Eun8e CH 006 Tom

International Parity Relationships and Forecasting
Exchange Rates
Chapter Six Copyright © 2018 by the McGraw-Hill Companies, Inc. All
rights reserved.
Chapter Outline
• Interest Rate Parity
– Covered Interest Arbitrage
– IRP and Exchange Rate Determination
– Currency Carry Trade
– Reasons for Deviations from IRP
• Purchasing Power Parity
– PPP Deviations and the Real Exchange Rate
– Evidence on Purchasing Power Parity
• The Fisher Effects
• Forecasting Exchange Rates
Copyright © 2018 by the McGraw-Hill Companies, Inc. All

rights reserved. 6-2
Interest Rate Parity Defined
• IRP is a “no arbitrage” condition.
• If IRP did not hold, then it would be possible for
an astute trader to make unlimited amounts of
money exploiting the arbitrage opportunity.
• Since we don’t typically observe persistent
arbitrage conditions, we can safely assume that
IRP holds.
– Most of the time…

Interest Rate Parity Example
• Consider an investor with €10,000 who faces an interest rate in the euro
zone of i€ = 5%
• He could invest in Europe and have €10,500 in one year.
• Or he could trade his euro for pounds sterling at the spot exchange rate and
invest in the United Kingdom at i£ = 15½%
• The spot exchange rates are £1.00 = $1.50 and €1.00 = $1.20. It makes the
spot cross rate: $1.20 £1.00 £0.80
S0(£/€) = × =
€1.00 $1.50 €1.00
• His investment will grow to:
£0.80
£9,240 = €10,000 × €1.00 × 1.155
• IRP says that the forward exchange rate must be £0.8800/€

£9,240
F1(£/€) = = £0.8800/€
€10,500
Interest Rate Parity Example
€10,000 invest at i€ = 5% €10,000 × (1.05) = €10,500
0 1
i€ = 5%; i£ = 15½%
$1.20 £1.00 £0.80
Alternatively S0(£/€) = × =
€1.00 $1.50 €1.00
£9,240 = €10,500
Trade € for
£8,000 at spot £0.80 × 1.155 £0.88
F1(£/€) = =
€1.00 × 1.05 €1.00
£0.80
€10,000 × = £8,000 invest at i£ = 15½% £9,240
€1.00
£9,240
IRP says that the 1-year forward rate must be £0.88/€ =
€10,500
Why IRP Holds: Part 1
• Suppose that the one-year forward rate was a tiny bit too
low at £0.8799/€
• An astute trader would move quickly to
1. Borrow €1,000,000 at i€ = 5%
£0.80
2. Trade €1,000,000 for £800,000 at the spot rate of
€1.00
3. Invest £800,000 at i£ = 15½%
4. Enter into a short position in a one-year forward contract on
£924,000 at £0.8799/€
• In one year he has a cash inflow of €1,050,119.33 from
the forward contract and owes €1,050,000
• Risk-free arbitrage profit of €119.33
At T = 0 borrow at i€ = 5% &
At T = 1, owe €1.05m:
€1,000,000 sell £924,000 forward €1m×(1.05) = €1,050,000
0 1
The easy profit of €119.33 will attract trades that will
Sell £924,000 per forward

Trade € for
force prices back into line.
£800,000 at
spot
Repay loan with €1,050,000
You are short in a forward contract
Sell £924,000 for €1,050,119.33
contract
€1.00
£924,000 × = €1,050,119.33
£0.8799
£0.80
€1,000,000 × = £800,000 invest at i£ = 15½%
€1.00 £924,000
• Suppose that the one-year forward rate was a tiny bit too
high at £0.8801/€
• An astute trader would move quickly to
– Borrow £800,000 at i£ = 15½%.
£0.80
– Trade £800,000 for €1,000,000 at spot rate of
€1.00
– Invest €1,000,000 at i€ = 5%
– Enter into a long position in a one-year forward contract on
£924,000 at £0.8801/€
• In one year he has a cash outflow of €1,049,880.70 from
the forward contract for £924,000 that he owes at
£0.8801/ € forward contract exchange rate. His inflow
from Euro investment = €1,050,000
• Risk-free arbitrage profit of €119.30 Copyright © 2018 by the McGraw-Hill Companies, Inc. All
Why IRP Holds: Part 2 receive
Invest at i€ = 5%
€1,000,000 €10,000 ×(1.05) = €1,050,000
0 1
Buy £924,000 forward

