Lecture Chapter 6 - accessiblePPT

Multinational Business Finance
Fifteenth Edition
Chapter 6
International Parity
Conditions
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Learning Objectives
6.1 Examine how price levels and price level changes
(inflation) in countries determine the exchange rates at
which their currencies are traded
6.2 Show how interest rates reflect inflationary forces within
each country and currency
6.3 Explain how forward markets for currencies reflect
expectations held by market participants about the future
spot exchange rate
6.4 Analyze how, in equilibrium, the spot and forward
currency markets are aligned with interest differentials and
differentials in expected inflation
International Parity Conditions (1 of 2)
• Some fundamental questions managers of MNEs,
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.

International Parity Conditions (2 of 2)
• These theories do not always work out to be “true” when
compared to what students and practitioners observe in
the real world, but they are central to any understanding
of how multinational business is conducted and funded in
the world today.
• The mistake is often not with the theory itself, but with the
interpretation and application of said theories.

Prices and Exchange Rates (1 of 2)
• If the identical product or service can be:
– sold in two different markets; and
– no restrictions exist on the sale; and
– transportation costs of moving the product between
markets are equal, then
– the product’s price should be the same in both
markets.
• This is called the law of one price.

Prices and Exchange Rates (2 of 2)
• A primary principle of competitive markets is that prices
will equalize across markets if frictions (transportation
costs) do not exist.
• Comparing prices then, would require only a conversion
from one currency to the other:
P $  S ¥$  P ¥
For long description, see slide 40: Appendix 1
Where the product price in U.S. dollars is (P $ ), the spot

exchange rate is (S ¥$ ) and the price in Yen is (P ¥ ).

Purchasing Power Parity and the
Law of One Price
• 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.
• A fun example is the Big Mac Index published annually by
the Economist. Exhibit 6.1 illustrates.

Exhibit 6.1 Selected Rates from the
Big Mac Index

* These exchange rates are stated in U S$ per unit of local currency,
** Percentage under/over valuation against the dollar is calculated as (Implied – Actual)/(Actual), except for the Britain
and Euro area calculations, which are (Actual-Implied)/(Implied)
Source: Data for columns (1) and (2) drawn from “The Big Mac Index,” The Economist, July 13, 2017.

Relative Purchasing Power Parity (1 of 2)
• 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 (relative PPP).
• Relative PPP holds that PPP is not particularly 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.
• See Exhibit 6.2

Relative Purchasing Power Parity (2 of 2)
• More specifically, with regard to relative PPP:
“If the spot exchange rate between two countries starts in
equilibrium, any change in the differential rate of inflation
between them tends to be offset over the long run by an
equal but opposite change in the spot exchange rate.”

Exhibit 6.2 Relative Purchasing
Power Parity (PPP)

Empirical Tests of Purchasing Power
Parity
• Empirical testing of PPP and the law of one price has
been done, but has not proved PPP to be accurate in
predicting future exchange rates.
• Two general conclusions can be made from these tests:
– PPP holds up well over the very long run but poorly
for shorter time periods
– The theory holds better for countries with relatively
high rates of inflation and underdeveloped capital
markets.

Exchange Rate Indices: Real and
Nominal
• Individual national currencies often need to be evaluated
against other currency values to determine relative
purchasing power to discover whether a nation’s exchange
rate is “overvalued” or “undervalued” in terms of PPP.
• This problem is often dealt with through the calculation of
exchange rate indices such as the nominal effective
exchange rate index.
C$
$
ER = E N $

C FC
• Exhibit 6.3 illustrates real effectives exchange rate

indexes for Japan, the euro area, and the U.S.
Exhibit 6.3 Real Effective Exchange
Rate Indexes (Base Year 2010 = 100)

Source: Bank for International Settlements, www.bis.org/statistics/eer/. BIS effective exchange rate (E ER), Real (CPI-
based), narrow indices, monthly averages, January 1980–November 2017.

Exchange Rate Pass-Through (1 of 3)
• Exchange rate pass-through is a measure of the
response of imported and exported product prices to
changes in exchange rates.

