International Parity Conditions

Book Chapter : 6
 Agenda

• What is PPP & law of one price?

• What is exchange rate pass-through?
• How do interest rates & exchange rates link?
• Interest rate parity?
• What is covered interest arbitrage?
• What is uncovered interest arbitrage?

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 International Parity Conditions
 Some fundamental questions managers of MNCs, international portfolio
investors, importers, exporters and government officials must deal with
every day are:

• What are the determinants of exchange rates?

• Are changes in exchange rates predictable?

 The economic theories that link exchange rates, price levels, and interest
rates together are called international parity conditions.
 These international parity conditions form the core of the financial theory
that is unique to international finance.

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 What is Law of One price?
 If the identical product or service can be sold
in two different markets, and no restrictions
exist on the sale and transportation costs then
the product price should be the same in the
both markets. This is called The Law of One
Price.
 Only the conversion from one currency to
another currency is required.
 For example: P$  S = P¥
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 Purchasing Power Parity (PPP):
 PPP is the popular metric used by
macroeconomic analysts that compares
different countries’ currencies through a
basket of goods approach.
 PPP allows for economists to compare
economic productivity and standard of living
between countries.
 It is important for the companies to set the
same prices for products across different
countries. 5
 Purchasing Power Parity (PPP)
and Exchange Rate Determination
 If the law of one price were true for all goods and
services, the purchasing power parity (PPP) exchange
rate could be found from any individual set of prices.
 By comparing the prices of identical products
denominated in different currencies, we could
determine the “real” or PPP exchange rate that
should exist if markets were efficient.
 This is the absolute version of the PPP theory.

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 Prices and Exchange Rates
 Law of one price:
 product’s price same in all markets
P$  S = P¥

 where spot exchange rate is S, yen per dollar.

P ¥

S $
P

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 Purchasing Power Parity &
Law of One Price

Absolute purchasing power parity:

 spot exchange rate is determined by relative prices of
similar basket of goods.

Relative purchasing power parity:

 Relative change in prices b/n countries determines
change in forex rate.

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 Absolute PPP: Big Mac Index
 Economist’s Big Mac PPP:
• Big Mac in China costs Yuan 9.90.
• Big Mac in US costs $2.71.
• Implied PPP exchange rate
Yuan9.90
 Yuan3.7/$
$2.71

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 Economist,
4/ 2003

Sfr6.30
 Sfr2.4803/$
$2.54
10
Over or under valued of yuan against dollar

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 Relative PPP:
 Relative PPP does not help in determining the
spot exchange rate but it helps to determine the
changes in exchange rate over a period of time
 More specifically, if the spot exchange rate
between two countries starts from an
equilibrium then any change in the expected
rate of inflation between countries tends to be
offset in long-term by an equal but opposite
change in the spot exchange rate
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 Relative PPP
% change spot rate foreign currency
4 US$/ yen
P

PP
P
3

li n
e
2

-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1
InfJAPAN- InfUS
-2

-3

-4

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 What RPPP Graph Does Present?
 The vertical axis shows the percentage appreciation
or depreciation of the FC relative to HC, and the
horizontal axis shows the percentage higher or lower
rate of expected inflation in FC relative to HC
 The diagonal parity line shows the equilibrium
position between a change in the exchange rate and
relative inflation rate
 Point P represents an equilibrium point where
inflation in Japan is 4% lower than USA
 So, RPPP predicts that the Yen would appreciate by
4% with respect to US dollar
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 Justification of RPPP?

 If a country’s inflation rate is higher than its

main trading partners, and its exchange rate
does not change then its export will be less
competitive to foreigners and its import will be
more competitive compare to local product
prices
 This price changes lead to a deficit on current
account in the balance of payments unless
offset by capital and financial flows
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 But:
 PPP is not very accurate predictor…
• Why?

 PPP holds well over very long term…

 PPP holds better for countries w/ high inflation &
underdeveloped capital markets…
• Why?

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 Is forex under-/over- valued?
 Use forex indices: trade-weighted bilateral exchange
rates b/n the home country & trading partners

 Nominal exchange rate index : use actual exchange

rates.
 Real effective exchange rate index indicates how the
weighted average purchasing power of the currency
has changed relative to some arbitrarily selected base
period. $
C
E  E x FC
$
R
$
N
C
17
 Q:

• Can you tell when a currency is overvalued?

• Why the real exchange rate deviates from 100?

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 Real Effective Exchange Rate Indices
United States & Japan (1995 = 100)
180

160
United States Japan
140

120

100

80

60

40

20

0
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999
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 Exchange Rate Pass-Through

 Pass-through: change in prices of imported/exported goods

when exchange rate changes
 S = $1/€1, if euro appreciate by 20% the S2 =$1.20/€
• BMW made in Germany cost @ spot rate US$ 35,000.
P $
BMW  PBMW x S
€ €/$

• where P$ is the price in US$, P€ is price in euros, S is spot

rate
• Euro appreciates by 20%. In 100% pass-through the BMW
price would be $42,000. But BMW is now only $40,000.
• Pass-through:
$
PBMW, $40,000
$
2
  1.1429, or  14.29%
PBMW, 1 $35,000

• Degree of pass-through: 14.29 % / 20 % = 0.71 or 71 %

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Interest Rates & Exchange Rates?
 What is a fair nominal interest rate?
– Well, can ask a banker … or read Irvin Fisher…
• Fisher Effect: nominal interest rates in each country
are equal to the required real rate of return plus
compensation for expected inflation.

i = r + + r
• i is nominal rate, r is real rate,  is expected rate of
inflation.
• FE good for short maturity bonds, NOT long maturity ones.
– Why?

