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INTERNATIONAL PARITY

RELATIONSHIP

Types of Transactions
A spot trade is an agreement to
exchange currency "on the spot
The exchange rate on a spot trade is
called the spot exchange rate
A forward trade is an agreement to
exchange currency at some time in the
future.
The exchange rate that will be used is
agreed upon today and is called the
forward exchange rate.

Example 1
The spot exchange rate for the Swiss
franc is SF1 = $0.9188.
The
180-day
(6-month)
forward
exchange rate is SF1 = $0.9257.
This means that you can buy a Swiss
franc today for $0.9188, or
You can agree to take delivery of a
Swiss franc in 180 days and pay
$0.9257 at that time.

Example 1
The Swiss franc is more expensive in the
forward market ($0.9257 versus $0.9188).
Because the Swiss franc is more
expensive in the future than it is today, it
is said to be selling at a premium relative
to the dollar.
For the same reason, the dollar is said to
be selling at a discount relative to the
Swiss franc.

Example 2
Suppose the spot exchange rate and
the 180-day forward rate in terms of
dollars per pound are $1.8091 = 1
and $1.7974 = 1, respectively.
You expect 1million in 180 days, and
you agree to a forward trade to
exchange pounds for dollars.
Then you will get 1million X $1.7974
per pound = $1.7974 million.

Example 2

Because it is less expensive to buy a


pound in the forward market than in
the spot market ($1.7974 versus
$1.8091), the pound is said to be
selling at a discount relative to the
dollar.

Covered Interest
Arbitrage

Let
S0 = Spot exchange rate
Ft = Forward exchange rate for
settlement at time t.
Rus = U.S. nominal risk-free interest
rate.
Rfc = Foreign country nominal riskfree interest rate.

Covered Interest
Arbitrage
Suppose we observe the following information
about U.S. and Swiss currencies in the market:
S0 = US$0.50 / SF1
Fl = US$0.53 / SF 1
iUS = 10% (home country)
is = 5%
where is is the nominal risk-free rate in
Switzerland.
The period is one year, so F1 is the 360-day
forward rate.

Covered Interest
Arbitrage

Suppose you have $1 to invest.


One option you have is to invest the
$1 in a riskless U.S. investment such
as a 360-day T-bill.
If you do this, then in one period your
$1 will be worth:
$ value in 1 period = $1 x (1 + iUS)
= $1.10

Covered Interest
Arbitrage
Alternatively, you can invest in the
Swiss risk-free investment
Convert your $1 to $1 / S0 = SF 2.00.
At the same time, enter into a forward
agreement to convert Swiss francs
back to dollars in one year. Because
the forward rate is US$0.53 /SF1, you
will get $0.53 for every SF1 that you
have in one year.

Covered Interest
Arbitrage
3. Invest your SF2.00 in Switzerland at is. In
one year you will have:
SF value in 1 year = SF 2.00 X (1 + is)
= SF2.00 X 1.05
= SF2.10
4. Convert your SF2.10 back to dollars at the
agreed-upon rate of US$1 = SF1
You end up with:
$ value in 1 year = SF2.10 x 0.53 = $1.113

Covered Interest
Arbitrage

The
return
on
investment
in
Switzerland is 11.3%
This is higher than the 10% return
from investment in the US.
There is an arbitrage opportunity and
it is called covered interest arbitrage.

Interest Rate Parity (IRP)


There must be some relationship
between spot exchange rates, forward
exchange rates, and relative interest
rates as such that covered interest
arbitrage opportunities do not exist
In equilibrium, the forward rate differs
from the spot rate by a sufficient
amount
to
offset
the
interest
differential between two currencies.

Interest Rate Parity (IRP)


As such:
1 + ih = [(1 + if) / S0] x F1
ih = interest rate in home country
if = interest rate in foreign country
Rearranging, we get interest rate
parity (IRP) condition:
F1 = S0 [(1 + ih) / (1 + if)]

Interest Rate Parity (IRP)

To determine forward rate premium:


p = [(1 + ih) / (1 + if)] - 1

Example 3
Suppose the exchange rate for Japanese
yen, S0, is currently US$0.0083 / I.
The interest rate in the United States
(home country) is ius = 10 percent
The interest rate in Japan is iJ = 5
percent
What must the forward rate be to
prevent covered interest arbitrage?