• Price elasticity of demand is an important factor when
determining pass-through levels.
• The own-price elasticity of demand for any good is the
percentage change in quantity of the good demanded as
a result of the percentage change in the good’s price.
%Qd
Price elasticity of demand  εp 
%P

• A number of emerging market countries have chosen in
recent years to change their objectives and choices.
• These countries have shifted from choosing a pegged
exchange rate and independent monetary policy over the
free flow of capital (point A in Exhibit 6.4) to policies
allowing more capital flows at the expense of a pegged or
fixed exchange rate (toward point C in Exhibit 6.4).

Exhibit 6.4 Pass-Through, the Impossible
Trinity, and Emerging Markets

Interest Rates and Exchange Rates (1 of 3)
• The Fisher effect states that nominal interest rates in
each country are equal to the required real rate of return
plus compensation for expected inflation.
• This equation reduces to (in approximate form):
i  r 
Where i = nominal interest rate, r = real interest rate and 
= expected inflation.
• Empirical tests (using ex-post) national inflation rates have
shown the Fisher effect usually exists for short-maturity
government securities (treasury bills and notes).

• The relationship between the percentage change in the
spot exchange rate over time and the differential between
comparable interest rates in different national capital
markets is known as the international Fisher effect.
• “Fisher-open,” as it is termed, states that the spot
exchange rate should change in an equal amount but in
the opposite direction to the difference in interest rates
between two countries.

• More formally:

• Where i $ and i ¥ are the respective national interest rates
and S is the spot exchange rate using indirect quotes
(¥/$).
• Justification for the international Fisher effect is that
investors must be rewarded or penalized to offset the
expected change in exchange rates.
The Forward Rate (1 of 4)
• A forward rate is an exchange rate quoted for settlement
at some future date.
• A forward exchange agreement between currencies
states the rate of exchange at which a foreign currency
will be bought forward or sold forward at a specific
date in the future.

• The forward rate is calculated for any specific maturity by
adjusting the current spot exchange rate by the ratio of
eurocurrency interest rates of the same maturity for the
two subject currencies.
• For example, the 90-day forward rate for the Swiss
franc/U.S. dollar exchange rate (F SF/ $90) is found by
SF
multiplying the current spot rate (S / $) by the ratio of the
90-day euro-Swiss franc deposit rate (i SF ) over the 90-day
eurodollar deposit rate (i $ ).

• Formulaic representation of the forward rate:
  SF 90  
1   i  360  
  
F SF/$
90 =S SF/$

  $ 90  
1   i  360  
  

• The forward premium or forward discount is the
percentage difference between the spot and forward
exchange rate, stated in annual percentage terms.
Spot  Forward 360
f SF    100
Forward days
• This is the case when the foreign currency price of the

home currency is used (SF/$).
• See Exhibit 6.5

Exhibit 6.5 Currency Yield Curves and the
Forward Premium

Interest Rate Parity (IRP)
• The theory of Interest Rate Parity (IRP) provides the
linkage between the foreign exchange markets and the
international money markets.
• The theory states, “The difference in the national interest
rates for securities of similar risk and maturity should be
equal to, but opposite in sign to, the forward rate discount
or premium for the foreign currency, except for
transaction costs.”
• See Exhibit 6.6

Exhibit 6.6 Interest Rate Parity (IRP)

Covered Interest Arbitrage (CIA)
• The spot and forward exchange rates are not constantly
in the state of equilibrium described by interest rate parity.
• When the market is not in equilibrium, the potential for
“risk-less” or arbitrage profit exists.
• The arbitrager will exploit the imbalance by investing in
whichever currency offers the higher return on a covered
basis.
• See Exhibit 6.7

Exhibit 6.7 Covered Interest
Arbitrage (CIA)

Uncovered Interest Arbitrage (UIA)
• In the case of uncovered interest arbitrage (UIA), 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.
• See Exhibit 6.8

Exhibit 6.8 Uncovered Interest
Arbitrage (UIA): The Yen Carry Trade

Equilibrium Between Interest Rates
and Exchange Rates
• Exhibit 6.9 illustrates the conditions necessary for
equilibrium between interest rates and exchange rates.
• The disequilibrium situation, denoted by point U, is
located off the interest rate parity line.
• However, the situation represented by point U is unstable
because all investors have an incentive to execute the
same covered interest arbitrage, which is virtually risk-
free.

