International Parity Conditions

(or chapter 4)
 Agenda

• What is PPP & law of one price?

• What is exchange rate pass-through?
• How do interest rates & exchange rates link?
• Interest rate parity?
• What is covered interest arbitrage?
• What is uncovered interest arbitrage?

2
 Prices and Exchange Rates
 Law of one price:
 product’s price same in all markets
P$  S = P¥

 where spot exchange rate is S, yen per dollar.

P ¥

S $
P

3
 Purchasing Power Parity &
Law of One Price

Absolute purchasing power parity:

 spot exchange rate is determined by relative prices of
similar basket of goods.

Relative purchasing power parity:

 Relative change in prices b/n countries determines
change in forex rate.

4
 Absolute PPP: Big Mac Index
 Economist’s Big Mac PPP:
• Big Mac in China costs Yuan 9.90.
• Big Mac in US costs $2.71.
• Implied PPP exchange rate

Yuan9.90
 Yuan3.7/$
$2.71

5
 Economist,
4/ 2003

Sfr6.30
 Sfr2.4803/$
$2.54
6
 Relative PPP
% change spot rate foreign currency
4 US$/ yen
P

PP
P
3

li n
e
2

-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1
InfJAPAN- InfUS
-2

-3

-4

7
 But:
 PPP is not very accurate predictor…
• Why?

 PPP holds well over very long term…

 PPP holds better for countries w/ high inflation &
underdeveloped capital markets…
• Why?

8
 Is forex under-/over- valued?
 Use forex indices: trade-weighted bilateral exchange
rates b/n the home country & trading partners

 Nominal exchange rate index : use actual exchange

rates.
 Real effective exchange rate index indicates how the
weighted average purchasing power of the currency
has changed relative to some arbitrarily selected base
period. $
C
E  E x FC
$
R
$
N
C
9
 Q:

• Can you tell when a currency is overvalued?

• Why the real exchange rate deviates from 100?

10
 Real Effective Exchange Rate Indices
United States & Japan (1995 = 100)
180

160
United States Japan
140

120

100

80

60

40

20

0
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999

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 Exchange Rate Pass-Through

 Pass-through: change in prices of imported/exported goods

when exchange rate changes

• BMW made in$ Germany cost @ spot rate US$ 35,000.

PBMW  PBMW
€
x S €/$
• where P$ is the price in US$, P€ is price in euros, S is spot
rate
• Euro appreciates by 20%. But BMW is now only $40,000.
• Pass-through:
$
PBMW, 2 $40,000
$
  1.1429, or  14.29%
PBMW, 1 $35,000
• Degree of pass-through: 14.29 % / 20 % = 0.71 or 71 %
12
Interest Rates & Exchange Rates?
 What is a fair nominal interest rate?
– Well, can ask a banker … or read Irvin Fisher…
• Fisher Effect: nominal interest rates in each country
are equal to the required real rate of return plus
compensation for expected inflation.

i = r + + r
• i is nominal rate, r is real rate,  is expected rate of
inflation.
• FE good for short maturity bonds, NOT long maturity ones.
– Why?

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 International Fisher effect
 International Fisher effect (Fisher-open):
spot exchange rate change equals opposite of interest rate
differential.

S1  S2
x 100  i $  i FC
S2
where S is indirect quote.
 Direct Quotes: US$/ Foreign Currency.
 Indirect Quotes: Foreign Currency / US$.
 Fisher-open not precise in short-term.
• Why?
 Should include forex risk premium.
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 Forward Rate
 Forward Rate
• A forward rate: exchange rate quoted today for
settlement @ future date
  FC 90 
 1   i x 360 
  
F90FC/$  SFC/$ x
  $ 90 
 1   i x 360 
  

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 Forward Rate
 Spot rate SF 1.48/$
 90-day euro Swiss franc deposit rate 4% p.a.
 90-day euro-dollar deposit rate 8% p.a.

  90  
 1   0.04 x 360 
SF/$
F90  SF1.48x
   SF1.48 x
1.01
 Sfr1.4655/$
  90   1.02
 1   0.08 x 360 
 

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 Premium or discount?
 Forward premium or discount : % difference b/n spot &
forward rates in annual percentage terms.
• For indirect quotes (FC per home currency, FC/$) then
Spot - Foward 360
f FC
 x x 100
Foward days

SF1.48 - SF1.4655 360

f SF
 x x 100   3.96% p.a.
SF1.4655 90

• Swiss franc sells forward @ premium 3.96% p. a.

(takes 3.96% more US$ to get franc at 90-day forward rate)
• For direct quotes ($/FC), use (F-S)/S.
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Currency Yield Curve & Forwards
Interest
yield
6.0 %
Euro yield curve
5.0 %

4.0 %

3.0 % Forward premium on

low interest rate currrency Eurodollar
yield curve
2.0 %

1.0 %

1 2 3 4 5 6
Months
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 Interest Rate Parity (IRP)
 Interest rate parity:difference in national interest
rates for securities of similar risk & maturity should
be equal to opposite of forward rate discount/
premium for foreign currency.

1  i   S
US$ FC/US$
1  i  F
FC 1
FC/US$

or
F FC/US$ 1  i FC

S FC/US$
1  i US$

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 Interest Rate Parity (IRP)
i $ = 8 % per annum
(2 % 90 days)
Start End
$1,000,000  1.02 $1,020,000

Dollar money market $1,019,993

S = SF 1.4800/$ 90 days F90 = SF 1.4655/$

Swiss franc money market

SF 1,480,000  1.01 SF 1,494,800

i SF = 4 % per annum
(1 % 90 days)

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 Covered Interest Arbitrage (CIA)
 Because spot & forward markets are not in
equilibrium, arbitrage exists.
 Covered interest arbitrage (CIA): invests in currency
that offers higher return on covered basis.

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Covered Interest Arbitrage (CIA)
Eurodollar rate = 8.00 % per annum
Start End
$1,000,000  1.04 $1,040,000 Arbitrage
$1,044,638 Potential
Dollar money market

S =¥ 106.00/$ 180 days F180 = ¥ 103.50/$

Yen money market

¥ 106,000,000  1.02 ¥ 108,120,000

Euroyen rate = 4.00 % per annum

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Uncovered Interest Arbitrage (UIA)
 Uncovered interest arbitrage (UIA): investors
borrow in currencies w/ low interest rates & convert
proceeds into currencies w/ high interest rates.
 “Uncovered” because investor does not sell the
currency forward.

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 Uncovered Interest Arbitrage (UIA):
The Yen Carry Trade
Investors borrow yen at 0.40% per annum
Start End
¥ 10,000,000  1.004 ¥ 10,040,000 Repay
¥ 10,500,000 Earn
Then exchanges Japanese yen money market ¥ 460,000 Profit
the yen proceeds
for US dollars,
S =¥ 120.00/$ 360 days S360 = ¥ 120.00/$
investing in US
dollar money
markets for US dollar money market
one year
$ 83,333,333  1.05 $ 87,500,000

Invest dollars at 5.00% per annum

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 Interest Rate Parity (IRP) & Equilibrium

2 Percentage premium on
foreign currency (¥)
1
4.83

-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1

-2

-3
Percent difference between
foreign (¥) and domestic X U
-4
($) Y
interest rates Z
25
 Forward Rate - Unbiased Predictor?
Exchange rate

S2 F2

Error Error
S1 F3

F1 S3 Error

S4

Time
t1 t2 t3 t4

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