INTERNATIONAL

FINANCIAL
MANAGEMENT

Fifth Edition

EUN / RESNICK

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 International Parity
Relationships and Forecasting
Foreign Exchange Rates
6
Chapter Six

Chapter Objective:

This chapter examines several key international

parity relationships, such as interest rate parity and
purchasing power parity.

6-1
Interest Rate Parity
Interest Rate Parity Defined
Covered Interest Arbitrage
Interest Rate Parity & Exchange Rate
Determination
Reasons for Deviations from Interest Rate Parity

6-2
Interest Rate Parity Defined
IRP is an 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 dont typically observe persistent
arbitrage conditions, we can safely assume that
IRP holds.almost all of the time!

6-3
 Interest Rate Parity Carefully Defined
Consider alternative one-year investments for $100,000:
1. Invest in the U.S. at i$. Future value = $100,000 (1 + i$)
2. Trade your $ for at the spot rate, invest $100,000/S$/ in
Britain at i while eliminating any exchange rate risk by
selling the future value of the British investment forward.
F$/
Future value = $100,000(1 + i)
S$/
Since these investments have the same risk, they must have
the same future value (otherwise an arbitrage would exist)
F$/ (1 + i$)
(1 + i) = (1 + i$) F$/ = S$/ (1 + i )
6-4
S$/
 Alternative 2: $1,000
Send your $ on a
IRP
round trip to
S$/
Step 2:
Britain
Invest those
pounds at i
$1,000 Future Value =
$1,000
(1+ i)
S$/
Step 3: repatriate
Alternative 1: future value to the
invest $1,000 at i$ U.S.A.
$1,000
$1,000(1 + i$) = (1+ i) F$/
S$/
IRP

Since both of these investments have the same risk, they must
6-5 have the same future valueotherwise an arbitrage would exist
Interest Rate Parity Defined
The scale of the project is unimportant
$1,000
$1,000(1 + i$) = (1+ i) F$/
S$/

F$/
(1 + i$) = (1+ i)
S$/

6-6
Interest Rate Parity Defined
Formally,
1 + i$ F$/
=
1 + i S$/

IRP is sometimes approximated as

i$ i F S
S

6-7
Interest Rate Parity Carefully Defined
Depending upon how you quote the exchange rate
(as $ per or per $) we have:

1 + i F/$ 1 + i$ F$/
= or =
1 + i$ S/$ 1 + i S$/
so be a bit careful about that.

6-8
 Interest Rate Parity Carefully Defined
No matter how you quote the exchange rate ($ per
or per $) to find a forward rate, increase the dollars
by the dollar rate and the foreign currency by the
foreign currency rate:

1 + i 1 + i$
F/$ = S/$ or F$/ = S$/ 1 + i
1 + i$

be carefulits easy to get this wrong.

6-9
IRP and Covered Interest Arbitrage
If IRP failed to hold, an arbitrage would exist. Its
easiest to see this in the form of an example.
Consider the following set of foreign and domestic
interest rates and spot and forward exchange rates.

Spot exchange rate S($/) = $2.0000/

360-day forward rate F360($/) = $2.0100/
U.S. discount rate i$ = 3.00%
British discount rate i = 2.49%

6-10
 IRP and Covered Interest Arbitrage
A trader with $1,000 could invest in the U.S. at 3.00%, in one
year his investment will be worth
$1,030 = $1,000 (1+ i$) = $1,000 (1.03)
Alternatively, this trader could
1. Exchange $1,000 for 500 at the prevailing spot rate,

2. Invest 500 for one year at i = 2.49%; earn 512.45

3. Translate 512.45 back into dollars at the forward rate

F360($/) = $2.01/, the 512.45 will be worth $1,030.

6-11
Alternative 2: Arbitrage I
buy pounds 500
1 Step 2:
500 = $1,000
$2.00 Invest 500 at
i = 2.49%
$1,000 512.45 In one year 500
will be worth
Step 3: repatriate 512.45 =
to the U.S.A. at 500 (1+ i)
F360($/) =
Alternative 1: $2.01/
invest $1,000 $1,030 F(360)
at 3% $1,030 = 512.45
1
FV = $1,030

6-12
Interest Rate Parity
& Exchange Rate Determination
According to IRP only one 360-day forward rate,
F360($/), can exist. It must be the case that

F360($/) = $2.01/
Why?
If F360($/) $2.01/, an astute trader could make
money with one of the following strategies:

6-13
Arbitrage Strategy I
If F360($/) > $2.01/
i. Borrow $1,000 at t = 0 at i$ = 3%.
ii. Exchange $1,000 for 500 at the prevailing spot
rate, (note that 500 = $1,000 $2/) invest 500 at
2.49% (i) for one year to achieve 512.45
iii. Translate 512.45 back into dollars, if
F360($/) > $2.01/, then 512.45 will be more than
enough to repay your debt of $1,030.