Exhibit 6.9 Interest Rate Parity and
Equilibrium

Forward Rate as an Unbiased
Predictor of the Future Spot Rate
• Some forecasters believe that forward exchange rates
are unbiased predictors of future spot exchange rates.
• Intuitively this means that the distribution of possible
actual spot rates in the future is centered on the forward
rate.
• Unbiased prediction simply means that the forward rate
will, on average, overestimate and underestimate the
actual future spot rate in equal frequency and degree.
• Exhibit 6.10 illustrates this theory.

Exhibit 6.10 Forward Rate as an
Unbiased Predictor of Future Spot

The forward rate available “today” (Ft) for delivery at a future time (t + 1) is used as a forecast or
predictor of the spot rate at time t + 1. The difference between the spot rate which then occurs and
the forward rate is the forecast error. When the forward rate is termed an “unbiased predictor of the
future spot rate,” it means that the errors are normally distributed around the mean future spot rate
(the sum of the errors equals zero).

Prices, Interest Rates, and Exchange
Rates in Equilibrium
• Exhibit 6.11 illustrates all of the fundamental parity
relations simultaneously, in equilibrium, using the U.S.
dollar and the Japanese yen.

Exhibit 6.11 International Parity Conditions
in Equilibrium (Approximate Form)

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Appendix 1
Long Description for a formula expresses a currency
conversion from dollars to yen.
P to the power of dollar sign, times S to the power of start
expression Yen sign times dollar sign end expression
equals P to the power of Yen sign.
Return to presentation

