FIE433 - Parity Conditions

INTERNATIONAL FINANCE:
Dr. Uwe Walz
Topic 5:
International Parity Conditions
6-1 2012 Pearson Education, Inc. All rights reserved. 1

Topic 5: International Parity Conditions
BH Chapter 6: Interest Rate Parity
BH Chapter 7: Uncovered interest rate parity
BH Chapter 8: Purchasing Power Parity

The main idea(s):
Main international markets
International capital markets
International goods markets

The main idea(s):
Equilibrium in both markets: no-arbitrage

possibilities in these markets
Interest rate parity: no-arbitrage in capital

markets
Without risk: covered interest-rate parity
With risk: uncovered interest-rate parity
Purchasing power parity: no-arbitrage in goods

markets

Chapter 6
Covered Interest
Rate Parity
adapted by Uwe Walz

Slides prepared by
April Knill, Ph.D., Florida State University

The Theory of Covered Interest Rate Parity
An Introductory Example:
Kim Deal is a portfolio manager at BNP Paribas.

Kim is trying to decide how to invest 10m and
she must choose between 1-year euro or yen
investments.
Suppose she has the following data

EUR interest rate: 3.52% p.a.
JPY interest rate: 0.5938%
Spot rate: S(/)=146.03
Forward rate: F(/)=141.9021
Which investment gives the highest return?

Why of the two options is better?
EUR asset: Future value (FV) of investment

10m x 1.0352 = 10,352,000
YEN asset: 3 steps required

Convert EUR to YEN:
10m x 146.03/=1,460,300,000
Compute FV
1,460,300,000 x 1.005938 = 1,468,971,261
Hedge risk with forward
1,468,971,261 / 141.9021/=10,352,005
Kim is indifferent! Why? Covered Interest Rate

Parity Holds

Deriving interest rate parity

An investor is indifferent between investing
at home or abroad
[1+i] = [1/S] * [1+i*] * F
Hence
(1+i)/(1+i*) = F/S
Covered interest rate parity

Subtracting 1 from each side and
simplifying we obtain
(F-S)/S=(i-i*)/(1+i*)
If the result of this equation is + (-), the

forward is selling at a premium (discount)
Depends on interest rate differential
Intuition: If, say, home interest rate is

higher than abroad, home currency needs
to pay less in future terms
Covered Interest Rate Parity in Practice
Bank market for deposits and loans that are

denominated in foreign currencies (from the
perspective of the bank)
Most prominent example: Eurodollars =
deposits denominated in USD; outside of US
(less regulation)
Offered in other currencies as well:
Example: pound-denominated deposits and
loans made by banks in Frankfurt
Market prospers because it is a way to get
around reserve requirements, which are usually
lower in this market

Interest Rates in the External Currency
Market
Lower than they would be due to the skirted regulations and

increased
Competition, i.e., supply of said currency
Annualized rate * (1/100) * (number of days/360) = de-annualized
rate

Covered Interest Rate Parity in Practice
Accounting for transaction costs (i.e. bid-ask

spreads), covered interest rate parity holds
well most of the time
Prior to 2007, documented violations of interest

rate parity were very rare
Frequency, size and duration of apparent

arbitrage opportunities do increase with market
volatility
For details how to deal with transaction costs,

see Example 6.4

Why Deviations from Interest Rate Parity May
Seem to Exist
Default risk
Counterparty may fail to honor its contract
Let p be default probability: (1-p)(1+i)
If different banks have different risk, then differ
interest rate might just reflect credit risk
Exchange controls
Limitations, taxes
See example 6.5
Political risk
SNB scraps fixed exchange rate

Covered Interest Parity Deviations During the
Financial Crisis

Hedging Transaction Risk in the Money
Market
When Interest Rate Parity holds, there are

two ways to hedge a transaction (either a
liability or a receivable)
Synthetic forward borrowing/lending
foreign currency and making a transaction
in the spot market
Money market hedge if an underlying
transaction gives you a liability, you use a
money market asset to hedge the position
(and vice versa)

Market
Hedging a foreign currency liability: US wine seller imports
French wine worth 4mill, due in 90 days
Spot rate: $1.0969 /
90day forward: $1.104/
90-day dollar interest rate: 2% p.a.
90-day Euro interest rate: -0.2% p.a.
Alternative 1:
forward contract: cost in 90 days:
4mill*($1.104/)=$4,416,000
Present value: $4,416,000/(1+0.024*90/360)=$4.389622

Market
Alternative 2: money market hedge
Invest now: 4,000,00*(1+(-0.002*90/360))=

