity (PPP)
 Absolute version of PPP
 Relative version of PPP
 Applications of PPP
 Interest Rate Parity (IRP)
 Forward contracts
 IRP defined
 Covered interest arbitrage (CIA)
 Applications of IRP
2
 Purchasing Power Parity
 The basic idea of purchasing power parity (PPP):
exchange rate between any two currencies should
equalize their purchasing powers.
 Suppose one Big Mac is sold for $3.5 in the U.S and
for ¥350 in Japan. What is the implied exchange rate
between $ and ¥ that would equalize their
purchasing powers for Big Mac?

3
 Purchasing Power Parity
 Suppose one Big Mac is sold for $3.5 and for
¥350. To equalize the Big Mac purchasing power
between $ and ¥, $3.5 must exchange for ¥350.
 Normalization yields $1 equals ¥100. In other
words, the exchange rate between $ and ¥, which
is implied from their “Big Mac implied PPP”, is
¥100/ $.
 In other words, we evaluate the purchasing power of both $ and
¥ against Big Mac

4
 Big Mac PPP
 More formally, let P$ be the dollar price of the Big Mac
in the U.S, and beP￡the pound price of the Big Mac in
the U.K. Big Mac PPP states that the exchange rate
between the dollar and the pound should be:
S BM ($ /￡）＝P$／P￡
P
which implies $  S BM
($ /￡） P￡ , where the right
hand side is the dollar price of Big Mac sold in the U.K.
 What if the market exchange rate, S ($ /￡）, deviates
from S BM ($ /￡） ?

5
 International Commodity Arbitrage
 Suppose we have the following data. in the FX
market, S($ |£) = $1.5/£. One Big Mac is sold for
$4 in the U.S and for £4 in the U.K.
 Ignoring all associated costs, there exists an
international commodity arbitrage opportunity.
Please identify it.

6
 International Commodity Arbitrage:
Identify the Arbitrage Opportunity
The implied dollar price of
BM in the U.K. is $6.00 £
UK product market FX market
P(£/BM)=4.00 S($/£)=1.50
In the U.S., BM is only
sold for $4.00, a US product market
BM $
violation of LOOP!
P($/BM)=4.00

So, how to devise an arbitrage strategy to make money?

Buy the BM @ $4 (buy low); sell BM @ $6 (sell high).
7
 International Commodity Arbitrage:
Implement the Arbitrage Strategy
£
UK product market
FX market
1. Buy BM with $, P(£/BM)=4.00
2 3 S($/£)=1.50
2. Sell BM for £,
1
3. Sell £ for $ BM US product market
$
P($/BM)=4.00
The combining effects of 2+3 is to sell BM for $ at the implied
dollar price of BM in the U.K. i.e., Sell BM @ $6.00
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 International Commodity Arbitrage
Suppose you start with $4m.
 Step 1: use the $4m to buy one million Big Macs in the

U.S product market.

 Step 2: ship the one million Big Macs to the U.K.,

which can be sold for £4m.

 Step 3: sell the £4m for $6m in the FX market at the rate

of $1.5/£, and you pocket an arbitrage profit of $2m!

 Note the combined effect in Step 2 & 3 is that you sell

one million Big Macs for $6m in the U.K.

