Chapter 7&9

Exchange rate
Determination
and
International
Parity Conditions
 LECTURE OUTLINE

• Chapter 7: International Parity Conditions

– Prices & exchange rates:
– Interest rate & exchange rates:
– Equilibrium
• Chapter 9: The exchange rate determination
– Three approaches to exchange rate
determination

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 International Parity Conditions

• Some fundamental questions managers of MNEs, international

portfolio investors, importers, exporters and government
officials must deal with every day are:
– What are the determinants of exchange rates?
– Are changes in exchange rates predictable?
• The economic theories that link exchange rates, price levels,
and interest rates together are called international parity
conditions.

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 International Parity Conditions

• International parity conditions:

– Purchasing power parity
– International fisher effect
– Interest rate parity

• These international parity conditions form the core

of the financial theory that is unique to
international finance.

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 Prices and Exchange Rates: Law
of one price

• If the identical product or service can be:

– sold in two different markets; and
– no restrictions exist on the sale; and
– transportation costs of moving the product
between markets are equal, then
then, the product’s price should be the same in
both markets.

• This is called the law of one price.

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 Prices and Exchange Rates:
Purchasing power parity
• Absolute version of the PPP theory: the spot
exchange rate is determined by the relative prices
of similar baskets of goods, if the law of one price
were true for all goods and services and the
market is efficient.
S(¥/$) = P¥/ P$

– S (¥/$) : spot exchange rate (yen per U.S dollar)

– P$: product price in U.S. dollars
– P¥: product price in Yen
• A fun example is the Big Mac Index published
annually by the Economist.
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 Exhibit 7.1 Selected Rates from the
Big Mac Index

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 Big Mac Index

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 Prices & Exchange Rates:

• Why BMI is not perfect ?

– Big Macs cannot be traded across borders,
– Costs and prices are influenced by a variety of other
factors in each country market, such as real estate rental
rates and taxes.
• A less extreme form of this principle asserts that in
relatively efficient markets, the price of a basket of
goods—rather than a single product—would be the
same in each market.

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 Prices and Exchange Rates:
Relative PPP

• The relative form of PPP accounts for the possibility

of market imperfections such as transportation
costs, tariffs, and quotas.

• RPPP holds that PPP is not particularly helpful in

determining what the spot rate is today, but that
the relative change in prices between two
countries over a period of time determines the
change in the exchange rate over that period.

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 Prices and Exchange Rates:
Relative PPP

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 Exhibit 7.2 Relative Purchasing
Power Parity (PPP)

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 Purchasing Power Parity:
example

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 Purchasing Power Parity:
example

Current exchange rate: S1 (VND/USD) = VND23,000/$

Vietnam expected inflation for next year is 6%
U.S expected inflation for next year is 4%
What is the expected future exchange rate in 1 year?
Answer:

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 Prices and Exchange Rates: PPP

• Empirical testing of PPP and the law of

one price has not proved PPP to be accurate
in predicting future exchange rates.
• Two general conclusions can be made from
these tests:
– PPP holds up well over the very long run but
poorly for shorter time periods; and,
– the theory holds better for countries with
relatively high rates of inflation and
underdeveloped capital markets.

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 Prices and Exchange Rates
• Individual national currencies often need to be
evaluated against other currency values to determine
relative purchasing power.
• The objective is to discover whether a nation’s
exchange rate is “overvalued” or “undervalued” in
terms of PPP.
• Nominal effective exchange rate index
• Real effectives exchange rate indexes

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 Exhibit 7.3 IMF’s Real Effective Exchange
Rate Indexes for the United States, Japan,
and the Euro Area

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 Interest Rates and Exchange
Rates: The Fisher effect
• The Fisher effect states that nominal interest rates in each
country are equal to the required real rate of return plus
compensation for expected inflation.
• This equation reduces to (in approximate form):
i=r+ 
i = nominal interest rate
r = real interest rate and
∏= expected inflation.
• Empirical tests (using ex-post) national inflation rates have
shown the Fisher effect usually exists for short-maturity
government securities (treasury bills and notes).

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 Interest Rates and Exchange
Rates: International Fisher effect

ef =

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 Interest Rates and Exchange
Rates: International Fisher effect

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 International Fisher Effect

• Assume the United Kingdom has a one-year

interest rate of 6% and the U.S. has a 4%,
one-year interest rate.
• If the spot rate is $1.50 per British pound
and the international Fisher effect (IFE)
holds, what would you forecast for the
future spot rate of the pound in one year ?

