International Parity Relationships and Forecasting Foreign Exchange Rates

International Parity Relationships and Forecasting Foreign
Exchange Rates
Chapter Six
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights
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
• Fisher Effects
• Forecasting Exchange Rates
– Efficient Market Approach
– Fundamental Approach
– Technical Approach
– Performance of the Forecasters
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 6-2
International Parity Relationships
• Law of one price (LOP)
– Requirement that similar commodities or securities should
be trading at the same or similar prices
– Prevails when the same or equivalent things are trading at
the same price across different locations or markets,
precluding profitable arbitrage opportunities
• Arbitrage equilibrium
– Arbitrage is the act of simultaneously buying and selling
the same or equivalent assets or commodities for the
purpose of making certain, guaranteed profits
Interest Rate Parity Defined
• Interest rate parity (IRP) is an arbitrage condition
that must hold when international financial markets
are in equilibrium
– Manifestation of the LOP applied to international money
market instruments and provides a linkage between interest
rates in two different countries
Interest Rate Parity - Example
• Suppose you have $1 to invest over a one-year
period, and you will only consider default-free
investments.
• There are two alternative ways on investing your
fund:
1. Invest domestically at the U.S. interest rate
• If you choose this option, the maturity value in one year
will be $1(1 + is), where is is the U.S. interest rate
Interest Rate Parity – Example (Continued)
• Suppose you have $1 to invest over a one-year
period. There are two alternative ways on investing
your fund:
2. Invest in a foreign country, say, the U.K., at the foreign
interest rate and hedge the exchange risk by selling the
maturity value of the foreign investment forward. This
option requires the following steps:
• Exchange $1 for a pound, that is, £(1/S) amount at the prevailing
spot exchange rate (S)
• Invest the pound amount at the U.K. interest rate (i£), with the
maturity value of £(1/S)(1+i£)
• Sell the maturity value of the U.K. investment forward in exchange
for a predetermined dollar amount, that is, $[(1/S)(1+i£)]F, where F
denotes the forward exchange rateCopyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 6-6
Interest Rate Parity: Equivalent Investments
• Effective dollar interest rate from the U.K. investment
alternative is given by:
• U.S. and U.K. investment examples are equivalent

• Future dollar proceeds from investing in the two
equivalent investments must be the same, implying the
following:
or
Arbitrage
• IRP can be derived by constructing an arbitrage
portfolio, which involves the following:
– No net investment
– No risk
– No net cash flow generated in equilibrium
• When IRP does not hold, the situation gives rise
to covered interest arbitrage opportunities,
allowing certain arbitrage profits to be made
without the arbitrageur investing any money out
of pocket or bearing any risk
IRP and Exchange Rate Determination
• Reformulating the IRP relationship in terms of the spot
exchange rate yields:
• Forward exchange rate can be viewed as the expected

future spot exchange rate conditional on all relevant
information being available
• Combining the two equations yields the following:
IRP and Exchange Rate Determination Continued
• Two things are noteworthy from the following

equation (presented on previous slide):
1. “Expectation” plays a key role in exchange rate

determination (i.e., when people “expect” the
exchange rate to go up in the future, it goes up now)
2. Exchange rate behavior will be driven by news events
Uncovered Interest Rate Parity
• When the forward exchange rate F is replaced
by the expected future spot exchange rate,
E(St+1), we obtain:
• Uncovered interest rate parity

– Interest rate differential between a pair of countries is
(approximately) equal to the expected rate of change in
the exchange rate
Currency Carry Trade
• Unlike IRP, the uncovered interest rate parity often
does not hold, giving rise to uncovered interest
arbitrage opportunities
• Currency carry trade involves buying a high-
yielding currency and funding it with a low-yielding
currency, without any hedging
• The carry trade is profitable if the interest rate
differential is greater than the appreciation of the
funding currency against the investment currency
EXHIBIT 6.3 Interest Rate Spreads and Exchange Rate Changes: Six-
Month Carry Trade Periods for Australian Dollar–Japanese Yen Pair
Reasons for Deviations from IRP
• IRP holds quite well, but it may not hold precisely all
the time due to (primarily) two main reasons:
1. Transaction costs
• Interest rate at which the arbitrager borrows tends to be
higher than the rate at which he lends, reflecting the bid-ask
spread
• There exist bid-ask spreads in the foreign exchange market
as well, as the arbitrager must buy currencies at the higher
ask price and sell at the lower bid price
2. Capital controls
• Governments sometimes restrict capital flows, inbound
and/or outbound via jawboning, imposing taxes, or outright
bans
EXHIBIT 6.4
Interest Rate Parity with Transaction Costs
EXHIBIT 6.5: Deviations from Interest Rate Parity:
Japan, 1978-1981 (in percent)
Purchasing Power Parity
• When the law of one price is applied international to a
standard consumption basket, we obtain the theory of
purchasing power parity (PPP)
– PPP states the exchange rate between currencies of two
countries should be equal to the ratio of the countries’
price levels of a commodity basket
– Let P$ be the dollar price of the standard consumption
basket in the U.S. and P£ the pound price of the same
basket in the U.K.
– Absolute version of PPP states the exchange rate
between the dollar and pound should be:
Purchasing Power Parity Continued
• When the PPP relationship is presented in the “rate of
change” form, instead of price level as in the absolute
version of PPP, we obtain the relative version of PPP:
Where:
• e is the rate of change in the exchange rate
• π$ and π£ are the inflation rates in the United States and
U.K., respectively
PPP Deviations and the Real Exchange Rate
• If there are deviations from PPP, changes in nominal
exchange rates cause changes in the real exchange
rates, affecting the international competitive positions
of countries
• Real exchange rate, q, is found by:
• If PPP holds, the real exchange rate will be unity (i.e.,