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 International Commodity Arbitrage:
Using Pound as the Underlying
 Through international commodity arbitrages, the
dollar prices of Big Mac in the two countries tend to
converge to one another.
 Equivalently, we may use £, instead of Big Mac, as
the underlying. Since £ is overvalued in the FX market
($1.5/£) relative to its Big Mac PPP-implied exchange
rate ($1/£), an arbitrageur would sell the over-priced £
for $ in the FX market.
 As a result of the arbitrage transactions, the market and
the PPP-implied exchange rates also tend to converge.
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 Over-valuation of Pound vs.
Over-priced Big Mac at UK
 When using the market exchange rate of S($ |£) =
$1.5/£ to convert the pound-denominated price
into dollar terms, we obtain the implied dollar
price of Big Mac in the U.K., which is $6
 Recall one Big Mac is sold for $4 in the U.S
 Big Mac appears to be over-priced at UK. The
reason lies in the over-valuation of £ in the FX
market ($1.5/£) relative to its Big Mac PPP-
implied exchange rate ($1/£).
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12
 Standard Commodity Basket
 In its actual applications, PPP is normally applied to a
standard commodity basket, i.e.,
S PPP ($ /￡）＝P$／P￡
where P$ and P￡ denote the price of the standard
commodity basket in $ and in ￡ , respectively.
 Commodities in the standard commodity basket must be
highly standardized and are actively traded across
borders
 Services that never enter into international trade such as haircut and
medical care should not enter the standard commodity basket.
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 Empirical Performance of PPP
 PPP does not hold well empirically. For example,
in his study of the exchange rate between the U.S.
dollar and the Canadian dollar, Richardson (1978)
reported: the hypothesis that PPP rate equals the
market rate is rejected for at least 13 out of 22
commodity groups.
 PPP is the manifestation of LOOP applied to a
standard commodity basket. If PPP is rejected
empirically, does that mean the LOOP is wrong?
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 Violations of PPP
 LOOP is based on two important assumptions:
 i) the ignorance of any associated costs
 ii) markets are integrated
 Are these two assumptions tend to be satisfied in
the international commodity arbitrage?
 Costs associated with international trade tend to be much
higher than costs associated with computerized trading.
 Various restrictions/ frictions are usually imposed for
international trades

15
 Applications of PPP:
 One can use the PPP-determined exchange rate as
the benchmark in deciding whether a country’s
currency is undervalued or overvalued against other
currencies.
 If a country’s currency is significantly undervalued
(overvalued) according to PPP, then in the long run,
its currency tends to appreciate (depreciate) against
other currencies
 From 2002 to 2007, Warren Buffet kept selling $ for euro,
because PPP suggested that $ was overvalued relative to euro.
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 Applications of PPP
 Relative to market-determined exchange rates, PPP-
determined exchange rates make more meaningful
international comparisons of economic data.
 Suppose you want to rank countries in terms of gross
domestic product (GDP). If you use market exchange
rates, you can either underestimate or overestimate the
true GDP values, i.e., GDP based on PPP
 Rankings of GDP based on market exchange rates:
http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)
 rankings of GDP based on PPP:
http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)
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 The Relative Version of PPP

S ($ /￡）＝P$／P￡
is called the absolute version of PPP
Start from St = P$ / P£ , where I suppress the currency
notations and add the time subscript in the exchange rate.
Suppose the realized inflation rate from period t to period
t+1 in the U.S. and in the U.K. are respectively  $ and
 £ , then P$ (1   $ )
St 1 =
P£ (1   £ )

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 The Relative Version of PPP
 Divide the second equation by the first equation,
St 1 1   $

St 1 £
 The above relationship is called the relative version of
PPP, which links the ratios of inflations in two countries to
the ratios of the exchange rates in two consecutive periods.
 If the U.S. experiences higher inflation than the U.K., then
St 1  St , which implies ￡ appreciates against $.

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 The Relative Version of PPP
 Intuitively, a higher inflation in the U.S. than in
the U.K. means $ loses more of its purchasing
power relative to ￡ . According to PPP, $ thus
should depreciate against ￡ .

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Absolute PPP vs. Relative PPP, a Summary

 Absolute PPP: the level of exchange rate should

reflect the ratio of purchasing power of two
currencies, evaluated by the ratio of two price
levels prevalent in the two countries.
 Relative PPP: changes in exchange rate should
reflect the ratio of changes in the purchasing
power of the two currencies, as indicated by the
ratio of (gross) inflation rates in the two countries.

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 PPP In History
 Although the basic idea of PPP was initially advanced
by David Ricardo in the 19th century, it did not
become popular until 1920s.
 During 1920s, Germany experienced hyperinflation
which was accompanied by the dramatic depreciation
of Deutsche Mark against stable currencies such as the
U.S. dollar. (Explain it using PPP).
 The PPP became popular against this historical
backdrop.

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 Interest Rate Parity (IRP)
 Interest rate parity (IRP) is another no arbitrage
condition when the international money markets,
the spot FX market, as well as the forward FX
market, are all in equilibrium.
 The crucial concept for deriving IRP is the
forward exchange rate. Hence, we digress by
talking about the forward contract first.