You are long in a forward contract
Buy £924,000 at £0.8801/€
this will only cost €1,049,880.70
Repay loan with £924,000
Risk-free arbitrage profit of €119.30
At T = 0 Trade £800,000 tor The easy money will attract traders who will force
€1m at spot; go long in forward prices back into line.
contract on £924,000 at
£0.8801/€
T = 1 owe
£0.80 At T= 0, Borrow £800,000 at i£ =
€1,000,000 × = £800,000
€1.00 15½% £924,000

•
Multi-Year Interest Rate Parity
So far we’ve computed the no-arbitrage 1-year forward rate
• To calculate the two-year forward rate compound the interest for 2 years:
£1,067,220
Spot rate
£924,000
£800,000 × 1.155
£800,000
F1(£/€) =
€1.00 $1.50 €1.00
$1.25 £1.00 £0.80
i£ = 15½%. i£ = 15½%. €1,000,000 × 1.05

£924,000 £0.8800
F1(£/€) = =
=
€1,050,000 €1.000
×
0 1 2 £0.8000 × (1.155)2
F2(£/€) =
€1.00 × (1.05)2
i€ = 5% i€ = 5% £0.9680
S0(£/€) =
=
€1,000,000
€1,102,500 €1.00
€1,050,000
£.80×(1+ i£)2
F2(£/€) =
€1.00×(1+ i€)2
IRP Even More Carefully Defined
• Interest Rate Parity is a “no arbitrage” condition that
suggests that forward exchange rates are defined by
today’s spot exchange rates grossed up and down by
the future value interest factors:
• In our example with a spot rate of £0.80/€ the interest
rate parity says that the N-year future exchange rate that
prevails today must be:
£0.8000 × (1 + 𝑖£ )𝑁
FN(£/€) =
€1.00 × (1 + 𝑖€ )𝑁
Notice that we increase the pounds in the spot rate at i£

and the euro in the spot rate by i€ to find the forward rate.
Currency Carry Trade
• Currency carry trade involves buying a currency
that has a high rate of interest and funding the
purchase by borrowing in a currency with low
rates of interest, without any hedging.
• The carry trade is profitable as long as the
interest rate differential is greater than the
appreciation of the funding currency against the
investment currency.

Currency Carry Trade Example
• Suppose the 1-year borrowing rate in dollars is 1%.
• The 1-year lending rate in pounds is 2½%.
• The direct spot ask exchange rate is $1.60/£.
• A trader who borrows $1m will owe $1,010,000 in one year.
• Trading $1m for pounds today at the spot generates £625,000.
• £625,000 invested for one year at 2½% yields £640,625.
• The currency carry trade will be profitable if the spot bid rate
prevailing in one year is high enough that his £640,625 will sell for at
least $1,010,000 (enough to repay his debt).
• No less expensive than:
b $1,010,000 $1.5766
S360($/£) = =
£640,625 £1.00
Reasons for Deviations from IRP
• Transactions Costs
– The interest rate available to an arbitrageur for
borrowing, I b, may exceed the rate he can lend at, I l.
– There may be bid-ask spreads to overcome, F b/S a <
F/S.
– Thus, (F b/S a)(1 + i ¥ l ) − (1 + i¥ b)  0.
• Capital Controls
– Governments sometimes restrict import and
export of money through taxes or outright
bans.
IRP with Transactions Costs
F1($/€) –S0($/€)
S0($/€)
←Unprofitable “arbitrage”
opportunity
exploitable arbitrage i$ − i €
opportunity →
Unprofitable
arbitrage Copyright © 2018 by the McGraw-Hill Companies, Inc. All
Setting Dealer Forward Bid and Ask
• Dealer stands ready to be on the opposite side of every trade.
– Dealer buys foreign currency at the bid price.
– Dealer sells foreign currency at the ask price.
– Dealer borrows (from customer) at the lending rates.
– Dealer lends to his customer at the posted borrowing rates.
Borrowing Lending il$ = 4.5% and i€l = 5.0%
$ 5.00% 4.50% i$b = 5.0%, i€b = 5.5%.
€ 5.50% 5.00% Bid Ask
𝑏 Τ 𝑏
𝑏 Τ
𝑆0 ($ €) × (1 + 𝑖 $ ) Spot $1.4200 = €1.00 $1.4500 = €1.00
𝐹1 ($ €) =
1 + 𝑖€𝑏
Forward 𝐹1𝑏 ($Τ€) 𝐹1𝑎 ($Τ€)
𝑆0𝑎 ($Τ€) × (1 + 𝑖$𝑏 )
𝐹1𝑎 ($Τ€) =
1 + 𝑖€𝑏
Setting Dealer Forward Bid Price
Our dealer is indifferent between buying euros with for example 1$m today
at the spot bid price and buying euros in 1 year at the forward bid price.
b
b $1m×(1+i$)
Does not buy - invests $m at i$
$1m x 1.05 = $1,050,000
forward bid
If he buys Euro with $1m today He is also willing to buy forward at
he receives:
spot bid
b b
b S0($/€) x (1+i$ )
1 F1 ($/€) =
$1m × b (1+i€b )
S0 ($/€)
= ($1.42 x 1.05)/(€1 x 1.055) = = 1.4133
$1m x 1/1.42 = € 704,225.35
$1m × 1 b
×(1+i€ )
Invest at i€ b b
S0($/€)
$1m x 1/1.42 x (1.055) = € 742,957.75
Copyright © 2018 by the McGraw-Hill Companies, Inc. All 6-17
rights reserved.
Setting Dealer Forward Ask Price
Our dealer is indifferent between selling For example €1m today at the
spot ask price and selling euros in 1 year at the forward ask price.
He sells € 1m today a
a
Invest at i$
b
€1m × S0 ($/€) ×(1+i$b)
and receives €1m × S0 ($/€)
= € 1m x $1.45 = $1,450,000 € 1m x $1.45 x 1.05 = $1,522,500
spot ask
He is also willing to sell at
forward ask
a b
a S0 ($/€) x (1+i$ )
F1 ($/€) =
(1+i€b )
= ($1.45 x 1.05)/(€1 x 1.055) = 1.4431
Invest €1m at i€b sell forward at forward ask 𝐹1𝑎 ($Τ€) €1m x (1 +i€b )
€ 1m x 1.055 = € 1,055,000
Copyright © 2018 by the McGraw-Hill Companies, Inc. All 6-18