4,002,001
This gives you 4mill in 90 days

Buying this @spot rate: $1.0969/ gives $4,389,794

INTERNATIONAL FINANCE:
Speculation and Risk in the Foreign

Exchange Market

Chapter 7
Speculation and
Risk in the
Foreign Exchange
Market
adapted by Uwe Walz
Slides prepared by

Speculating in the Foreign Exchange Market:
Example
Uncovered foreign money market investments: no hedge
Kevin Anthony, a portfolio manager, was considering

several ways to invest $10,000,000 for 1 year. The data
are as follows:
USD interest rate: 8.0% p.a.; GBP interest rate: 12.0%

p.a.; Spot: $1.60/
If Kevin invests in the USD-denominated asset at 8%,

after 1 year he will have $10M * 1.08 = $10.8M

Speculating in the Foreign Exchange Market:
Example
Suppose Kevin invests his $10M in the pound money

market, but he decides not to hedge the foreign exchange
risk.
Step 1. Convert dollars into pounds in the spot market.

The $10,000,000 will buy $10M/($1.60/) = 6.25M
Step 2. Kevin can invest his pound principal at 12%

yielding a return in 1 year of 6.25M * 1.12 = 7M
Step 3. Sell the pound principal plus interest at the spot

exchange rate in 1 year: Dollar proceeds in 1 year - 7M
* S(t+1,$/)
6-21
Excess return (t+1) = S(t+1) * (7M/$10M) 1.08
2012 Pearson Education, Inc. All rights reserved. 21
Speculating in the Foreign Exchange Market
Speculating with forward contracts
Break-even spot rate:

! !#1 + i ($ )"$
BE
S = S (t )
!#1 + i ( )"$
Kevins breakeven rate would be:
SBE = 1.08/0.7 = $1.5429/
If future exchange rate < forward, Kevin has a
negative return
If future exchange rate > forward, Kevin has a
positive return

Speculating in the Foreign Exchange Market
Comparing forward market and foreign money market

investments
Foreign currency is bought forward

Forward Market return (fmr) (per $) =
fmr (t+1) = [S(t+1) F(t)]/S(t)
Excess return of strategy is
fmr(t+1) * [1+i()] =
[S(t+1)/S(t)]*[1+i()]-[1+i($)] = exr(t+1)

Example again: what is the risk of Kevins trade
Currency speculation and profits and losses
Use the conditional expectation of the future

exchange rate
Kevin expects the to depreciate against the $ by
3.57% over next year
$1.60/ * (1-0.0357) = $1.5429/ 7M *
$1.5429/ = $10.8003M
At what forex rate will Kevin just get his $10M
back? 7M * S = $10M $1.4286/
Probability that he will lose with 10% standard
deviation of appreciation of would be [S(t+1/$/ )
- $1.5429/ ]/$0.16/.

Example: Kevin -- Solution

Standard Deviations of Monthly Exchange Rate Changes
and Forward Market Returns: lessons from history

Uncovered Interest Rate Parity
Covered interest rate parity:

doesnt matter where you invest
same domestic currency return as long as the
foreign exchange risk is covered using a
forward contract
Uncovered interest rate parity

domestic and foreign investments have same
expected returns: E(S)=F
In the context of Kevins investment, suggests
that the pound is not a great investment
relative to the dollar in fact, it suggests that
the pound will depreciate by 3.57%

Unbiasedness hypothesis
Unbiasedness hypothesis no systematic

difference
between the forward rate and the expected
future
spot rate
! ! S (t + 1)" F (t )
Et # $ !%1 + i ( )"& = !%1 + i ($ )"& = !%1 + i ( )"&
% S (t ) & S (t )
Uncovered Interest Co vered Interest

Rate Parity Rate Parity

Unbiasedness Hypothesis
Forecast error
the difference between the actual future spot exchange
rate and its forecast
Unbiased predictors
implies expected forecast error = 0
Can have large errors as long as they dont favor one side
The unbiasedness hypothesis and market efficiency
If the forward rate were biased then one side or the other
of a bet (i.e., futures contract) would be expected the win
and none would volunteer to be the other side of that bet
Consistency problem if unbiased from perspective of,
its biased in the other direction, i.e., $/

Uncovered Interest Rate Parity and the
Unbiasedness Hypothesis in Practice
Situations where premiums matter

International portfolio management
Costs of hedging
Exchange rate forecasting
Exchange rate determination

Empirical Evidence on the Unbiasedness Hypothesis
A test using the sample means
Weakest implication of unbiasedness hypothesis
Says that on averagethe unconditional mean of the

realized appreciation = unconditional mean of the
forward premium
Does this hold empirically?