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 Interest Rates and Exchange
Rates

• A forward rate is an exchange rate quoted

for settlement at some future date.
• A forward exchange agreement between
currencies states the rate of exchange at
which a foreign currency will be bought
forward or sold forward at a specific date in
the future.

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 Interest Rates and Exchange
Rates: Forward rate

• The forward rate is calculated for any specific

maturity by adjusting the current spot exchange
rate by the ratio of eurocurrency interest rates of
the same maturity for the two subject currencies.

General formula:

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 Interest Rates and Exchange
Rates: Forward rate

• Assuming a spot rate of SF1.4800/$, a 90-

day euro Swiss franc deposit rate of 4.00%
per annum, and a 90-day eurodollar deposit
rate of 8.00% per annum. What is the 90-
day forward rate?

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 Interest Rates and Exchange
Rates: Forward rate

• The forward premium or discount is the

percentage difference between the spot and
forward exchange rate, stated in annual
percentage terms.

• This is the case when the foreign currency

price of the home currency is used (SF/$).
(indirect quote on the dollar)

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 Interest Rates and Exchange
Rates: Interest rate parity

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 Interest Rates and Exchange
Rates: Forward rate
Example: Assuming a spot rate of SF1.4800/$, a 90-
day euro Swiss franc deposit rate of 4.00% per annum,
and a 90-day Eurodollar deposit rate of 8.00% per
annum. Calculate the 90-day SF/$ forward rate and
forward premium on Swiss franc.
Answer:
➢ f(SF) ≈ 8%-4% ≈ 4%
➢ f(SF) = (1.8-1.4655)/1.4655*360/90 = 3.96%
➢ F=S*(1+0.04*90/360)/(1+0.08*90/360)=
1.4655

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 Exhibit 7.5 Currency Yield Curves
and the Forward Premium

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 Exhibit 7.5 Currency Yield Curves
and the Forward Premium

Consider the following set of foreign & domestic interest rates

and spot and forward exchange rates.
Spot exchange rate: S(SF/USD) = 1.48
90-day Forward exchange rate: F(SF/USD) = 1.4655
US interest rate: 8% pa
Swiss interest rate: 4% pa

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 Interest Rate Parity (IRP)

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 Exhibit 7.6 Interest Rate Parity
(IRP)

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 Interest Rate Parity (IRP)

iSF, i$ : adjust
for maturity

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 Interest Rates and Exchange
Rates: Covered interest arbitrage
• The spot and forward exchange rates are not,
however, constantly in the state of equilibrium
described by interest rate parity.
• When the market is not in equilibrium, the
potential for “risk-less” or arbitrage profit exists.
• The arbitrager will exploit the imbalance by
investing in whichever currency offers the higher
return while covering your exchange rate risk with
a forward contract.

This is known as covered interest arbitrage

(CIA).

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 Interest Rates and Exchange
Rates: Covered interest arbitrage

Consider the following set of foreign & domestic interest rates

and spot and forward exchange rates.
Spot exchange rate: S(SF/USD) = 1.48
US interest rate: 8% pa
Swiss interest rate: 4% pa
a) 90-day Forward exchange rate: F(SF/USD) = 1.49
b) 90-day Forward exchange rate: F(SF/USD) = 1.45
Any arbitrage opportunity ?

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 Interest Rates and Exchange
Rates: Covered interest arbitrage
a) F(SF/USD) = 1.49
• Compare: |i$ - iSF| =|8% – 4%| = 4%
f = (S-F)/F*360/n = [(1.48-1.49)/1.49]*4
= - 0.02684%
→|i$ - iSF| > |f|→ invest in higher yielding currency
→Invest USD, borrow SF.
• OR: Calculate: E(R$) = (1+8%/4) = 1.02
E(RSF) = 1.48/1.49*(1+4%/4) = 1.00322
→ E(R$) > E(RSF) → invest USD, borrow SF
• OR: market rate = 1.49 > IRP implied rate = 1.4655 → $
is overvalued → Sell $ forward (borrow SF, invest USD)