Answer

F1 = S0 [(1 + ih) / (1 + if)]


= 0.0083 (1.10 / 1.05)
= 0.00869

Answer
Forward premium:
p = [(1 + 0.10) / (1 + 0.05)] 1
= 0.0476
ih > if , so it must be forward premium
*S0 = 0.0083
F1 = 0.0083 x (1 + 0.0476) = 0.00869

Example 4
Suppose the exchange rate for Mexican
peso, S0, is currently US$0.10 / peso.
The interest rate in the United States
(home country) is ih = 5 percent
The interest rate in Mexico is if = 6
percent
What must the forward rate be to
prevent covered interest arbitrage?

Answer

F1 = S0 [(1 + ih) / (1 + if)]


= 0.10 (1.05 / 1.06)
= 0.09906

Answer
Forward premium:
p = [(1 + 0.05) / (1 + 0.06)] 1
= - 0.0094
ih < if , so it must be forward discount
*S0 = 0.10
F1 = 0.10 x (1 0.0094) = 0.09906

Interest Rate Parity (IRP)

Exercise 1
The treasurer of a major U.S. firm has $30 million
to invest for three months.
The annual interest rate in the United States is
0.25 percent per month.
The interest rate in Great Britain is 0.41 percent
per month.
The spot exchange rate is 0.54, and the threemonth forward rate is 0.53.
Ignoring transaction costs, in which country
would the treasurer want to invest the company's
funds? Why?

Answer

If we invest in the U.S. for the next


three months, we will have:

Answer
If we invest in Great Britain, we must
exchange the dollars today for pounds,
and exchange the pounds for dollars in
three months. After making these
transactions, the dollar amount we
would have in three months would be:

Exercise 2
Question 7 (Ch. 7, Madura, 2012)
Assume the following information:
Spot rate of Mexican peso = US$0.10
180-day forward rate of Mexican peso
= US$0.098
180-day Mexican interest rate = 6%
180-day US interest rate = 5%
Question: Is covered interest arbitrage
worthwhile for Mexican investors who have
peso to invest?

Answer

Exercise 3
Question 17 (Ch. 7, Madura, 2012)
The 1-year interest rate in New Zealand is 6%.
The 1-year U.S. interest rate is 10%.
The spot rate of the New Zealand dollar (NZ$) is
US$0.50/NZ$1.
The forward rate of the New Zealand dollar is
US$0.54/NZ$1.
Questions:
Is covered interest arbitrage feasible for U.S.
investors?
Is it feasible for New Zealand investors?

Answer

For U.S. investors:


Investment in New Zealand would
provide return of:
=

Answer
For New Zealand investors:
Direct Quotation:
Spot rate = 1/0.50 = NZ$2 / USD1
Forward rate = 1/0.54 = NZ$1.85 / USD1
Investment in U.S. would provide return
of:
=

Assignment

Chapter 7:
Q39, Q30, Q32, Q46
Blades, Inc. Case.

Purchasing Power
Parity

Purchasing Power of
Parity (PPP)

Two forms of PPP:


- Absolute Purchasing Power Parity
- Relative Purchasing Power Parity

Absolute Purchasing
Power Parity
The basic idea behind absolute purchasing
power parity is that a commodity costs the
same regardless of what currency is used to
purchase it or where it is selling.
If a bread costs 2 in London, and the exchange
rate is $1.67/ per dollar, then a bread costs 2
x 1.67 = $3.34 in New York.
Absolute PPP says that $1 will buy you the same
number of, say, cheeseburgers anywhere in the
world. (This concept is sometimes referred to as
the "law of one price. )

Absolute Purchasing
Power Parity
let S0 be the spot exchange rate between
the British pound and the U.S. dollar today
(time 0), and we are quoting exchange rates
as the amount of dollar per foreign
currency
Let Ph and Pf be the current home country
and foreign country prices, respectively, on
a particular commodity, say, apples
Absolute PPP simply says that:
Pf = 1/S0 X Ph

Absolute Purchasing
Power Parity
Suppose apples are selling in New York
for $4 per bushel, whereas in London the
price is 2.40 per bushel (assume U.S. is
the home country). Absolute PPP implies
that:
Puk = 1/S0 X Pus
2.40 = 1/S0 X $4
S0 = $4 / 2.40
= $1.67 /

Absolute Purchasing
Power Parity

If PPP did not hold, arbitrage would


be possible (in principle) if apples
were moved from one country to
another.

