Lecture 3 - Parity Conditions

International Parity Conditions
Covered interest arbitrage
Covered interest arbitrage is the process of capitalizing on the interest rate differential
between two countries while covering your exchange rate risk with a forward contract. The
International Finance (ECON 3231)

logic of the term covered interest arbitrage becomes clear when it is broken into two parts:
“interest arbitrage” refers to the process of capitalizing on the difference between interest
rates between two countries; “covered” refers to hedging your position against exchange
rate risk.
Example 1: You desire to capitalize on relatively high rates of interest in the United
Kingdom and have funds available for 90 days. The interest rate is certain; only the future
exchange rate at which you will exchange pounds back to U.S. dollars is uncertain. You
can use a forward sale of pounds to guarantee the rate at which you can exchange
pounds for dollars at a future point in time. This actual strategy is as follows:
1. On day 1, convert your U.S. dollars to pounds and set up a 90-day deposit account in a
British bank.
2. On day 1, engage in a forward contract to sell pounds 90 days forward.
3. In 90 days when the deposit matures, convert the pounds to U.S. dollars at the rate that
was agreed upon in the forward contract.
1
Covered interest arbitrage (cont ‘d)
Example 2. Assume the following information:

• You have $800,000 to invest.

• The current spot rate of the pound is $1.60.
• The 90-day forward rate of the pound is $1.60.
• The 90-day interest rate in the United States is 2 percent.
• The 90-day interest rate in the United Kingdom is 4 percent.
Steps;
Based on this information, you should proceed as follows:
1. On day 1, convert the $800,000 to £500,000 and deposit the £500,000 in a British bank.
2. On day 1, sell £520,000 90 days forward. By the time the deposit matures, you will have
£520,000 (including interest).
3. In 90 days when the deposit matures, you can fulfil your forward contract obligation by
converting your £520,000 into $832,000 (based on the forward contract rate of $1.60 per
pound)
2
Example 3. You are given the following data.

You have $100,000 to invest for one year. Would you benefit from engaging in covered
interest arbitrage?
• Convert $100,000 to buy euros (ask quote): $100,000/$1.13=€88,496
• Calculate accumulated euros over one year at 6.5 percent: €88,496 *1.065 €94,248
• Sell euros for dollars at the forward rate (bid quote): €94,248*$1.12 $105,558
• Determine the yield earned from covered interest arbitrage: ($105,558 *
$100,000)/$100,000 .05558, or 5.558%
• The yield is less than you would have earned if you had invested the funds in the
United States. Thus, covered interest arbitrage is not feasible. 3
Example 4. The dollar interest rate is 8% and Euro interest rate is 6%. The spot rate is
EUR = USD 1.30 and the 1-year forward rate is EUR = USD 1.35. Using the data,

determine whether arbitrage is possible.
Based on the data, it is noticed forward value of the EUR is high. Under CIP condition, the
forward rate would be 1.30*(1.08/1.06) = $1.3245.
So, one would sell the EUR in the forward market and buy EUR in the spot market.
Initial steps:
• Borrow $ 1000 at 8% and buy EUR (1000/1.30=EUR 769.23).
• Invest the EUR at 6% which would yield 769.23*1.06=EUR 815.38
• Enter the forward market (at beginning itself) to exchange proceeds in 1-yr at rate
EUR=USD1.35
After 1-year
• Sell the EUR 815.38 at EUR=USD1.35 implying $1,100.76
• Repay loan of $1000 at 8%, i.e, an amount of $1080.
• Arbitrage profit 1100.76 – 1080 = $ 20.76 4
Covered interest rate parity holds when any forward premium or discount exactly offsets
differences in interest rates, so that an investor will earn the same return irrespective of

whether she invests in the domestic or foreign market.
If CIP holds, the currency bearing the higher interest rate will depreciate to offset the gain
from the relatively higher interest rates.
Overall, with covered interest rate parity, arbitrage will force the forward contract exchange
rate to a level consistent with the difference between the difference in the nominal interest
rates of two countries.
5
Uncovered interest rate parity
Uncovered interest rate parity states that the expected return on an uncovered or
unhedged foreign currency investment should equal the return on a comparable domestic

currency investment.
Consider country A where the interest rate is 3% and country B where the interest rate is
5%. Under uncovered interest rate parity, the currency of country B is expected to
depreciate by 2% annually relative to currency A so that an investor will be indifferent
between the investing in country A or B.
6
Uncovered interest rate parity (cont ‘d)
Uncovered interest rate parity states that an investor’s expected return from the following
investment options should be the same.