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 Interest Rates and Exchange
Rates: Covered interest arbitrage
a) F(SF/USD) = 1.49
• Strategy:
– Borrow…………at……, payable in 3 months….......
– Convert from ………… to …………… at
– Invest ………in………at…………
– Sell…..forward
– After 3 months, receive………., convert back to ……… at

– Net profit = …………………………

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 Interest Rates and Exchange
Rates: Covered interest arbitrage

b) F(SF/USD) = 1.45

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 Interest Rates and Exchange
Rates: Covered interest arbitrage

Consider the following set of foreign & domestic interest rates

and spot and forward exchange rates.
Spot exchange rate: S(JPY/USD) = 106
180-day Forward exchange rate: F(JPY/USD) = 103.50
US interest rate: 8% pa
Japan interest rate: 4% pa

Any arbitrage opportunity ?

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 Exhibit 7.9 Interest Rate Parity
(IRP) and Equilibrium

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 Exhibit 7.7 Covered Interest
Arbitrage (CIA)

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 Covered Interest Arbitrage (CIA)

Solution:
- Borrow

- Spot convert

- Invest

- Sell……..forward

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 Covered interest arbitrage (CIA)

• Covered interest arbitrage opportunities continue

until interest rate parity is reestablished
• CIA will force IRP back to equilibrium
• Example:
✓ The purchase of yen in the spot market and the
sale of yen in the forward market narrows the
premium on the forward yen. (decrease
S(JPY/USD) and increase F(JPY/USD))
✓ The demand for yen-denominated securities
causes yen interest rates to fall, and the higher
level of borrowing in the United States causes
dollar interest rates to rise.

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 Summary: Covered Interest Arbitrage
(CIA)

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 Interest Rates and Exchange Rates:
Uncovered interest arbitrage
• Uncovered interest arbitrage (UIA): Investors
borrow in countries and currencies exhibiting
relatively low interest rates and convert the
proceed into currencies that offer much higher
interest rates without covering the position.
• The transaction is “uncovered” because the
investor does not sell the higher yielding currency
proceeds forward, accept the currency risk at the
end of the period.

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 Exhibit 7.5 Currency Yield Curves
and the Forward Premium

Consider the following set of foreign & domestic interest rates

and spot and forward exchange rates.
Spot exchange rate: S(JPY/USD) = 120
360-day expected exchange rate: Se(JPY/USD) = 120
US interest rate: 5% pa
Japan interest rate: 0.4% pa

Any arbitrage opportunity ?

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 Exhibit 7.8 Uncovered Interest Arbitrage
(UIA): The Yen Carry Trade

In the yen carry trade, the investor borrows Japanese yen at relatively low interest rates, converts
the proceeds to another currency such as the U.S. dollar where the funds are invested at a higher
interest rate for a term. At the end of the period, the investor exchanges the dollars back to yen to
repay the loan, pocketing the difference as arbitrage profit. If the spot rate at the end of the period
is roughly the same as at the start, or the yen has fallen in value against the dollar, the investor
profits. If, however, the yen were to appreciate versus the dollar over the period, the investment
may result in significant loss.

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 Interest Rates and Exchange
Rates
• Some forecasters believe that forward exchange
rates are unbiased predictors of future spot
exchange rates.
• Intuitively this means that the distribution of
possible actual spot rates in the future is centered
on the forward rate.
• Unbiased prediction simply means that the forward
rate will, on average, overestimate and
underestimate the actual future spot rate in equal
frequency and degree.

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 Exhibit 7.11 International Parity Conditions in
Equilibrium (Approximate Form)

(∏¥ = 1%; ∏$ = 5%; i¥ = 4%; i$ = 8% (1-year government security).

S = ¥104/$; 1-month F = ¥100/$ )
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 Foreign Exchange Rate
Determination

• Exchange rate determination is complex.

• Three major schools of thought
– Parity conditions
– Balance of payments approach
– Asset market approach
• These are not competing theories but rather
complementary theories.

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 Foreign Exchange Rate
Determination
• Without the depth and breadth of the various
approaches combined, our ability to capture the
complexity of the global market for currencies is
lost.
• In addition to gaining an understanding of the basic
theories, it is equally important to gain a working
knowledge of:
– the complexities of international political economy;
– societal and economic infrastructures; and,
– random political, economic, or social events that affect the
exchange rate markets.