Absolute Purchasing
Power Parity
Suppose instead that the actual exchange
rate is $2/. Starting with $4, a trader
could buy a bushel of apples in New York,
ship it to London, and sell it there for 2.40.
The trader could then convert the 2.40
into dollars at the prevailing exchange rate,
$2/, yielding a total of 2.40 x 2 = $4.80.
The round-trip gain would be 80 cents.

Relative Purchasing
Power Parity
It tells us what determines the change in the
exchange rate over time.
Suppose the British pound-U.S. dollar exchange
rate is currently S0 = $2/.
Further suppose that the inflation rate in Britain
is predicted to be 10 percent over the coming
year, and (for the moment) the inflation rate in
the United States (home country) is predicted to
be zero.
What do you think the exchange rate will be in a
year?

Relative Purchasing
Power Parity
S0 = Current (Time 0) spot exchange rate
(per foreign currency).
E(S1) = Expected exchange rate in period 1.
Ih = Home country inflation rate.
If = Foreign country inflation rate.
S1 = S0 x [(1+Ih) / (1+If)]

Relative Purchasing
Power Parity

S1 = S0 x [(1+Ih) / (1+If)]
S1 = 2 x [(1+0) / (1+0.10)]
= $1.818/

Relative Purchasing
Power Parity
To compute percentage change in the
value of foreign currency:
ef = [(1+Ih) / (1+If)] 1
Ih > If , ef should be positive implying
foreign currency appreciates.
Ih < If , ef should be negative implying
foreign currency depreciates.

Relative Purchasing
Power Parity

ef = [(1+Ih) / (1+If)] 1
= (1/1.10) 1
= - 0.0909

Relative Purchasing
Power Parity

In general, Relative PPP says that the


change in the exchange rate is
determined by the difference in the
inflation rates of the two countries.

Relative Purchasing
Power Parity

Example 1

Home country inflation rate is 5%


Foreign country inflation rate is 3%
According to PPP, the foreign
currency will adjust as follow:
ef = [(1+Ih) / (1+If)] 1
= (1.05 / 1.03) 1
= 0.0194

Exercise 1

Assume that $1 can buy you either


107 or 0.55.
If a TV in London costs 500, what
will that identical TV cost in Tokyo if
absolute purchasing power parity
exists?

Answer

Exercise 2
In the spot market, A$1 is currently
equal to $0.7042.
The expected inflation rate is 3 percent
in Australia and 2 percent in the U.S.
(assume U.S. is the home country).
What is the expected exchange rate
one year from now if relative
purchasing power parity exists?

Answer

Exercise 3
In the spot market, $1 is currently
equal to 0.55.
The expected inflation rate in the U.K.
is 4 percent and in the U.S. 3 percent
(assume U.S. is the home country).
What is the expected exchange rate
two years from now if relative
purchasing power parity exists?

Answer

Exercise 4
QUESTION 41 (Ch.8, Madura, 2012)
Boston Co. will receive 1 million euros in 1 year from
selling exports. It did not hedge this future transaction.
Boston believes that the future value of the euro will be
determined by purchasing power parity (PPP). It expects
that inflation in countries using the euro will be 12
percent next year, while inflation in the United States will
be 7 percent next year. Today the spot rate of the euro is
$1.46, and the 1-year forward rate is $1.50.

Estimate the amount of U.S. dollars that Boston will


receive in 1 year when converting its euro receivables
into U.S. dollars.