6-14
 Step 2:
buy pounds
Arbitrage I
500
1 Step 3:
500 = $1,000
$2.00 Invest 500 at
i = 2.49%
$1,000 512.45 In one year 500
will be worth
512.45 =
Step 4: repatriate 500 (1+ i)
to the U.S.A.
Step 1:
borrow $1,000 More F(360)
Step 5: Repay than $1,030 $1,030 < 512.45
1
your dollar loan
with $1,030.
If F(360) > $2.01/ , 512.45 will be more than enough to repay
6-15
your dollar obligation of $1,030. The excess is your profit.
 Arbitrage Strategy II
If F360($/) < $2.01/
i. Borrow 500 at t = 0 at i= 2.49% .
ii. Exchange 500 for $1,000 at the prevailing spot
rate, invest $1,000 at 3% for one year to achieve
$1,030.
iii. Translate $1,030 back into pounds, if
F360($/) < $2.01/, then $1,030 will be more than
enough to repay your debt of 512.45.
6-16
 Step 2:
buy dollars
500
Arbitrage II
$2.00
$1,000 = 500 Step 1:
1
borrow 500
$1,000 Step 5: Repay
Step 3: More
than your pound loan
Invest $1,000
512.45 with 512.45 .
at i$ = 3%
Step 4:
repatriate to
the U.K.
In one year $1,000
F(360)
will be worth $1,030 $1,030 > 512.45
1

If F(360) < $2.01/ , $1,030 will be more than enough to repay

6-17
your dollar obligation of 512.45. Keep the rest as profit.
 IRP and Hedging Currency Risk
You are a U.S. importer of British woolens and have just ordered
next years inventory. Payment of 100M is due in one year.
Spot exchange rate S($/) = $2.00/
360-day forward rate F360($/) = $2.01/
U.S. discount rate i$ = 3.00%
British discount rate i = 2.49%

IRP implies that there are two ways that you fix the cash outflow to a
certain U.S. dollar amount:
a) Put yourself in a position that delivers 100M in one yeara long
forward contract on the pound.
You will pay (100M)($2.01/) = $201M in one year.
b) Form a money market hedge as shown below.
6-18
IRP and a Money Market Hedge
To form a money market hedge:
1. Borrow $195,140,989.36 in the U.S.
(in one year you will owe $200,995,219.05).
2. Translate $195,140,989.36 into pounds at the spot
rate S($/) = $2/ to receive 97,570,494.68
3. Invest 97,570,494.68 in the UK at i = 2.49% for
one year.
4. In one year your investment will be worth 100
millionexactly enough to pay your supplier.
6-19
Money Market Hedge
Where do the numbers come from? We owe our supplier 100
million in one yearso we know that we need to have an
investment with a future value of 100 million. Since i = 2.49%
we need to invest 97,570,494.68 at the start of the year.

100,000,000
97,570,494.68 =
1.0249
How many dollars will it take to acquire 97,570,494.68
at the start of the year if S($/) = $2/?
$2.00
$195,140,989.36 = 97,570,494.68
1.00
6-20
Money Market Hedge
This is the same idea as covered interest arbitrage.
To hedge a foreign currency payable, buy a bunch
of that foreign currency today and sit on it.
Buy the present value of the foreign currency payable
today.
Invest that amount at the foreign rate.
At maturity your investment will have grown enough to
cover your foreign currency payable.

6-21
 Money Market Hedge: an Example
Suppose that the spot dollar-pound exchange rate is $2.00/ and
i$ = 1%
0 1 i = 4%
Step 1 Step 5
Order Inventory; agree to Redeem -denominated
pay supplier 100 in 1 year. investment receive 100
Step 2 million
Borrow $192,307,692 at i$ = 1% Step 6
($192,307,692 = 96,153,846$2/) Pay supplier 100 million
Step 3 100,000,000 Step 7
Buy 96,153,846 = 1.04 Repay dollar loan with
at spot exchange rate. $194,230,769
Step 4 Invest 96,153,846 at i = 4%
6-22
Another Money Market Hedge
A U.S.based importer of Italian bicycles
In one year owes 100,000 to an Italian supplier.
The spot exchange rate is $1.50 = 1.00
The one-year interest rate in Italy is i = 4%
100,000
Can hedge this payable by buying 96,153.85 = 1.04
today and investing 96,153.85 at 4% in Italy for one year.
At maturity, he will have 100,000 = 96,153.85 (1.04)