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 Exhibit 9.1 The Determinants of
Foreign Exchange Rates

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 Exchange Rate Determination:
The Theoretical Thread
• The theory of purchasing power parity is the
most widely accepted theory of all exchange
rate determination theories:
– Most exchange rate determination theories have
PPP elements embedded within their
frameworks.
– PPP calculations and forecasts are however
plagued with structural differences across
countries and significant data challenges in
estimation.

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 Balance Of Payments Approaches
– The second most utilized theoretical approach
– The demand for foreign exchange arises from the
“debit” items in the BOP, whereas the supply of foreign
exchange arises from the “credit” items.
• A BOP deficit → Depreciation of the home currency.
• A BOP surplus → Appreciation of the home currency.
– The exchange rate is the function of the supply &
demand for foreign money (known as “Demand –
Supply Theory”)
→ More realistic than the PPP approach in that the
exchange rate is seen as a function of many significant
variables.

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 Balance Of Payments Approaches

• In general, persistent current account deficits lead to

depreciation of the domestic currency & vice versa.
• If the country sells less goods & services than it
purchases, demand for its currency should fall.
→ Countries with persistent current account
deficits should see their currencies depreciate
over time.

→ In the long-run, exchange rate movements

should help to eliminate the initial imbalances.

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 Balance Of Payments Approaches

• Capital flows tend to have a more immediate

impact on exchange rates than trade flows.
• With greater financial integration of the world’s
capital markets & increased capital mobility, capital
flows are now the DOMINANT force in influencing
exchange rates (also interest rates & asset price
bubbles).
• Criticisms of the balance of payments approach
arise from the theory’s emphasis on flows
of currency and capital rather than on stocks of
money or financial assets.
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 Monetary Approaches

• The monetary approach, in its simplest form,

states that the exchange rate is determined by
the supply and demand for national
monetary stocks, as well as the expected
future levels and rates of growth of monetary
stocks.
• Other financial assets, such as bonds, are not
considered relevant for exchange rate
determination, as both domestic and foreign
bonds are viewed as perfect substitutes.

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 Monetary Approaches

• Exchange rates adjust to ensure that the quantity of

money in each currency supplied is equal to the
quantity demanded.
• Demand for money depends upon the level of real
income, the general price level and the rate of
interest
• Supply of money depends on the authority
• Quantity Theory Of Money: M x V = P x T
More money → higher inflation will put into effect the
PPP resulting in the depreciation of the currency.

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 Asset Market Approach

• Also called The Portfolio Balance Approach or The

Relative Price Of Bonds.
• Exchange rates are determined by the supply
and demand for a wide variety of financial
assets=> Shifts in the supply and demand for
financial assets alter exchange rates.
• Changes in monetary and fiscal policy alter
expected returns and perceived relative risks of
financial assets, which in turn alter exchange
rates.

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 Forecasting in Practice

• Technical analysts, traditionally referred to as chartists, focus

on price and volume data to determine past trends that are
expected to continue into the future.
• The single most important element of technical analysis is that
future exchange rates are based on the current exchange
rate.
• Exchange rate movements can be subdivided into three
periods:
– Day-to-day
– Short-term (several days to several months)
– Long-term

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 Forecasting in Practice

• The longer the time horizon of the forecast, the

more inaccurate the forecast is likely to be.
• Forecasting for the long run must depend on the
economic fundamentals of exchange rate
determination,
• Many of the forecast needs of the firm are short
to medium term can be addressed with less
theoretical approaches.
• Exhibit 9.5 summarizes the various forecasting
periods, regimes, and the authors’ suggested
methodologies.

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 Exhibit 9.5 Exchange Rate
Forecasting in Practice

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 Forecasting: What to Think?

• From decades of theoretical and empirical

studies, exchange rates do adhere to the
fundamental principles and theories
previously outlined.
• Fundamentals do apply in the long term
→ There is a fundamental equilibrium path for
a currency’s value.

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 Forecasting: What to Think?
• In the short term, a variety of random events,
institutional frictions, and technical factors may
cause currency values to deviate significantly from
their long-term fundamental path.
• This is referred to as noise which occurs with some
regularity and relative longevity.

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 Exhibit 9.6 Short-Term Noise
Versus Long-Term Trends

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 Exhibit 9.7 Exchange Rate
Dynamics: Overshooting

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 Summary

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