Appendix 2 (1 of 2)
Long Description for a comparison of 12 foreign currencies based on the price of a Big Mac against the US Dollar.
A table shows Big Mac prices in 14 currencies, and shows the conversion of that price into dollars. It then compares
the currency to the dollar showing the difference in valuation.
A table has 14 rows and 7 columns. The columns have the following headings from left to right. Country, Currency,
Column 1, Big Mac Price in Local Currency, Column 2, Actual Dollar Exchange Rate July 2017, Column 3, Big Mac
Price in Dollars, Column 4, Implied P PP of the Dollar, Column 5, Under or over valuation against the dollar. Footnote
asterisk, asterisk, . The row entries are as follows. Row 1. Country, United States. Currency, Dollar sign. Column 1, Big
Mac Price in Local Currency, 5.3. Column 2, Actual Dollar Exchange Rate July 2017, blank. Column 3, Big Mac Price in
Dollars, 5.3. Column 4, Implied P PP of the Dollar, blank. Column 5, Under or over valuation against the dollar.
Footnote asterisk, asterisk, blank. Row 2. Country, Britain. Currency, Pound sign. Column 1, Big Mac Price in Local
Currency, 3.19. Column 2, Actual Dollar Exchange Rate July 2017, 1.2889 asterisk. Column 3, Big Mac Price in
Dollars, 4.11. Column 4, Implied P PP of the Dollar, 1.6614. Column 5, Under or over valuation against the dollar.
Footnote asterisk, asterisk, Negative 22.4%. Row 3. Country, Canada. Currency, C, dollar sign. Column 1, Big Mac
Price in Local Currency, 5.97. Column 2, Actual Dollar Exchange Rate July 2017, 1.2823. Column 3, Big Mac Price in
Dollars, 4.66. Column 4, Implied P PP of the Dollar, 1.1264. Column 5, Under or over valuation against the dollar.
Footnote asterisk, asterisk, Negative 12.2%. Row 4. Country, China. Currency, Yuan. Column 1, Big Mac Price in Local
Currency, 19.8. Column 2, Actual Dollar Exchange Rate July 2017, 6.7875. Column 3, Big Mac Price in Dollars, 2.92.
Column 4, Implied P PP of the Dollar, 3.7358. Column 5, Under or over valuation against the dollar. Footnote asterisk,
asterisk, negative 45.0%. Row 5. Country, Denmark. Currency, D, K. Column 1, Big Mac Price in Local Currency, 30.
Column 2, Actual Dollar Exchange Rate July 2017, 6.5126. Column 3, Big Mac Price in Dollars, 4.61. Column 4,
Implied P PP of the Dollar, 5.6604. Column 5, Under or over valuation against the dollar. Footnote asterisk, asterisk,
negative 13.1%. Row 6. Country, Euro area. Currency, Euro sign. Column 1, Big Mac Price in Local Currency, 3.91.
Column 2, Actual Dollar Exchange Rate July 2017, 1.1419 asterisk. Column 3, Big Mac Price in Dollars, 4.46. Column
4, Implied P PP of the Dollar, 1.3555 asterisk. Column 5, Under or over valuation against the dollar. Footnote asterisk,
asterisk, negative 15.8%.
Appendix 2 (2 of 2)
Row 7. Country, India. Currency, Rupee. Column 1, Big Mac Price in Local Currency, 178. Column 2, Actual Dollar
Exchange Rate July 2017, 64.558. Column 3, Big Mac Price in Dollars, 2.76. Column 4, Implied P PP of the Dollar,
33.585. Column 5, Under or over valuation against the dollar. Footnote asterisk, asterisk, negative 48.0%. Row 8.
Country, Japan. Currency, Yen sign. Column 1, Big Mac Price in Local Currency, 380. Column 2, Actual Dollar
Exchange Rate July 2017, 113.06. Column 3, Big Mac Price in Dollars, 3.36. Column 4, Implied P PP of the Dollar,
71.698. Column 5, Under or over valuation against the dollar. Footnote asterisk, asterisk, negative 36.6%. Row 9.
Country, Mexico. Currency, Peso. Column 1, Big Mac Price in Local Currency, 49. Column 2, Actual Dollar Exchange
Rate July 2017, 17.7908. Column 3, Big Mac Price in Dollars, 2.75. Column 4, Implied P PP of the Dollar, 9.2453.
Column 5, Under or over valuation against the dollar. Footnote asterisk, asterisk, negative 48.0%. Row 10. Country,
Norway. Currency, k, r. Column 1, Big Mac Price in Local Currency, 49. Column 2, Actual Dollar Exchange Rate July
2017, 8.2852. Column 3, Big Mac Price in Dollars, 5.91. Column 4, Implied P PP of the Dollar, 9.2453. Column 5,
Under or over valuation against the dollar. Footnote asterisk, asterisk, 0.116. Row 11. Country, Peru. Currency, S o l.
Column 1, Big Mac Price in Local Currency, 10.5. Column 2, Actual Dollar Exchange Rate July 2017, 3.2515. Column
3, Big Mac Price in Dollars, 3.23. Column 4, Implied P PP of the Dollar, 1.9811. Column 5, Under or over valuation
against the dollar. Footnote asterisk, asterisk, negative 39.11%. Row 12. Country, Russia. Currency, Ruble. Column 1,
Big Mac Price in Local Currency, 137. Column 2, Actual Dollar Exchange Rate July 2017, 60.1369. Column 3, Big Mac
Price in Dollars, 2.28. Column 4, Implied P PP of the Dollar, 25.849. Column 5, Under or over valuation against the
dollar. Footnote asterisk, asterisk, negative 57.0%. Row 13. Country, Switzerland. Currency, Swiss Franc. Column 1,
Big Mac Price in Local Currency, 6.5. Column 2, Actual Dollar Exchange Rate July 2017, 0.9642. Column 3, Big Mac
Price in Dollars, 6.74. Column 4, Implied P PP of the Dollar, 1.2264. Column 5, Under or over valuation against the
dollar. Footnote asterisk, asterisk, 0.272. Row 14. Country, Thailand. Currency, Baht. Column 1, Big Mac Price in Local
Currency, 119. Column 2, Actual Dollar Exchange Rate July 2017, 34.0365. Column 3, Big Mac Price in Dollars, 3.5.
Column 4, Implied P PP of the Dollar, 22.4528. Column 5, Under or over valuation against the dollar. Footnote asterisk,
asterisk, negative 34.0%.
Appendix 3
Long Description for a graph plots the change in the spot exchange rate versus the difference in
expected rates of foreign inflation.
The graph is known as the Purchasing Power Parity, or P PP line. The following list details how the
features of the graph represent the strength or weakness of the home currency based on the spot
exchange rate and expected rates of inflation.
• The PPP line falls through point P at (negative 4, 4) and the origin. Point P forms the top left
vertex of a square region in quadrant 2. The other vertices of the square are at (0, 4), (0, 0), and
(negative 4, 0). As a result, the right side of the square lies on the positive vertical axis, and the
bottom side of the square lies on the negative horizontal axis.
• Point W is above the line at (negative 2, 4) on the top side of the square. If the market was at point
W, the expected change in the spot exchange rate would be 4%, although the percentage
difference in expected inflation was only negative 2%. the home currency would be weak.
• Point S is below the line at (negative 4, 2) on the left side of the square. If the market was at point
S, the expected change in the spot exchange rate would be 2%, although the percentage
difference in expected inflation was negative 4%. the home currency would be strong.