Answer

Assignment

Chapter 8:
Q35, Q32

International Fisher
Effect

Fisher Effect
The relationship between a country's nominal
interest rate and inflation.
The Fisher effect suggests that the nominal
interest rate contains two components:
(1) expected inflation rate and (2) real rate of
interest.
The real rate of interest represents the return on
the investment to savers after accounting for
expected inflation.
Real rate of interest = nominal interest rate
expected inflation rate

International Fisher
Effect
The international Fisher (IFE) effect involves
two steps when attempting to predict
exchange rate movements between two
countries:
(1) applying the Fisher effect to estimate
the expected inflation for each country and
(2) relying on purchasing power parity
theory (PPP) to estimate how the difference
in expected inflation will affect the
exchange rate.

Example 1
Assume that the real rate of interest is 2 percent in
Canada and is also 2 percent in the United States.
Assume the 1-year nominal interest rate is 13 percent
in Canada versus 8 percent in the United States.
Based on the Fisher effect, the expected inflation rate
over the next year for Canada is 13% - 2% = 11%.
For the United States, the expected inflation rate is
8% 2% = 6%.
Thus, the differential in expected inflation between
the two countries is 11 % - 6% = 5%.

Example 1
(Notice that this differential in expected
inflation between the two countries is
equal to the differential in nominal interest
rates (13% 8% = 5%) between the two
countries.)
Since the expected inflation is 5 percent
higher in Canada, the Purchasing Power
Parity suggests that the Canadian dollar
should depreciate against the U.S. dollar
by about 5 percent.

International Fisher
Effect

IFE theory suggests that currencies


with high interest rates will have high
expected inflation (due to Fisher
effect).
The relatively high inflation will cause
the currencies to depreciates (due to
PPP effect).

Example 2
The nominal interest rate is 8 percent in the
United States and 5 percent in Japan.
Assume the real rate of interest is 2 percent
in each country.
The U.S. inflation rate is expected to be 6
percent, while the inflation rate in Japan is
expected to be 3 percent.
According to PPP theory, the Japanese yen is
expected to appreciate by the expected
inflation differential of 3 percent.

Example 2
If the exchange rate changes as expected,
Japanese investors who attempt to capitalize on the
higher U.S. interest rate will earn a return similar to
what they could have earned in their own country.
Though the U.S. interest rate is 3 percent higher
than the Japanese interest rate, the Japanese
investors will repurchase their yen at the end of the
investment period for 3 percent more than the
price at which they initially exchanged yen for
dollars. Therefore, their return from investing in the
United States is no better than what they would
have earned domestically.

International Fisher
Effect
According to the IFE, the effective return on a foreign
investment should, on average, be equal to the
interest rate on a local money market investment.
To make the investment in both countries generate
similar returns, the foreign currency must change by:
ef = [(1 + ih) / (1 + if)] 1
when ih > if, ef will be positive and as such foreign
currency will appreciate.
when ih < if, ef will be negative and as such foreign
currency will depreciate

Exercise

QUESTION 19 (Ch.8, Madura, 2012)


Assume that the spot exchange rate
of the Singapore dollar is $0.70.
The 1-year interest rate is 11 percent
in the United States and 7 percent in
Singapore.
What will the spot rate be in 1 year
according to the IFE?

Answer

Forward Rates and


Future Spot Rates

What is the connection between the


forward rate and the expected future
spot rate?
the unbiased forward rates (UFR)
condition says that, on average, the
forward exchange rate is equal to the
future spot exchange rate.

Forward Rates and


Future Spot Rates

The unbiased forward rates (UFR)


condition says that the forward rate.
F1 is equal to the expected future
spot rate, E(S1):
F1 = E(S1)
With t periods, UFR would be written
as:
Ft = E(St)

Forward Rates and


Future Spot Rates
Suppose the forward rate for the Japanese
yen is consistently lower than the future
spot rate by, say, 10 yen.
This means that anyone who wanted to
convert dollars to yen in the future would
consistently get more yen by NOT agreeing
to a forward exchange.
Then, the forward rate would have to rise to
get anyone interested in a forward
exchange.

Forward Rates and


Future Spot Rates

Similarly, if the forward rate were


consistently higher than the future
spot rate, then anyone who wanted
to convert yen to dollars would get
more dollars per yen by NOT
agreeing to a forward trade.
The forward exchange rate would
have to fall to attract such traders.

Assignment

Chapter 8:
Q37
Blades, Inc. Case