Dollar cost today = $144,230.77 = 96,153.85 $1.50

1.00
6-23
Another Money Market Hedge
With this money market hedge, we have
redenominated a one-year 100,000 payable into
a $144,230,77 payable due today.
If the U.S. interest rate is i$ = 3% we could borrow
the $144,230,77 today and owe in one year

$148,557.69 = $ 144,230,77 (1.03)

100,000
$148,557.69 = S($/) (1+ i $ ) T
(1+ i)T
6-24
Generic Money Market Hedge: Step One
Suppose you want to hedge a payable in the amount
of y with a maturity of T:
i. Borrow $x at t = 0 on a loan at a rate of i$ per year.
y
$x = S($/) (1+ i )T

Repay the loan in T years

$x $x(1 + i$)T

0 T
6-25
Generic Money Market Hedge: Step Two
y
ii. Exchange the borrowed $x for
(1+ i)T
at the prevailing spot rate.
y
Invest T
at i for the maturity of the payable.
(1+ i)

At maturity, you will owe a $x(1 + i$)T.

Your British investments will have grown to y. This
amount will service your payable and you will have no
exposure to the pound.
6-26
Generic Money Market Hedge
y
1. Calculate the present value of y at i
(1+ i)T
2. Borrow the U.S. dollar value of receivable at the spot rate.
y y
3. Exchange $x = S($/) for
(1+ i)T (1+ i)T
4. Invest y at i for T years.
(1+ i) T

5. At maturity your pound sterling investment pays your

receivable.
6. Repay your dollar-denominated loan with $x(1 + i$)T.
6-27
Forward Premium
Its just the interest rate differential implied by
forward premium or discount.
For example, suppose the is appreciating from
S($/) = 1.25 to F180($/) = 1.30
The forward premium is given by:

F180($/) S($/) 360 $1.30 $1.25

f180,v$ = 180 = 2 = 0.08
S($/) $1.25

6-28
Reasons for Deviations from IRP
Transactions Costs
The interest rate available to an arbitrageur for borrowing,
ib may exceed the rate he can lend at, il.
There may be bid-ask spreads to overcome, Fb/Sa < F/S
Thus
(Fb/Sa)(1 + il) (1 + i b) 0
Capital Controls
Governments sometimes restrict import and export of
money through taxes or outright bans.
6-29
Transactions Costs Example
Will an arbitrageur facing the following prices be
able to make money?
Borrowing Lending (1 + i$)
F($/ ) = S($/ )
$ 5.0% 4.50% (1 + i)
5.5% 5.0%
Bid Ask
Spot $1.42 = 1.00 $1.45 = 1,00
Forward $1.415 = 1.00 $1.445 = 1.00
a b b l
b S 0 ($/) (1+i $) a S 0 ($/)(1+i $)
F1($/) = F1($/) =
6-30 (1+il ) (1+ib)
 Step 1
Borrow $1m at i$b
$1m $1m(1+ib$)

0 IRP 1
Step 2 1 (1+il )Fb($/) = $1m(1+ib)
$1m
Buy at S0a($/)
1 $

spot ask No arbitrage forward bid price (for customer):

b a b
(1+i $ ) S0 ($/) (1+i $) Step 4
F1($/) =
b
=
1 (1+i l
) (1+i l
) Sell at

S0a($/) forward
= $1.4431/ bid
$1m a 1 Step 3 invest at il $1m a 1 (1+il )
S0($/) S0($/)
6-31 (All transactions at retail prices.)
 Step 3
1m S0b($/) lend at i$l 1m Sb0($/) (1+i$l )

0 IRP 1
1m Sb0($/) (1+i$l ) F1a($/) = 1m(1+ib)

No arbitrage forward ask price:

S0b($/)(1+i$l ) Step 4
Step 2 Fa1($/) =
(1+ib) buy at
sell 1m at forward
= $1.4065/
spot bid ask
1m Step 1borrow 1m at ib 1m(1+ib)

6-32 (All transactions at retail prices.)

Why This Seems Confusing
On the last two slides we found no arbitrage
Forward bid prices of $1.4431/ and
Forward ask prices of $1.4065/
Normally the dealer sets the ask price above the
bidrecall that this difference is his expected profit.
But the prices on the last two slides are the prices of
indifference for the customer NOT the dealer.
At these forward bid and ask prices the customer
is indifferent between a forward market hedge
6-33 and a money market hedge.
 Setting Dealer Forward Bid and Ask
Dealer stands ready to be on opposite side of every trade
Dealer buys foreign currency at the bid price
Dealer sells foreign currency at the ask price
Dealer borrows (from customer) at the lending rates
i$l = 4.5% and il = 5.0%
Dealer lends to his customer at the borrowing rate i$b = 5.0%, ib = 5.5%.
Borrowing Lending
$ 5.0% 4.50%
5.5% 5.0% Bid Ask
Spot $1.42 = 1.00 $1.45 = 1.00
6-34 Forward $1.415 = 1.00 $1.445 = 1.00
 Setting Dealer Forward Bid Price
Our dealer is indifferent between buying euro today at spot
bid price and buying euro in 1 year at forward bid price.