Appendix 4
Long Description for E subscript R in dollars equals E
subscript N in dollars times start expression C in dollars
divided by C in F, C end expression.
Appendix 5
Long Description for a graph plots the real effective exchange rate index for the U. S. dollar, Japanese yen, and the Euro
from 1980 to 2017.
The graph has three curves representing the exchange rate indexes for United States dollar, Japanese yen, and Euro
Area euro. The following list outlines the trends demonstrated by the graph. All rates are based on base year 2010 = 100.
All values are estimated.
• The index for the United States dollar started at 106 in January 1980, before rising to a peak at 145 around August
1984. The index then fell to a low at 95 in December 1991, before fluctuating between 95 and 130 during the period
from 1991 and 2017. The index for the dollar reached notable peaks at 125 in 2001, at 112 in 2008, and at 129 in
2016. The index reached notable valleys at 95 in 1991, 2007, and 2010. By 2017, the index for the United States
dollar was at 120.
• The index for the Japanese yen started at 73 in January 1980. Despite fluctuations of up to 30 points over 2 years, the
index generally rose between the years 1982 and 1995, with notable peaks at 115 in 1998 and at 142 in 1995. From
1995 to 2017, the index for the yen then generally declined. During this period, the index had notable peaks at 123 in
2001 and at 108 in 2011. The index had notable valleys at 93 in 1997, at 75 in 2006, and at 72 in 2014. By 2017, the
index for the Japanese yen was at 95.
• The index for the Euro Area euro started at 98 in 1980, before falling to near 80 by 1981. From 1981 to 1984, the
index for the euro fluctuated between 78 and 88, before rising to near 98 in 1986. From 1986 to 1998, the index
fluctuated between 85 and 100, ending at 95. The index then fell to near 74 in 2000, before once again climbing to
near 110 by 2007. From 2007 to 2017, the index for the euro generally fell, ending at 95.

Appendix 6
Long Description for a formula summarizes the previous
paragraph.
Price elasticity of demand equals epsilon subscript rho
equals start expression percent delta Q subscript d end
expression divided by start expression percent delta P end
expression.
Appendix 7
Long Description for a diagram presents the impossible trinity of pegged exchange rate, free
flow of capital and independent monetary policy.
A triangle has vertices that represent the pegged exchange rate, the free flow of capital, and
independent monetary policy. Points A, B, and C on the sides of the triangle represent the
changing approach of emerging market nations to their exchange rates. The following list
outlines this changing approach.
• Emerging market nations generally start at point A on the side of the triangle between the
pegged exchange rate and independent monetary policy. These nations traditionally
value exchange rate stability and monetary independence.
• Emerging market nations want to attract capital inflows. So, they have shifted toward
point C on the side of the triangle between independent monetary policy and free flow of
capital.
• Exchange rate pass through has also led emerging market nations to shift toward point B
on the side of the triangle between pegged exchange rate and free flow of capital. Now
that these countries are experiencing changing exchange rates, exchange rate pass
through is a growing source of inflationary pressure and price instability.
Appendix 8
Long Description for a math formula represents the last
point of the previous slide.
Start expression start expression S subscript 1 minus S
subscript 2 end expression divided by S subscript 2 end
expression times 100 equals I in dollars minus I in yen