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 The Forward Contract
 A forward contract is an agreement to buy or sell an asset
in the future at prices agreed upon right now. By contrast,
a spot contract is an agreement to buy or sell an asset
immediately at prices agreed upon right now.
 Take the purchase of a book for example:
 If the book is available in-stock, you can buy it immediately.
 However, if the book is out-of-stock, you may have to agree to buy
the book one month later when it arrives, at a price agreed upon
today.
 Itis possible that spot price of the book one month later is different
from the price agreed upon today.

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 The Forward Contract: Notations
 The price at which the two counterparties have agreed
upon entering of a forward contract is called the forward
price for that contract.
 A forward price is a price for the future delivery that is agreed
upon today.
 A forward price is normally denoted by Ft ,T , where t
denotes the current date; T denotes the date when
deliveries occur, i.e., the delivery date, which is also the
expiration date of the forward contract; T  t is called
the maturity (or the term) for the forward contract.
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 The Currency Forward Contract:
An Example
 On October 15, 2023, a $/£ trader A agrees to sell
£100,000 forward at the forward rate of $1.5/£.
 A is said to be on the short side
 At the same time another $/£ trader B (on the long side)
agrees to buy £100,000 forward at the same forward rate.
Assume the delivery date is January 15, 2024.
 B is said to be on the long side
 The forward rate of $1.5/£ is determined at current date
of October 15, 2023, but it is for delivery three months
later on January 15, 2024.
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 The Currency Forward Contract:
Physical Settlements
 Three months later, trader A (the short) delivers the
underlying security of £100,000 to trader B (the long)
 To take the delivery of the underlying, trader B (the
long) pays $150,000 to trader A according to the pre-
determined price of $1.5/£, regardless of the spot
exchange rate prevailing on January 15, 2024.
 Since the underlying is actually delivered at the
expiration date, we say that the forward contract has
physical settlements or settled by the underlying.
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 The Currency Forward Contract:
Profit and Loss for the Short and the Long
 Suppose three months later the spot rate is $1.8/£. To
fulfil his obligation, A (the short) has to purchase
£100,000 for $180,000 from the spot market and
then delivers it to B for only $150,000. Hence, he
loses $180,000 - $150,000 =$30,000
 On the other hand, Trader B (the long) takes the
delivery of £100,000 for only $150,000, and then he
can immediately go back to the spot market and
dump it for $180,000, which implies that he pockets
a profit of $180,000 - $150,000 =$30,000.
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 The Currency Forward Contract:
Cash Settlements
 Given that A and B are playing a zero-sum game,
alternatively they can choose to settle this forward
contract by simply A (the losing side) handing
over to B (the winning side) $30,000 without the
actual delivery of the underlying of £100,000.
 This way of settlement by the losing side paying
the winning side the difference between the spot
and the forward price (adjusted for contract size) is
referred to as cash settlement.
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 Cash Settlements

 With cash settlements,

 When the price of the underlying rises, money will be
transferred from the short’s account into the long’s
account
 When the price of the underlying decreases, money will be
transferred from the long’s account into the short’s
account
 As a result, the profit and the loss for the long and
the short always exactly offset each other. This is
because the two sides are playing a zero-sum game.
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Cash Settlements vs. Physical Settlements

 People who trade forwards solely for financial

reasons generally prefer the cash settlement
because, compared with physical settlements, cash
settlement is simpler and more convenient.
 On the other hand, physical settlements are
preferred when the buyer actually need the
underlying to be delivered.

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 Profit/Loss on the Forward Positions
at the Expiration date
The figure plots Short Long
position position
the profit/loss on
the two forward
positions relative
to the forward
rate of $1.50/£ at $0 Exchange
the expiration $1.50/£ rate on the
date. Note the expiration
long and the short date
are playing a
“zero sum game”
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 Profit/Loss on the Forward Positions
at the Expiration date
Short Long
With cash position
position
settlements, if
exchange rate is $30 m
$1.80/£ at the
expiration date,
$30,000 will be $0 Exchange
transferred from $1.50/£ $1.80/£ rate on the
the short’s expiration
–$30 m date
account into the
long’s account

33
 Profit/Loss on the Forward Positions
at the Expiration date
Short Long
On the other position
position
hand, if the
exchange rate is $30 m
$1.20/£ at the
expiration date,
$30,000 will be $0 Exchange
transferred from $1.20/£ $1.50/£ rate on the
the long’s expiration
–$30 m date
account into the
short’s account

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 Bank Quotations of Forward Rate
 Forward exchange rates are quoted in the same way as
the spot rate (i.e., American term, European term,
cross rate), but for a variety of maturities.
 Bank quotes for maturities of 1,3,6,9, and 12 months
are readily available. Quotations on nonstandard
maturities are also available. Maturities extending
beyond one year are becoming more frequent, and for
good customers, a maturity extending out to 5 years,
and even as long as 10 years, is possible.