Option 1: Invest the funds at the domestic nominal risk-free rate (i) for a particular period
of time.
• After 1 yr, value of the investment grows to (1+i)
Option 2: Convert funds into a foreign currency (at the current spot rate, S), and invest
them at the foreign nominal risk‐free rate, i*, (for the same period of time as in Option 1)
and then converts them back into the domestic currency after 1 year at the expected spot
exchange rate one year from today (Se).
• When converting 1 unit of domestic currency into foreign currency today and investing
at i*, the investment grows to S(1+i*) after a year.
• This amount is converted back into domestic currency at the expected spot exchange
rate one year from today given by Se . After 1 year, the value of the investment in
𝑆(1+𝑖 ∗ )
domestic currency terms equals:
𝑆𝑒 7
The UIP equation (1-yr) becomes:

𝑆(1 + 𝑖 ∗ )
1+𝑖 =
𝑆𝑒
The above equality can be used to derive the formula for the expected future spot
exchange rate:
𝑒
𝑆(1 + 𝑖 ∗ )
𝑆 =
(1 + 𝑖)
The expected percentage change in the spot exchange rate can be calculated as:
𝑒
𝑆 −𝑆
%∆𝑆 𝑒 =
𝑆
And this can be approximated as:

∗
%∆𝑆 𝑒 = 𝑖 −𝑖 8
Consider the following information:

• Risk free rate on the USD = iUSD = 4%
• Risk free rate on the GBP = iGBP = 5%
• Current spot USD/GBP exchange rate = SUSD/GBP = 1.5025
1. Compute the 1‐year USD/GBP forward rate and the forward premium/discount
assuming interest rate parity holds?
2. Compute the expected USD/GBP spot rate in 1 year and the expected change in the
spot exchange rate over the year assuming that uncovered interest parity is expected to
hold.
9
UIP vs. CIP
The CIP derives a no-arbitrage forward rate while UIP derives an expected future spot rate
(not market traded).

If the forward rate equals the expected future spot rate, we say that the forward rate is an
unbiased predictor of the future spot rate. In this case, F=E(S1). In this special case, if the
UIP holds, the forward rate is an unbiased predictor of the future spot rate.
10
Purchasing-power parity condition
Inflation is one of the major factors that affects exchange rates in the long-run.

The long-term connection between inflation and exchange rate forms the basis of the
Purchasing-power parity condition..
The Law of one price

Every individual would want to profit from disequilibrium in markets by buying at a lower
price in one market and selling at a higher price in another market.
One issue may be the transportation costs of shipping the item to another place. Hence, if
the price difference between two markets is sufficiently large to cover the transportation
costs, there exists the possibility of arbitrage.
People who buy in one market and sell in another are commodity arbitragers. Through
their actions, they remove any profitable opportunities that may exist. They force up prices
in low-cost markets and reduce prices where they are high.
Arbitragers will stop their activities provided there are no further profitable opportunities in 11
markets, i.e, when the prices of products in one market is equal to the price in another
market.
The Law of one price (cont ‘d)

The law of one price states that, in the absence of frictions such as differential shipping

costs and tariffs, the price of a product when converted into a common currency such as
the US dollar, using the spot exchange rate, is the same in every country:
𝑔𝑜𝑙𝑑 𝑔𝑜𝑙𝑑
𝑃𝑈𝑆 = 𝑆($ £)𝑃𝑈𝐾
That is, price of a particular commodity (say gold) in the US should be equivalent to the
price of gold in the UK in USD terms. For example, if price of gold is $ 1,100/ounce in the
US and the USD-GBP rate is 0.65 it implies that the price of 1 ounce of gold in the UK
should be 0.65*1100 = £ 715. If say price of gold was higher in the US at $ 1,150 gold
buyers will prefer buying from the US pushing down gold prices in the US and driving up
prices in the UK until the equilibrium is reached as per the above equation.
Absolute PPP condition

If the above equation were to hold for each and every good and service, it would imply
that a basket of goods and services in Britain would cost the same in the US when
denominated in USD, that is, 12
𝑃𝑈𝑆 = 𝑆($ £)𝑃𝑈𝐾 Eq. 1