q = 1), but when PPP is violated, the real exchange rate
will deviate from unity
Evidence on PPP
• PPP has been the subject of a series of tests, yielding
generally negative results, especially over short
horizons
• Generally unfavorable evidence about PPP suggests
that substantial barriers to international commodity
arbitrage exist
– As long as there are nontradables (e.g., haircuts, housing,
etc.), PPP will not hold in its absolute version
– If PPP holds for tradables and the relative prices between
tradables and nontradables are maintained, then PPP can
hold in its relative version
Fisher Effects
• The Fisher effect holds that an increase (decrease) in the
expected inflation rate in a country will cause a
proportionate increase (decrease) in the interest rate in the
country
• Formally, the Fisher effect is written as follows:
• Fisher effect implies that the expected inflation rate is the

different between the nominal and real interest rates in
each country, that is,
Fisher Effects Continued
• If we assume the real interest rate is the same between
countries, that is, ρ$ = ρ£, we obtain the international
Fisher effect (IFE), which suggests the nominal interest
rate differential reflects the expected change in exchange
rate
• When the international Fisher effect is combined with

IRP, we obtain the forward expectations parity (FEP),
which states any forward premium or discount is equal
to the expected change in the exchange rate
EXHIBIT 6.9: International Parity Relationships among
Exchange Rates, Interest Rates, and Inflation Rates
Forecasting Exchange Rates
• Many business decisions are now made based on
forecasts, implicit or explicit, of future exchange
rates
• Forecasting techniques can be classified into three
distinct approaches:
1. Efficient market approach
2. Fundamental approach
3. Technical approach
Efficient Market Approach
• Efficient market hypothesis (EMH) states that
financial markets are informationally efficient in that
the current asset prices reflect all the relevant and
available information
– Implies that the exchange rate will change only when the
market receives new information
• Random walk hypothesis suggests today’s exchange rate is
the best predictor of tomorrow’s exchange rate
– To the extent that interest rates are different between two
countries, the forward exchange rate will be different from
the current spot exchange rate
Fundamental Approach
• Uses various models to forecast exchange rates
• Three main difficulties of this approach:
1. One must forecast a set of independent variables to
forecast the exchange rates, and forecasting the former
will certainly be subject to errors and may not be
necessarily easier than forecasting the latter
2. Parameter values that are estimated using historical data
may change over time because of changes in government
policies and/or the underlying structure of the economy
3. Model itself can be wrong
Technical Approach
• First analyzes the past behavior of exchange rates for the
purpose of identifying “patterns” and then projects them
into the future to generate forecasts
– Based on the premise that history repeats itself
– At odds with the efficient market approach
– Differs from fundamental approach in that it does not use
the key economic variables, like money supplies or trade
balances, for purpose of forecasting
• Two examples of technical analysis:
1. Moving average crossover rule
2. Head-and-shoulders pattern
EXHIBIT 6.10: Moving Average Crossover Rule: Golden
Cross vs. Death Cross
EXHIBIT 6.11: Head-and-Shoulders Pattern:
A Reversal Signal
Performance of the Forecasters
• Can professional forecasters outperform the
market?
– Eun and Sabherwal (2002) study found that banks as a
whole could not outperform the random walk model, but
some banks significantly outperformed the random walk
model, especially in the longer run
– Beckmann and Czudaj (2017) suggest professionals have
a hard time predicting exchange rates, and uncertainty
regarding economic policy and macroeconomic and
financial conditions significantly affects professionals’
forecast errors

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International Parity Relationships and Forecasting Foreign

• U.S. and U.K. investment examples are equivalent

• Forward exchange rate can be viewed as the expected

• Combining the two equations yields the following:

• Two things are noteworthy from the following

1. “Expectation” plays a key role in exchange rate

• Uncovered interest rate parity

• If PPP holds, the real exchange rate will be unity (i.e.,

• Fisher effect implies that the expected inflation rate is the

• When the international Fisher effect is combined with

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