35
 Forward Rate Quotations

Country
USD equiv
Friday
USD equiv
Thursday
Currency per
USD Friday
Currency per
USD Thursday
The spot
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 pound
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762 exchange rate
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
is $1.9077/£,
1 Month Forward 1.9044 1.9101 0.5251 0.5235 whereas the 6
3 Months Forward 1.8983 1.9038 0.5268 0.5253 month forward
6 Months Forward 1.8904 1.8959 0.5290 0.5275
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
pound
1 Month Forward 0.8037 0.8069 1.2442 1.2393 exchange rate
3 Months Forward 0.8043 0.8074 1.2433 1.2385 is $1.8904/£
6 Months Forward 0.8057 0.8088 1.2412 1.2364

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Deduce Forward Rates that are not Quoted:
(Deeper Issue)
 As shown in the previous table, bank quotes of
forward rates for forward contracts are available
only for 1, 3, 6, 9, and 12 month maturities.
 For those who want to trade forward contracts
whose rates are not quoted, e.g., a two month
forward contract, how to compute the
corresponding forward rates?
 The answer is by interpolation, which efficiently
extracts information from existing quotations.
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 Interest Rate Parity
 Whereas PPP is the manifestation of LOOP applied to a
standard commodity basket, interest rate parity (IRP) is
the manifestation of LOOP applied to investment in
international money markets.
 Roughly speaking, IRP states that, by abstracting from
all frictions and transaction costs, the market interest rate
and the synthetic interest rate that is of the same degree
of risks must be equal to each other, when there does not
exist covered interest arbitrage (CIA) opportunities.

38
 Interest Rate Parity Defined
Consider two investment strategies in the international
money market over a one year horizon for $1,000:
Strategy 1: Invest in the U.S. at the interest rate of i$.
value one year later = $1,000 × (1 + i$)
Strategy 2: Sell your $ for £ at the spot rate pound rate of
S$/£ , invest in the U.K. at the interest rate of i£ , and sell
the value of the British investment forward at the
forward pound rate of F$/£ $1, 000
 1+i£   F$ / £
value one year later = S$ / £
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 Strategy 2: IRP
Step 1: £1,000
Send your $ on a
round trip to
S$/£
Step 2:
Britain
Invest those
pounds at i£
$1,000 Future Value =
£1,000
 (1+ i£)
S$/£
Step 3: sell the £
Strategy 1: investment forward
invest $1,000 at i$ for $
$1,000
$1,000×(1 + i$)  (1+ i£) × F$/£
S$/£

What is the relation between the two values in one year?

40
 Interest Rate Parity Defined
 The future values of the two strategies both denote
the risk-free value of the U.S. dollar in one year.
 The point is by trading in the forward market, we’ve
eliminated the foreign exchange risk. In other words,
the foreign exchange risk is completely hedged by
using the forward contract.
 The two strategies are thus perfect substitutes of
each other, which should yield the same future
values.
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 Interest Rate Parity Defined
From the above analysis,
$1,000  (1+ i ) × F
$1,000×(1 + i$) = £ $/£
S$/£
The scale of the project is unimportant,
F$/£
(1 + i$) = × (1+ i£)
or equivalently, S$/£
1  i$ F$/ £
＝
1  i£ S$/ £
which is called the interest rate parity (IRP) relationship.
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 Interest Rate Parity Interpreted
To interpret IRP from the perspective of LOOP, rewrite
its formula as:
F$ / £
i$  1  i£   1
S$ / £
The right hand side denotes the “synthesized” dollar
interest rate by investing in the U.K money market and
then selling the pound forward.
You can think of the interest rate as the price of a time
deposit. IRP is thus simply a manifestation of LOOP
applied to the default-free time deposit of dollar.
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 Covered Interest Arbitrage (CIA)
 If IRP doesn’t hold, LOOP applied to interest rates is
violated. The situation gives rise to covered interest
arbitrage opportunities.
 Consider the following numerical example ：
Spot exchange rate S($/£) = 1.25 $ /£