rights reserved.
PPP and Exchange Rate Determination
• The exchange rate between two currencies should equal
the ratio of the countries’ price levels:
P$
S($/£) =
P£
For example, if an ounce of gold costs $300 in the U.S. and
£150 in the U.K., then the price of one pound in terms of dollars
should be: P$ $300
S($/£) = = = $2/£
P£ £150
Suppose the spot exchange rate is $1.25 = €1.00. If the inflation rate in the
U.S. is expected to be 3% in the next year and 5% in the euro zone, then the
expected exchange rate in one year should be $1.25×(1.03) = €1.00×(1.05).

PPP and Exchange Rate Determination
• The euro will trade at a 1.90% discount in the forward
market: $1.25×(1.03)
F($/€) €1.00×(1.05) 1.03 1 + $
= = =
S($/€) $1.25 1.05 1 + €
€1.00
Calculated 1.90% discount above. Relative PPP states that the

rate of change in the exchange rate is equal to differences in
the rates of inflation—roughly 2%.
PPP and IRP
• Notice that our two big equations equal
each other:
PPP IRP
F($/€) 1 + $ 1 + i$ F($/€)
= = =
S($/€) 1 + € 1 + i€ S($/€)

Expected Rate of Change in Exchange
Rate as Interest Rate Differential
F($/€) – S($/€) $ – €
E(e) = = ≈ $ – €
S($/€) 1 + €
F($/€) – S($/€) i$ – i€
E(e) = = ≈ i$ – i€
S($/€) 1 + i€
▪ Given the difficulty in measuring expected inflation,
managers often use a “quick and dirty” shortcut:
$ – € ≈ i$ – i€ Copyright © 2018 by the McGraw-Hill Companies, Inc. All
EXHIBIT 6.7 Real Effective Exchange Rates for
Selected Currencies (Index, 2010 base year = 100)

Evidence on PPP
• PPP probably doesn’t hold precisely in the real
world for a variety of reasons.
– Haircuts cost 10 times as much in the developed
world as in the developing world.
– Film, on the other hand, is a highly standardized
commodity that is actively traded across borders.
– Shipping costs, as well as tariffs and quotas, can lead
to deviations from PPP.
• PPP-determined exchange rates still provide a
valuable benchmark.

EXHIBIT 6.8
A Guide to World Prices: March 2016
6-25
The Exact Fisher Effects
• An increase (decrease) in the expected rate of inflation
will cause a proportionate increase (decrease) in the
interest rate in the country.
• For the U.S., the Fisher effect is written as:
1 + i$ = (1 + $ ) × E(1 + $)
Where:
$ is the equilibrium expected “real” U.S. interest rate.
E($) is the expected rate of U.S. inflation.
i$ is the equilibrium expected nominal U.S. interest rate.