Appendix 9
Long Description for a math formula represents the last
point of the previous slide.
F to the power of S, F divided by $90 equals start
expression S to the power of S, F divided by dollar sign end
expression times start fraction 1 plus left parenthesis i to
the power of S, F times 90 divided by 360 right parenthesis
over 1 plus left parenthesis i to the power of dollar sign
times 90 divided by 360 right parenthesis end fraction.
Appendix 10
Long Description for a math formula represents how the
forward premium or forward discount is derived.
F to the power of S, F equals start fraction spot minus
forward over forward end fraction times start fraction 360
over days end fraction times 100.
Appendix 11
Long Description for a graph plots interest yield in percent for the euro
dollar and euro Swiss franc versus maturity or days forward.
The graph has two yield curves for the euro dollar and euro Swiss
franc. Each curve rises with decreasing steepness from a point on the
positive vertical axis. The euro dollar yield curve rises from (0, 3.5)
through (90, 8.0) to (180, 8.6). So, at 80 days forward, the interest yield
for the euro dollar is 8.0%. The euro Swiss franc yield curve rises from
(0, 1.6) through (90, 4.0) to (180, 4.6). So, at 80 days forward, the
interest yield for the euro Swiss franc is 4.0%. The forward pendulum is
the percentage difference between interest yields. The percentage
difference is equal to the vertical distance between the curves at 80
days forward. The percentage difference is 3.96%. All values
estimated.
Appendix 12
Long Description for a diagram shows interest rate parity for the U S dollar passing through U S and
Japanese money markets for 90 days.
A diagram demonstrates how the same U S dollar amount can generate very similar final amounts
when it passes through the U S dollar money market and the Swiss franc money market over a 90 day
period. The following list outlines the conversion process in each market and compares the final
amounts.
• Start. $1,000,000 enters the U S dollar money market and the Swiss franc money market.
• The US dollar money market uses the euro dollar interest rate of 8.00%, which is equivalent to 2%
for 90 days. $1,000,000 times 1.02 = $1,020,000.
• Before entering the Swiss franc money market, the starting amount is converted using the spot
exchange rate of S F 1.4800 = $1.00. $1,000,000 times 1.4800 = S F 1,480,000. The Swiss franc
money market uses the Swiss franc interest rate of 4.00% per annum, which is equivalent to 1%
for 90 days. S F 1,480,000 times 1.01 = S F 1,494,800. This Swiss franc amount is then converted
using the 90 day forward rate, or F 90, of S F 1.4655 = $1.00. S F 1,494,800 divided by 1.4655 =
$1,019,993.
• End. The final amount from the U S dollar money market is $1,020,000. The final amount from the
Swiss franc money market is $1,019,993. The amounts only differ by a transaction cost of $7.00.

Appendix 13
Long Description for a diagram shows covered interest arbitrage for U S dollars passing through U S
and Japanese markets for 180 days.
A diagram demonstrates how the same U S dollar amount can generate different final amounts when
it passes through the U S dollar money market and the Japanese money market over a 180 day
period. The following list outlines the conversion process in each market and compares the final
amounts.
• Start. $1,000,000 enters the U S dollar money market and the Japanese yen money market.
• The U S dollar money market uses the euro dollar interest rate of 8.00%, which is equivalent to
4% for 180 days. $1,000,000 times 1.04 = $1,040,000.
• Before entering the Japanese yen money market, the starting amount is converted using the spot
exchange rate 106.00 yen = $1.00. $1,000,000 times 106 = S F 106,000,000 yen. For the
Japanese yen money market, the investor uses a euro yen account with an interest rate of 4.00%
per annum, which is equivalent to 2% for 180 days. 106,000,000 yen times 1.02 = 108,120,000
yen. This yen amount is then converted using the 180 day forward rate, or F 180, of 103.50 yen =
$1.00. S F 108,120,000 yen divided by 103.50 = $1,044,638.
• End. The final amount from the U S dollar money market is $1,040,000. The final amount from the
Japanese yen money market is $1,044,638. The amounts only differ by an arbitrage potential of
$44,638.