360-day forward rate F360($/£) = 1.22 $ /£

U.S. interest rate i$ = 7.10%

British interest rate i£ = 11.56%

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 Covered Interest Arbitrage (CIA)
First compute the effective dollar interest rate by
investing in the U.K. money market:
F$ / £ 1.22
1  i£   1  (1  11.56%)  1  8.88%
S$ / £ 1.25
which is greater than i$  7.10%, i.e., the dollar
interest rate in the U.S. money market. Hence, IRP does
not hold.
In order to make arbitrage profits, we need to borrow $
at the lower rate of 7.1% and then lend $ at the higher
synthetic (dollar-denominated) rate of 8.88%.
45
 Step 2: Arbitrage Strategy I
buy pounds
£800
£1 Step 3:
£800 = $1,000×
$1.25 Invest £800 at
i£ = 11.56%
$1,000 £892.48 In one year £800
will be worth
£892.48 =
Step 4: sell £ £800 (1+ i£)
forward
Step 1:
borrow $1,000 More $1.22
Step 5: Repay than $1,071 $1,089 = £892.48 ×
£1
your dollar loan
with $1,071.
You can pocket an arbitrage profit of $18 for each $1,000!
46
 Covered Interest Arbitrage (CIA)
 The key of the covered interest arbitrage is that by first
converting $ into £ at the spot market, then investing £ in
the U.K. money market for one year, and finally selling
the British investment forward for $ in the forward
market, the arbitrageur has created a synthetic dollar-
denominated interest rate that is higher than the rate
prevailing in the U.S. money market.
 Next question: what is the consequence of CIA to the
money markets and the FX (both spot and forward)
markets?
47
 Covered Interest Arbitrage (CIA):
the Convergence
 Borrowing from the U.S. money market and investing
in the U.K. money market will
 drive ___ (up/down) the interest rate prevailing in the U.S.
money market.
 drive ___ (up/down) the interest rate prevailing in the U.K.
money market.
 Selling $ for £ in the spot market and selling £ for $ in
the forward market will
 drive ___ (up/down) the spot pound exchange rate
 drive ___ (up/down) the forward pound exchange rate
48
 Covered Interest Arbitrage (CIA)

F$/ £
Initially: i$  1  i￡   1
S$/ £
Associated with CIA, i$  , i£  , S$ / £  , and F$ / £ 
Hence, we can expect convergence of the two
interest rates, which restores IRP.

49
 Forward Premium and
Forward Discount
 We know forward rate (or forward price) in general
differs from spot rate (or spot price).
 When forward rate is high than spot rate, we say the
currency is trading at the forward premium.
 Conversely, when forward rate is lower than spot
rate, we say the currency is trading at the forward
discount.

50
 Intuition for IRP: Forward Premium
and Forward Discount
 Recall the formula for IRP:
1  i$ F$ / £
＝
1  i£ S$ / £
 When ￡ pays the lower interest rate than $, i.e.,i£  i$
or equivalently,i$  i£  0,then from IRP, F$ / £  S$ / £ .
In other words, ￡ which pays the lower interest
rate is trading at the forward premium.
 Simultaneously, $ which pays the higher interest
rate is trading at the forward discount.
51
 Intuition for IRP
 Intuitively, currency that pays a higher interest rate (e.g., $) is a
“good currency”, whereas currency that pays a lower interest
rate (e.g., ￡ ) is a “bad currency”.
 In equilibrium, investors must be indifferent to holding either
“good” or “bad” currency. Thus,
 Something bad should happen to “good currency”. Specifically, $ as the
”good currency” should be trading at forward discount: it means the
“good currency” is expected to depreciate.
 Something good should happen to “bad currency”. Specifically, ￡ as
the “bad currency” should be trading at forward premium: it means the
“bad currency” is expected to appreciate.

52
 Application of IRP
 One application to Hong Kong (HK) interest rate policy:
interest rate in HK tends to change with the interest rate
in the U.S. Why?
 The exchange rate between the HK dollar and the U.S.
dollar is roughly fixed due to the currency board
arrangement. Hence at least for the near future, forward
exchange rates are roughly equal to the spot rates for
these two currencies.
 What is the implication from IRP in this special case?

53