Means of Monthly Rates of Appreciation,
Forward Premiums,
and the Differences Between the Two

Main findings
High-interest-rate currencies depreciate
Forward premium on a foreign currency =
interest differential between the two
currencies
Failure to reject the unbiasedness hypothesis
with the test of conditional mean
Problem with test

only speaks about its average performance
What about performance at different points in
time?=

Regression tests of the unbiasedness of

forward rates
S(t+30) = a + b fp(t) + (t+30)
Unbiasedness hypothesis is true if a=0

and b=1
Results suggest existence of a forward

rate bias

Regression Tests of the Unbiasedness
Hypothesis
s(t+30) = a + b fp(t) + (t+30)

Interpreting the forward bias

Some suggest that the results are evidence
against unbiasedness hypothesis but they are
forgetting about the constant term
Exh. 7.6 shows the importance of the constant
term in the regression (see third line for correct
interpretation)
Results suggest a speculator should buy dollars
forward if he believes in the predictability of the
regression

Interpreting the Unbiasedness Regression

Risk Premia in the FX Market
Alternative view
Unbiasedness should be rejected
Uncovered IRP is risky
Risk averse investors should be compensated
Types of risks:
Unsystematic (Idiosyncratic) risk the risk that is attributed to
the individual asset and can be diversified away
Systematic risk the risk associated with an assets return
arising from the covariance of the return with the return on a
large, well-diversified portfolio
Capital Asset Pricing Model (CAPM):

FX Risk Premium
Existence is relevant for
International portfolio management

If premium exists, add FX risk to a diversified
portfolio
Costs of hedging
If premium exists, then hedging may be costly
Exchange rate forecasting

If unbiasedness holds, forecasting is useless
Exchange rate determination

If theories rely un UCIRP, then theory is in doubt

Example: Carry trade
Suppose Mrs. Watanabe faces a spot rate of

S(/$)=100 and a 3-month forward rate of
F(/$)=99.17
What is one way of making money?
Answer: buy dollar in forward market!

Example: Carry trade
What is forward discount (or carry)?
99.17 100
4 = 3.32%
100
Corresponds to 83 basis points
As long as dollar does not depreciate by more

than 83bp over next quarter, Mrs. Watanabe
makes money

Carry trade
Popular strategy among hedge funds!
Have carry trades been profitable?
Sharpe ratio excess return per unit of risk

In U.S. stock market 0.3 0.4;
Excess return 5-6% and annualized standard deviation is 15%
Sharpe ratio of carry trades often high but distorted

Non-normal returns (i.e. sudden large adjustment)
Leverage makes correcting for volatility even more important
Time-varying risk-premia
Bottom line: carry trade profitability seems to

compensate for risk but many details are still an open
research question
Next topic
Do price levels influence FX rates?

Chapter 8
Purchasing Power
Parity and Real
Exchange Rates
adapted by Uwe Walz

Slides prepared by

Purchasing Power Parity: The general idea
A simple model of the determination of

exchange rates
Baseline forecast for predicting exchange rate
Plays a fundamental role in corporate
decision making
Location of plants
Pricing products
Hedging decisions
Assessing cost of living decisions (or job
opportunities?!)

Price Level, Price Indexes, and the Purchasing
Power of a Currency
The general idea of purchasing power

Nominal price the monetary value
Price level the nominal price level of a
countrys basket of goods
Weighted average of goods and services (i.e., we
spend 1% of our income on shoes)
Inflation/deflation
Inflation when price level is rising
Deflation when price level is falling
Purchasing power inverse of price level

Absolute PPP and the Law of One Price
FX rate reflects the relative price levels
PPP P(h)
S (h / f ) =
P( f )
FX rate adjusts to equalize the internal with

external purchasing powers of a currency
What if it doesnt adjust? Then arbitrage is
possible
Suppose Volkswagen Golf 30TEUR in Europe,
25TUSD in US; exchange rate: 1.1USD/ ..