International Fisher Effect
If the Fisher effect holds in the U.S.,
1 + i$ = (1 + $ ) × E(1 + $)
and the Fisher effect holds in Japan,
1 + i¥ = (1 + ¥ ) × E(1 + ¥)
and if the real rates are the same in each country,
$ = ¥
then we get the International Fisher Effect:
1 + i¥ E(1 + ¥)
=
1 + i$ E(1 + $)
International Fisher Effect
If the International Fisher Effect holds,
1 + i¥ E(1 + ¥)
=
1 + i$ E(1 + $)
and if IRP also holds,
1 + i¥ F¥/$
=
1 + i$ S¥/$
then forward rate PPP holds:
F¥/$ E(1 + ¥)
=
S¥/$ E(1 + $) Copyright © 2018 by the McGraw-Hill Companies, Inc. All
Approximate Equilibrium Exchange Rate Relationships
E(e)
≈ Forward expectations Parity
≈ International Fisher effect (FEP)
(IFE)
≈ PPP F–S
(i$ – i¥) ≈ IRP
S
≈ Fisher Effect ≈ Forward Real Power Parity Principle
E($ – £)
Exact Equilibrium Exchange Rate Relationships
E (S ¥ / $ )
≈ International Fisher effect S¥ /$ ≈ Forward expectations Parity
(FEP)
(IFE)
1 + i¥ PPP F¥ / $
IRP
1 + i$ S¥ /$
≈ Fisher Effect ≈ Forward Real Power Parity Principle
E(1 + ¥)
E(1 + $)
Performance of the Forecasters
• Forecasting is difficult, especially with regard to
the future.
• As a whole, forecasters cannot do a better job of
forecasting future exchange rates than the
forecast implied by the forward rate.
• The founder of Forbes Magazine once said,
“You can make more money selling financial
advice than following it.”