Appendix 14
Long Description for a diagram shows uncovered interest arbitrage for Japanese yen passing through
Japanese and US markets for 360 days.
A diagram demonstrates how the same Japanese yen amount can generate different final amounts
when it passes through the Japanese yen money market and the U S dollar money market over a 360
day period. The following list outlines the conversion process in each market and compares the final
amounts.
• Start. 10,000,000 yen enters the Japanese yen money market and the U S dollar money market.
• For the Japanese yen money market, the investor borrows yen for 360 days at 0.40% per annum.
10,000,000 yen times 1.004 = 10,040,000.
• Before entering the U S dollar money market, the starting amount is converted using the spot
exchange rate of 120.00 yen = $1.00. 10,000,000 yen divided by 120.00 = $83,333.33. The investor
deposits this amount in the U S dollar money market at 5.00% per annum. $83,333.33 times 1.05 =
$87,500.00. The investor then converts this dollar amount back to yen, using the expected spot
exchange rate of 120.00 yen = $1.00. $87,500.00 times 120.00 = 10,500,000 yen.
• End. The final amount from the Japanese yen money market is 10,040,000, which is repaid. The final
amount from the US dollar money market is 10,500,000, which is earned. The amounts differ by a
profit of 4460,000 yen.
Appendix 15
Long Description for a graph plots the difference between foreign and
domestic interest rates versus the premium on foreign currency.
The graph falls diagonally through the origin, point X at (4, negative 4),
point Y at approximately (4.41, negative 4.41), and point Z at (4.83,
negative 4.83). The line intersects a rectangular region in quadrant 4.
Counterclockwise from the top right, the rectangular region has vertices
at (4.83, 0), (0, 0), (0, negative 4), and point U at (4.83, negative 4).
Point X lies on the bottom side of the region, 0.83 units to the left of
point U. Point Z is 0.83 units below point U. If market interest rates
were at point U, covered interest arbitrage profits are available, and
would be undertaken until the market drove interest rate differences
back to point X, Y, or Z.

Appendix 16
Long Description for a graph plots spot exchange rate S and forward rate F versus time t
for times t sub 1 to t sub 4.
The graph includes separate plots for spot rate S and forward rate F, as described in the
following list.
• The plot of spot rate S rises from (t sub 1, S sub 1) to (t sub 2, S sub 2) and then falls
through (t sub 3, S sub 3) to (t sub 4, S sub 4). Vertical lines rise through the t axis at t
sub 1, t sub 2, t sub 3, and t sub 4. The vertical lines intersect the graph of S at S sub
1, S sub 2, S sub 3, and S sub 4, respectively.
• The plot of forward rate F consists of three line segments with end points on the
vertical lines at t sub 1, t sub 2, t sub 3, and t sub 4. The first line segment falls from (t
sub 1, S sub 1) to (t sub 2, F sub 1), where F sub 1 is less than S sub 2. The second
line segment rises from (t sub 2, S sub 2) to (t sub 3, F sub 2), where F sub 2 is
greater than S sub 3. The third line segment rises from (t sub 3, S sub 3) to (t sub 4, F
sub 3), where F sub 3 is greater than S sub 4.
• On each vertical line, the distance between the S and F values represents the error in
the forward rate.
Appendix 17
Long Description for a diagram represents international parity conditions in equilibrium.
A diagram represents international parity conditions in equilibrium. This approximate model of
equilibrium involves five relations identified by the letters A, B, C, D, and E. The following list describes
each relation based on changes to exchange rates, interest rates, and inflation for the Japanese yen.
• Relation A. purchasing power parity. The forecast change in the spot exchange rate is plus 4%,
meaning the yen strengthens. The forecast difference in rates of inflation is minus 4%, meaning less
in Japan.
• Relation B. Fisher effect. The forecast difference in rates on inflation is minus 4%, meaning less in
Japan. The difference in nominal interest rates is minus 4%, meaning less in Japan.
• Relation C. international Fisher effect. The forecast change in the spot exchange rate is plus 4%,
meaning the yen strengthens. The difference in nominal interest rates is minus 4%, meaning less in
Japan.
• Relation D. interest rate. The difference in nominal interest rates is minus 4%, meaning less in Japan.
The forward premium on foreign currency is plus 4%, meaning the yen strengthens.
• Relation E. forward rate as an unbiased predictor. The forward premium on foreign currency is plus
4%, meaning the yen strengthens. The forecast change in the spot exchange rate is plus 4%,
meaning the yen strengthens.

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Where the product price in U.S. dollars is (P $ ), the spot

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• Exhibit 6.3 illustrates real effectives exchange rate

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• This is the case when the foreign currency price of the

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