Absolute PPP condition (cont ‘d)

This refers to the absolute form of the PPP and we can rearrange to obtain the spot rate:

𝑃𝑈𝑆
𝑆 $ £ =
𝑃𝑈𝐾
For example, if the basket costs $2,000 in the United States and £1,200 in Britain, the
exchange rate should be $1.67/£.
The major limitation in validating the PPP is that different countries use different baskets of
goods and services in computing their respective consumer price indexes, for example,
cold countries use more heating oil than hot countries.
Even if the law of one price would hold for individual goods, this might not reflect in the
price index of each country due to varying weights in the basket of goods and services.
Hence, if the price of heating oil changes, this would affect colder countries relatively
more.
13
Relative PPP condition

In view of the limitations of the absolute PPP, there is an alternative form known as the

relative PPP. The model is based on the following:
𝑃𝑈𝑆 = 𝑆($ £)𝑃𝑈𝐾 Eq. 2
Where 𝑆($ £) is the percentage change in the spot exchange rate over a year, and
𝑃𝑈𝑆 and 𝑃𝑈𝐾 are respectively the percentage annual rates of change in the price levels
(annual inflation rates) in the United States and UK.
If the PPP condition holds, that is, 𝑃𝑈𝑆 = 𝑆($ £)𝑃𝑈𝐾 , the following should hold at the end of
a year:
𝑃𝑈𝑆 (1 + 𝑃𝑈𝑆 ) = 𝑆($ £) 1 + 𝑆 $ £ . 𝑃𝑈𝐾 (1 + 𝑃𝑈𝐾 ) Eq. 3
The LHS is simply the price in the US after 1 year by multiplying the price in the US at the
beginning of the year by 1 plus the inflation rate. On the RHS, we have the sot rate after
one year time the price in the UK after one year. 14
Therefore, the absolute PPP applies to one particular point in time whereas the relative
PPP equation is the PPP condition one year later.
Relative PPP condition (cont ‘d)

By equating equation 1 and equation 2, we end up with the following:

(1 + 𝑃𝑈𝑆 ) = 1 + 𝑆 $ £ . (1 + 𝑃𝑈𝐾 )
Which can be re-arranged as:
𝑃𝑈𝑆 −𝑃𝑈𝐾
𝑆 $ £ = Eq.4
1+𝑃𝑈𝐾
Equation 4 is the PPP in its relative form. For example, if the United States experiences
inflation of 2 percent and UK 1 percent, the dollar price of pounds should fall – that is, the
pound should appreciate at a rate of 0.9 percent. If the reverse happens, that is US
inflation is 1% and UK inflation is 2%, the USD should appreciate by 0.8%.
Given that both scenarios yield near answers, equation 4 can be approximated by the 15
following:
∗
𝑆 $ £ = 𝑃𝑈𝑆 − 𝑃𝑈𝐾 or in general form: %∆𝑆 = 𝜋 −𝜋
Relative PPP condition (cont ‘d)

The PPP in relative form says that the rate of change in the exchange rate is equal to the
difference between the inflation rates. Note that this equation is only a good approximation
for low inflation rates.
16
Ex-ante version of PPP

The ex-ante version of the PPP is same as the relative version except that it is based on

expectations of inflation instead of actual inflation.
∗
%∆𝑆 = 𝜋𝑒 −𝜋e
According to the ex-ante version of the PPP, countries that are expected to see
persistently high (low) inflation rates should expect to see their currencies depreciate
(appreciate) over time.
Example: The current spot USD/AUD = 1.00. You expected an annualised Australia
inflation rate of 5% and that of the US to be 2%. According to the ex-ante version of the
PPP, what is the expected change of the spot rate over the coming year.
17
Ex-ante version of PPP (cont ‘d)

The PPP in relative form says that the rate of change in the exchange rate is equal to the
difference between the inflation rates. Note that this equation is only a good approximation
for low inflation rates.
Example: Assume that the U.S. is the foreign country and that Japan is the
domestic country. The current spot exchange rate is S0 = 115 yen per dollar ($1 per
¥115.00). The expected annual inflation rate for the U.S. is 4.89%, and the annual
expected Japanese inflation rate is 6.23%. Compute the approximate expected
change in the spot rate and the expected spot rate one year from now.
Answer:
Japan is the domestic country
The approximation method would indicate that the yen should decline against the dollar
by: 0.0489 - 0.0623) = -0.0134 = -1.34%
So the value of the yen relative to the dollar would be expected to decline to 18
(1 + 0.0134) × 115 = ¥116.55 per $
Reasons for departure from the PPP