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 International Fisher effect
 International Fisher effect (Fisher-open): The relationship
between the percentage change in spot exchange rate over
time and the difference between interest rates in different
national market. Spot exchange rate change equals opposite of
interest rate differential.
S1  S2 FC
x 100  i  i
$

S2
where S is indirect quote.
 Direct Quotes: US$/ Foreign Currency.
 Indirect Quotes: Foreign Currency / US$.
 Fisher-open not precise in short-term.
• Why?
 Should include forex risk premium.
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 Forward Rate
 Forward Rate
• A forward rate: exchange rate quoted today for
settlement @ future date. This rate is calculated by
adjusting the spot rate by the ratio of eurocurrency
interest rates of the same maturity for the given
currencies.

  FC 90 
 1   i x 360 
  
F90FC/$  SFC/$ x
  $ 90 
 1   i x 360 
  

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 Forward Rate
 Spot rate SF 1.48/$
 90-day euro Swiss franc deposit rate 4% p.a.
 90-day euro-dollar deposit rate 8% p.a.

  90  
 1   0.04 x 360 
SF/$
F90  SF1.48x
   SF1.48 x
1.01
 Sfr1.4655/$
  90   1.02
 1   0.08 x 360 
 

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 Premium or discount?
 Forward premium or discount : % difference b/n spot &
forward rates in annual percentage terms.
• For indirect quotes (FC per home currency, FC/$) then
Spot - Foward 360
f FC
 x x 100
Foward days

SF1.48 - SF1.4655 360

f SF
 x x 100   3.96% p.a.
SF1.4655 90

• Swiss franc sells forward @ premium 3.96% p. a.

(takes 3.96% more US$ to get franc at 90-day forward rate)
• For direct quotes ($/FC), use (F-S)/S x (360/90)x100.
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Currency Yield Curve & Forwards
Interest
yield
6.0 %
Euro yield curve
5.0 %

4.0 %

3.0 % Forward premium on

low interest rate currrency Eurodollar
yield curve
2.0 %

1.0 %

1 2 3 4 5 6
Months
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 Interest Rate Parity (IRP)
 Interest rate parity:difference in national interest
rates for securities of similar risk & maturity should
be equal to opposite of forward rate discount/
premium for foreign currency.

1  i   S
US$ FC/US$
1  i  F
FC 1
FC/US$

or
F FC/US$ 1  i FC

S FC/US$
1  i US$

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 Interest Rate Parity (IRP)
i $ = 8 % per annum
(2 % 90 days)
Start End
$1,000,000  1.02 $1,020,000

Dollar money market $1,019,993

S = SF 1.4800/$ 90 days F90 = SF 1.4655/$

Swiss franc money market

SF 1,480,000  1.01 SF 1,494,800

i SF = 4 % per annum
(1 % 90 days)

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 Covered Interest Arbitrage (CIA)
 Because spot & forward markets are not in
equilibrium, arbitrage exists.
 Covered interest arbitrage (CIA): invests in currency
that offers higher return on covered basis.

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Covered Interest Arbitrage (CIA)
Eurodollar rate = 8.00 % per annum
Start End
$1,000,000  1.04 $1,040,000 Arbitrage
$1,044,638 Potential
Dollar money market

S =¥ 106.00/$ 180 days F180 = ¥ 103.50/$

Yen money market

¥ 106,000,000  1.02 ¥ 108,120,000

Euroyen rate = 4.00 % per annum

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Uncovered Interest Arbitrage (UIA)
 Uncovered interest arbitrage (UIA): investors
borrow in currencies w/ low interest rates & convert
proceeds into currencies w/ high interest rates.
 “Uncovered” because investor does not sell the
currency forward.

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 Uncovered Interest Arbitrage (UIA):
The Yen Carry Trade
Investors borrow yen at 0.40% per annum
Start End
¥ 10,000,000  1.004 ¥ 10,040,000 Repay
¥ 10,500,000 Earn
Then exchanges Japanese yen money market ¥ 460,000 Profit
the yen proceeds
for US dollars,
S =¥ 120.00/$ 360 days S360 = ¥ 120.00/$
investing in US
dollar money
markets for US dollar money market
one year
$ 83,333.333  1.05 $ 87,500.000

Invest dollars at 5.00% per annum

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 Interest Rate Parity (IRP) & Equilibrium

2 Percentage premium on
foreign currency (¥)
1
4.83

-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1

-2

-3
Percent difference between
foreign (¥) and domestic X U
-4
($) Y
interest rates Z
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 Forward Rate - Unbiased Predictor?
Exchange rate

S2 F2

Error Error
S1 F3

F1 S3 Error

S4

Time
t1 t2 t3 t4

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 Study Work:
 Questions: 1,2,3,4,5,6,7,8,9
 Problems: 1,2,3,4,5,6,7,8,9,10,12,13,14

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