$1m Invest at i$b $1m(1+ib$)

forward bid
He is willing to spend He is also willing to buy at
spot bid

$1m today and receive b b

S 0 ($/) (1+i $)
1 F1($/) =
b
$1m b
S0($/) (1+ib)
1
$1m Invest at ib 1 b
S0b($/) $1m b
(1+i )
6-35
S0($/)
 Setting Dealer Forward Ask Price
Our dealer is indifferent between selling euro today at spot
ask price and selling euro in 1 year at forward ask price.

1m S0b($/) Invest at i$b 1m S0b($/) (1+i$b)

forward ask
He is willing to spend He is also willing to buy at
spot ask

1m today and receive a b

S 0 ($/) (1+i $)
1m S0($/)
b
F1($/) =
a

(1+ib)

1m Invest at ib 1m(1+ib)
6-36
Purchasing Power Parity
Purchasing Power Parity and Exchange Rate
Determination
PPP Deviations and the Real Exchange Rate
Evidence on PPP

6-37
Purchasing Power Parity 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
6-38
Purchasing Power Parity and
Exchange Rate Determination
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)

F($/) = $1.25(1.03) = $1.23

1.00(1.05) 1.00

6-39
Purchasing Power Parity 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

Relative PPP states that the rate of change in the

exchange rate is equal to differences in the rates of
inflationroughly 2%
6-40
Purchasing Power Parity
and Interest Rate Parity
Notice that our two big equations today equal
each other:
PPP IRP
F($/) 1 + $ 1 + i$ F($/)
= = =
S($/) 1 + 1 + i S($/)

6-41
Expected Rate of Change in Exchange
Rate as Inflation Differential
We could also reformulate
our equations as inflation F($/) 1 + $
=
or interest rate differentials: S($/) 1 +

F($/) S($/) 1 + $ 1 + $ 1 +
= 1=
S($/) 1 + 1 + 1 +

F($/) S($/) $
E(e) = = $
S($/) 1 +
6-42
Expected Rate of Change in
Exchange Rate as Interest Rate
Differential
F($/) S($/) i$ i
E(e) = = i$ i
S($/) 1 + i

6-43
Quick and Dirty Short Cut
Given the difficulty in measuring expected
inflation, managers often use
$ i$ i

6-44
Evidence on PPP
PPP probably doesnt 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.

6-45
Approximate Equilibrium Exchange
Rate Relationships

E(e)
IFE FEP
PPP FS
(i$ i) IRP
S
FE FRPPP
E($ )

6-46
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

6-47
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 + $)
6-48
International Fisher Effect
If the International Fisher Effect holds,
1 + i E(1 + )
=
1 + i$ E(1 + $)

and if IRP also holds

1 + i F/$
=
1 + i$ S/$
F/$ E(1 + )
then forward rate PPP holds: =
S/$ E(1 + $)
6-49
Exact Equilibrium Exchange Rate
Relationships

E (S / $ )
IFE S /$ FEP

1 + i PPP F / $
IRP
1 + i$ S /$
FE FRPPP
E(1 + )
E(1 + $)

6-50
Forecasting Exchange Rates
Efficient Markets Approach
Fundamental Approach
Technical Approach
Performance of the Forecasters

6-51
Efficient Markets Approach
Financial Markets are efficient if prices reflect all
available and relevant information.
If this is so, exchange rates will only change when
new information arrives, thus:
St = E[St+1]
and
Ft = E[St+1| It]
Predicting exchange rates using the efficient
markets approach is affordable and is hard to beat.
6-52
Fundamental Approach
Involves econometrics to develop models that use a
variety of explanatory variables. This involves
three steps:
step 1: Estimate the structural model.
step 2: Estimate future parameter values.
step 3: Use the model to develop forecasts.
The downside is that fundamental models do not
work any better than the forward rate model or the
random walk model.

6-53
Technical Approach
Technical analysis looks for patterns in the past
behavior of exchange rates.
Clearly it is based upon the premise that history
repeats itself.
Thus it is at odds with the EMH

6-54
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 forward
rate.
The founder of Forbes Magazine once said:
You can make more money selling financial
advice than following it.

6-55