• Restrictions on movement of goods - Two-way arbitrage allows prices to differ between
markets by up to the cost of transportation. For example, if a good costs $2.00 per unit
to ship between the United States and Canada, the price difference must exceed $2.00
per unit for arbitrage to occur.
Quotas, which are limits on the amounts of different commodities that can be imported,
generally mean that price differences can become quite sizable, because commodity
arbitragers are limited in their ability to narrow the gaps.
Import tariffs can also cause PPP violations. If one country has, for example, a 15
percent import tariff, prices within the country will have to move more than 15 percent
above those in the other before it pays to ship and cover the tariffs. Price levels can
move higher in only the country which has the import tariffs.
• Price indexes. See previous discussion on price indexes and individual good
weightage.
19
Real Interest Rate Parity & International Fisher Effect
The international Fisher effect (IFE) theory uses interest rate rather than inflation rate
differentials to explain why exchange rates change over time, but it is closely related to the

PPP theory because interest rates are often highly correlated with inflation rates. It is
based on the Fisher effect.
The Fisher effect asserts that the nominal interest rate (i) in a country equals the sum of
the real interest rate in that country (r) and the expected inflation rate (πe).
𝐹𝑖𝑠ℎ𝑒𝑟 𝑒𝑓𝑓𝑒𝑐𝑡: 𝑖 = 𝑟 + 𝜋 𝑒
If investors of all countries require the same real return, interest rate differentials between
countries may be the result of differentials in expected inflation.
From the PPP, exchange rate movements are caused by inflation rate differentials. If real
rates of interest are the same across countries, any difference in nominal interest rates
could be attributed to the difference in expected inflation.
The IFE theory suggests that foreign currencies with relatively high interest rates will
depreciate because the high nominal interest rates reflect expected inflation. The nominal 20
interest rate would also incorporate the default risk of an investment. The following
examples focus on investments that are risk free so that default risk will not have to be
accounted for.
Real Interest Rate Parity & International Fisher Effect (Cont ‘d)
From the Fisher equation:

Domestic: 𝑖 = 𝑟 + 𝜋 𝑒 Eq. a
∗ ∗
Foreign: 𝑖 = 𝑟 +𝜋 ∗𝑒 Eq. b
Eq. a – Eq. b yields:

∗ ∗
𝑖 −𝑖 = 𝑟 −𝑟 − (𝜋 ∗𝑒 −𝜋 𝑒 ) Eq. c
This tells us that the nominal interest rate spread between the foreign and domestic
countries equals the sum of:
1. The foreign‐domestic real yield spread
2. The foreign‐domestic expected inflation differential
Eq. c can be re-arranged in terms of real interest rate:

∗ ∗
𝑟 −𝑟 = 𝑖 − 𝑖 − (𝜋 ∗𝑒 −𝜋 𝑒 ) Eq. d
21
Recall that:

• If uncovered interest rate parity holds, the nominal interest rate spread (i*-i)
approximately equals the expected change in the exchange rate (% ΔSe).
• If the ex-ante version of the PPP holds, the difference in expected inflation rates
𝜋 𝑒 −𝜋 ∗𝑒 approximately equals the expected change in the spot rate (% ΔSe).
Therefore, assuming that both the uncovered interest rate parity and the ex ante PPP
hold, the real yield spread between the foreign and domestic countries will equal 0. This
proposition that real interest rates will converge to the same level across different
countries (as real yield spreads across countries equal zero) is known as the real interest
rate parity condition.
∗ ∗
Real Interest Rate Parity: 𝑟 − 𝑟 = 𝑖 −𝑖 − (𝜋 ∗𝑒 − 𝜋 𝑒 ) = (% ΔSe) - (% ΔSe) = 0
22
Further, if the real yield spread (r*-r) equals zero in all markets, it follows that the foreign
domestic nominal yield spread (i*-i) will be determined by the foreign‐domestic expected