Hints
• Problem 1: Find the correct answers below and base your presentation
structure (sequence and content) on the correct answers.
• What will the value of the investment be in six months if invested in US$?
• a. $100,000,000 x 1.04 = $104,000,000
• b. $100,000,000 x 1.035 = $103,500,000
• c. $100,000,000 x (1.04 -1.035) = $100,500,000
• d. None of the above
•
• What will the value of the investment in Euros be if invested in Germany for 6 months?
• a. $100,000,000 x 1.04 = $104,000,000 x 0.99 = €102,960,000
• b. $100,000,000 x 1.01 x 1.04 = €105,040,000
• c. $100,000,000 x 1.01 x 1.035 = €104,535,000
• d. $100,000,000 x 0.99 x 1.035 = €102,465,000
•
• If he considers to do an investment in Euros – then what forward position will he take with preference to the currency that he will
exchange his investment to after 6 months?
• a. Long in €
• b. Short in €
• c. Long in $
• d. Short in $
6-32
Hint
• Problem 1 continued:
• What will the $ value of the investment in Germany be after 6 months?
• a. €102,960,000 / 0.99 = $104,000,000.00
• b. €105,040,000 x 0.99 =$103,989.00
• c. €104,535,000 / 0.99 = $105,590,909.09
• d. €102,465,000 x 0.99 = $101,440,350.00
• e. €102,960,000 / 1.01 = $101,940,594.06
• f. €105,040,000 x 1.01 = $106,090,400.00
• g. €104,535,000 / 1.01 = $103,500,000.00
• h. €102,465,000 x 1.01 = $103,489,650.00
6-33
Hint
• In what currency and for what amount should the forward contract be entered into if you keep the funds in your US account?
• a. Long in pound = £35,000
• b. Long In dollar = £35,000 x $1.40/£ = $49,000
• c Short in pound = £35,000
• d. Short In dollar = £35,000 x $1.40/£ = $49,000
•
• What will be the cost of the Jaguar as of today in $ if you enter into the forward contract and keep the funds in your US
account?
• a. PV =(£35,000/(1.02) x 1.40 = $48,039.22
• b. PV = $49,000/(1.0035)3) = $48,489.08
•
• What amount in pound will you purchase today to invest in the UK if you apply option b?
• a. PV = $49,000/(1.0035)3) / 1.40 = £34,635.06
• b. PV = £35000/(1.02) = £34,313.73
•
• Which method is the best and why?
• a. Alternative A because cheaper
• b. Alternative B because cheaper
6-34
Hint
• Calculate the forward rate, based on IRP ($(1+i$)/£(1+i$)), to determine whether the interest rate parity is currently holding – What rate do
you find?
• a. $1.53/£
• b. $1.52/£
• c. $1.51/£
•
• Does interest rate parity hold or not?
• a. Yes
• b. No
•
• What currency will you borrow?
• a. $
• b. £
• c. Will not borrow
•
• What is the interest rate at which you will borrow?
• a. 2% for three months
• b. 1.45% for three months
• c. Not applicable
6-35
Hint
• What is the total end-of-period borrowed amount?
• a. $1,521,750
• b. £1,014,500
• c. $1,530,000
• d. £1,020,000
• e. Not applicable
•
• In what currency will you invest?
• a. $
• b. £
•
• Will you go short or long in a forward contract?
• a. Short $1,521,750
• b. Long $1,521,750
• c. Short £1,014,500
• d. Long £1,014,500
• e. Short $1,530,000
• f. Long $1,530,000
• g. Short £1,020,000
• h. Long £1,020,000
• i. Not applicable
6-36
Hint
• How much arbitrage profit will you make in $?
• a. $22,185
• b. €22,185
• c. $12,040
• d. £12,040
• e. No profit due to no arbitrage opportunity
• Indicate which of the following situations may occur to restore the IRP as a result of covered arbitrage activities:
• a. The dollar interest rate will rise
• b. The pound interest rate will fall
• c. The spot exchange rate will rise
• d.The forward exchange rate will fall
• e. a and b
• f. c and d
• g. a, b, c and d
6-37
• Problem 7:
Hint
• Formulas to be applied:
• The absolute version of purchasing power parity (PPP):
• S = P$/P£.
• The relative version is: e = $ - £.
• The international Fisher effect: E(e) = i$ - i£.
•
• You are provided with the following solutions to the questions in this problem:
• i. [1.10/1.08] (0.158) = $0.1609/rand.
• ii. [(1.07)4/(1.05)4] (0.158) = $0.1704/rand.
• iii. [1.05/1.11](0.175) = $0.1655/rand.
•
• Which one of the solutions calculates the ZAR spot rate under PPP?
• a. i.
• b. ii.
• c. iii.
• Which one of the solutions calculates the expected ZAR spot rate?
• a. i.
• b. ii.
• c. iii.
•
• Which one of the solutions calculates the expected ZAR spot rate in USD four years from now?
• a. i.
• b. ii.
• c. iii.
6-38
Hint
• Calculate the forward rate, based on IRP (SFr(1+iSFr)/$(1+i$)), to determine whether the interest rate parity is currently holding – What rate
do you find?
• a. SFr1.2021$
• b. SFr1.0210/$
• c. SFr1.2102/$
•
• Does interest rate parity hold or not?
• a. Yes
• b. No
•
• What currency will you borrow?
• a. $
• b. SFr
• c. Will not borrow
•
• What is the interest rate at which you will borrow?
• a. 1% for six months
• b. 1.25% for six months
6-39
Hint
• What is the total end-of-period borrowed amount?
• a. $1,012,500
• b. SFr 1,217,151
• c. $1,010,000
• d. SFr1, 220,164
• e. Not applicable
•
• In what currency will you invest?
• a. $
• b. SFr
•
• a. Short $1,012,500
• b. Long $1,012,500
• c. Short SFr 1,217,151
• d. Long SFr 1,217,151
• e. Short $1,020,929
• f. Long $1,020,929
• g. Short SFr1, 220,164
• h. Long SFr1, 220,164
6-40
Hint
• How much arbitrage profit will you make in $?

• a. $8,428.54
• b. SFr 8,932.88
• c. $ 8,932.88
• d. SFr8,428.54
• e. No profit due to no arbitrage opportunity
6-41

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International Parity Relationships and Forecasting

Copyright © 2018 by the McGraw-Hill Companies, Inc. All

Copyright © 2018 by the McGraw-Hill Companies, Inc. All

• IRP says that the forward exchange rate must be £0.8800/€

Sell £924,000 per forward

Buy £924,000 forward

Copyright © 2018 by the McGraw-Hill Companies, Inc. All

i£ = 15½%. i£ = 15½%. €1,000,000 × 1.05

Notice that we increase the pounds in the spot rate at i£

Copyright © 2018 by the McGraw-Hill Companies, Inc. All

He is also willing to sell at

Copyright © 2018 by the McGraw-Hill Companies, Inc. All 6-18

Copyright © 2018 by the McGraw-Hill Companies, Inc. All

Calculated 1.90% discount above. Relative PPP states that the

Copyright © 2018 by the McGraw-Hill Companies, Inc. All

Copyright © 2018 by the McGraw-Hill Companies, Inc. All

Copyright © 2018 by the McGraw-Hill Companies, Inc. All

Copyright © 2018 by the McGraw-Hill Companies, Inc. All

Copyright © 2018 by the McGraw-Hill Companies, Inc. All

• c. Short SFr 1,217,151

• d. Long SFr 1,217,151

• g. Short SFr1, 220,164

• h. Long SFr1, 220,164

• How much arbitrage profit will you make in $?

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