The Law of One Price
The perfect market ideal

The Big Mac as a Price Index
Big Mac should cost the same (once you convert
money) no matter where you go
Burgernomics
Implied MacPPP Rates

Overvaluations/Undervaluations

Burgernomics

Burgernomics

Describing Deviations from absolute PPP
Overvalued - when its external purchasing power

exceeds its internal purchasing power
Undervalued when its external purchasing power is
less than its internal purchasing power
Overvaluation of one currency implies
undervaluation of the other currency in the
exchange rate
Think taller/shorter these are relative terms
Predictions
Overvaluations must weaken (depreciate)
Undervaluations must strengthen (appreciate)

Actual USD/EUR and PPP Exchange Rates

Actual JPY/USD and PPP Exchange Rates

Actual CAD/USD and PPP Exchange Rates

Actual MXN/USD and PPP Exchange Rates

Explaining the Failure of Absolute PPP
Overview
Changes in relative prices what if Japanese spend
more on sushi than Americans do?
Different weights
Non-traded goods
Houses
Technology/productivity improvements
PPP deviations and the Balance of Payments
When a currency is overvalued (relative to that implied
by the PPP), the external purchasing power increases
and consumers buy more foreign goods, thus pulling the
value of the domestic currency back down

PPP and the Real Exchange Rate
PPP allows us to think about the real exchange

rate the exchange rate adjusted for inflation
S (t ,$ / euro) P (t , euro)
RS (t ,$ / euro) =
P (t ,$)
How can real exchange rate increase?

An increase in the nominal forex rate S(h/f), holding
price levels constant
An increase in the f-prices of goods
An decrease in the h-prices of goods
Will come back to it later (when needed)

Relative PPP
Exchange rates adjust in response to differences

in inflation across countries keeping the real
exchange rate constant
General expression for relative PPP

1+ H
1+ s(h / f ) =
1+ F
Inflation lowers the purchasing power of money

Next topic
How can we hedge transaction risk?

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INTERNATIONAL FINANCE:

Dr. Uwe Walz

International Parity Conditions

6-1 2012 Pearson Education, Inc. All rights reserved. 1

BH Chapter 6: Interest Rate Parity

BH Chapter 7: Uncovered interest rate parity

BH Chapter 8: Purchasing Power Parity

6-2 2012 Pearson Education, Inc. All rights reserved. 2

Main international markets

International capital markets

International goods markets

6-3 2012 Pearson Education, Inc. All rights reserved. 3

Equilibrium in both markets: no-arbitrage

Interest rate parity: no-arbitrage in capital

Purchasing power parity: no-arbitrage in goods

6-4 2012 Pearson Education, Inc. All rights reserved. 4

adapted by Uwe Walz

April Knill, Ph.D., Florida State University

Kim Deal is a portfolio manager at BNP Paribas.

Suppose she has the following data

Which investment gives the highest return?

6-6 2012 Pearson Education, Inc. All rights reserved. 6

EUR asset: Future value (FV) of investment

YEN asset: 3 steps required

Kim is indifferent! Why? Covered Interest Rate

6-7 2012 Pearson Education, Inc. All rights reserved. 7

Deriving interest rate parity

[1+i] = [1/S] * [1+i*] * F

Covered interest rate parity

If the result of this equation is + (-), the

Depends on interest rate differential

Intuition: If, say, home interest rate is

Bank market for deposits and loans that are

6-10 2012 Pearson Education, Inc. All rights reserved. 10

Lower than they would be due to the skirted regulations and

6-11 2012 Pearson Education, Inc. All rights reserved. 11

Accounting for transaction costs (i.e. bid-ask

Prior to 2007, documented violations of interest

Frequency, size and duration of apparent

For details how to deal with transaction costs,

6-12 2012 Pearson Education, Inc. All rights reserved. 12

6-13 2012 Pearson Education, Inc. All rights reserved. 13

6-14 2012 Pearson Education, Inc. All rights reserved. 14

When Interest Rate Parity holds, there are

6-15 2012 Pearson Education, Inc. All rights reserved. 15

6-16 2012 Pearson Education, Inc. All rights reserved. 16

Alternative 2: money market hedge

Invest now: 4,000,00*(1+(-0.002*90/360))=

This gives you 4mill in 90 days

6-17 2012 Pearson Education, Inc. All rights reserved. 17

Speculation and Risk in the Foreign

6-18 2012 Pearson Education, Inc. All rights reserved. 18

April Knill, Ph.D., Florida State University

Uncovered foreign money market investments: no hedge

Kevin Anthony, a portfolio manager, was considering

USD interest rate: 8.0% p.a.; GBP interest rate: 12.0%

If Kevin invests in the USD-denominated asset at 8%,

6-20 2012 Pearson Education, Inc. All rights reserved. 20

Suppose Kevin invests his $10M in the pound money

Step 1. Convert dollars into pounds in the spot market.

Step 2. Kevin can invest his pound principal at 12%

Step 3. Sell the pound principal plus interest at the spot

Speculating with forward contracts

Break-even spot rate:

[1+i] = [1/S] * [1+i] F

Invest now: 4,000,00(1+(-0.00290/360))=