inflation rate differential. This is known as the international Fisher effect:
∗
0 = 𝑖 −𝑖 − (𝜋 ∗𝑒 − 𝜋 𝑒 )
∗
𝑖 −𝑖 = (𝜋 ∗𝑒 − 𝜋 𝑒 )
The International Fisher effect asserts that if, (1) the Fisher effect holds in each market
(i.e., the nominal interest rate in each country equals the real interest rate plus the
expected inflation rate) and (2) real interest rate parity holds (i.e., real interest rates across
markets are the same) then the difference between domestic and foreign nominal interest
rates will equal the difference between domestic and foreign expected inflation rates.
Example: Assume that the Eurozone expected annual inflation is 9.0% and that of the
South African is 13.0%. The nominal interest rate is 10.09% in the Eurozone. Use the IFE
to estimate the nominal interest rate in South Africa.
23
Carry trade
Uncovered interest rate parity asserts that countries with higher (lower) interest rates
should expect their currencies to depreciate (appreciate). If uncovered interest rate parity

held at all times, investors would not be able to profit from a strategy that involved taking
long positions in high‐yield currencies and short positions in low‐yield currencies (as the
change in the spot rate over the investment horizon would offset the interest rate
differential).
Studies have found that, on average, high‐yield currencies do not depreciate to the levels
predicted by interest rate differentials; nor do low‐yield currencies appreciate to the levels
predicted by interest rate differentials. These findings imply that FX carry trades can be
potentially profitable. An FX carry trade involves taking long positions in high‐yield
currencies and short positions in low‐yield currencies (also known as funding currencies).
Example: Consider the following information:

iJPY = 1%
iAUD = 3%
SJPY/AUD today = 85
1. Compute the profit on a carry trade between the JPY and the AUD assuming that
SJPY/AUD in one year equals 85. 24
2. Compute the profit on a carry trade between the JPY and the AUD assuming that
SJPY/AUD in one year equals 84.

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International Parity Conditions

Covered interest arbitrage

International Finance (ECON 3231)

Covered interest arbitrage (cont ‘d)

Example 2. Assume the following information:

International Finance (ECON 3231)

Covered interest arbitrage (cont ‘d)

Example 3. You are given the following data.

International Finance (ECON 3231)

Covered interest arbitrage (cont ‘d)

International Finance (ECON 3231)

Covered interest arbitrage (cont ‘d)

International Finance (ECON 3231)

Uncovered interest rate parity

International Finance (ECON 3231)

Uncovered interest rate parity (cont ‘d)

International Finance (ECON 3231)

Uncovered interest rate parity (cont ‘d)

The UIP equation (1-yr) becomes:

International Finance (ECON 3231)

And this can be approximated as:

Uncovered interest rate parity (cont ‘d)

Consider the following information:

International Finance (ECON 3231)

UIP vs. CIP

International Finance (ECON 3231)

Purchasing-power parity condition

International Finance (ECON 3231)

The Law of one price

Purchasing-power parity condition

The Law of one price (cont ‘d)

International Finance (ECON 3231)

Absolute PPP condition

𝑃𝑈𝑆 = 𝑆($ £)𝑃𝑈𝐾 Eq. 1

Purchasing-power parity condition

Absolute PPP condition (cont ‘d)

International Finance (ECON 3231)

Purchasing-power parity condition

Relative PPP condition

International Finance (ECON 3231)

𝑃𝑈𝑆 = 𝑆($ £)𝑃𝑈𝐾 Eq. 2

𝑃𝑈𝑆 (1 + 𝑃𝑈𝑆 ) = 𝑆($ £) 1 + 𝑆 $ £ . 𝑃𝑈𝐾 (1 + 𝑃𝑈𝐾 ) Eq. 3

Purchasing-power parity condition

Relative PPP condition (cont ‘d)

International Finance (ECON 3231)

Which can be re-arranged as:

Purchasing-power parity condition

Relative PPP condition (cont ‘d)

International Finance (ECON 3231)

Purchasing-power parity condition

Ex-ante version of PPP

International Finance (ECON 3231)

Purchasing-power parity condition

Ex-ante version of PPP (cont ‘d)

International Finance (ECON 3231)

Purchasing-power parity condition

Reasons for departure from the PPP

International Finance (ECON 3231)

Real Interest Rate Parity & International Fisher Effect