Ethiopian Civil Service University, Addis Ababa

MSc. In Accounting and Finance

Chapter 2:

International Parity conditions

 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

contents of the chapter

International Parity conditions
– International Parity-An Overview
– Exchange Rate Determination
– Measuring Exchange Rate Movements
– Parity Conditions
• The Purchasing Power Parity Theory
• Interest Rate Parity Theory
• The Fisher Effect

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 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

International Parity-An Overview

In international exchange, parity refers to the exchange

rate between the currencies of two countries making the
purchasing power of both currencies substantially equal.
Theoretically, exchange rates of currencies can be set at a
parity or par level and adjusted to maintain parity as
economic conditions change.
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MSc. In Accounting and Finance

Foreign Exchange Rate Determination.

• Foreign Exchange Rate is the amount of
domestic currency that must be paid in order
to get a unit of foreign currency. 

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MSc. In Accounting and Finance

Method of Quotation

• Direct
• Indirect
• Cross

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 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Measuring Exchange Rate Movements

Predicting Exchange Rates
• On arbitrage and speculation
• Purchasing Power Parity (PPP)
• Interest Rate Parity (IRP)
• The International Fisher Effect (IFE)

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 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Arbitrage

Business operation involving the purchase of foreign exchange, gold,

financial securities, or commodities in one market and their almost
simultaneous sale in another market, in order to profit from price
differentials existing between the markets.

Arbitrage generally tends to eliminate price differentials between

markets.

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 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Mind the distinction

Arbitrage: attempt at exploiting short-term market inconsistencies in order to
extract risk-free profits.

Speculation: betting that the market will go up or down in the short-term.

Speculators take on tremendous risks.

Whenever there is high risk involved, arbitrage becomes speculation

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Arbitrage (Problem with Solution)

• TD Bank (TD) trades on both the Given This
Toronto Stock Exchange (TSX) • 47*1.35= 63.45
and the New York Stock Clearly, there's an opportunity for arbitrage
Exchange (NYSE). Let's say TD is here as, given the exchange rate, TD is
trading for CAD62.50 on the TSX priced differently in both markets. A trader
can purchase TD shares on the TSX for
and USD47.00 on the NYSE. The CAD62.50 and sell the same security on the
exchange rate of USD/CAD is NYSE for USD47.00 (the equivalent of
1.35, which means that 1 U.S. CAD63.45), netting them CAD0.95 per share
dollar = CAD1.35 (63.45 - 62.50) for the transaction.

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 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

PPP: Background

The basis for PPP is the "law of one price".

Purchasing Power Parity (PPP) is an idea that the cost of goods in

one nation will be equivalent to the cost of the same good in
another nation if their exchange rate is applied.
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MSc. In Accounting and Finance

• This concept drives the notion that two countries have equal
currencies if the cost of goods is the same in both countries.
• The purchasing power parity is determined by the comparison of
the price s of similar products in different countries.
• However, it is quick to dismiss this concept in the real world as
purchasing power parity doesn't account for price changes in the
short-run and long-run due to different reasons.

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 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

• The APPP states that ratio of price levels for two nations involved in
trades would be equivalent to their currency exchange rates.
• The APPP states that the currency exchange rate between Country A
and Country B is equivalent to the level of the price ratio of the two
countries. 
• The APPP is derived from the "law of one price", which states that
the actual cost of commodities must be equivalent in all nations for
exchange rates to be properly determined or considered.

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 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

• Relative Purchasing Power Parity (RPPP) refers to the expansion of

the purchasing power parity (PPP) theory to involve inflation
changes as time goes by.
• The amount of goods and services that one power of money can
purchase is referred to as purchasing power.
• It also implies the reduction of this money power by inflation.
• According to the RPPP, nations with higher inflations will have a
lesser valued currency compared to their counterparts with lower
inflation rates.
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MSc. In Accounting and Finance

PPP (Problem with Solution)

• For example, if the price of a Big Mac is $4.00 in the
U.S. and 2.5 pounds sterling in Britain, we would
expect the exchange rate to be 1.60 (4/2.5 = 1.60). If
the exchange rate of dollars to pounds is any greater,
the Big Mac index would state the pound was
overvalued, any lower and it would be undervalued.

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 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

The Big Mac Index

• The Big Mac Index was invented by The Economist in 1986 as a

lighthearted guide to whether currencies are at their “correct” level. It is
based on the theory of purchasing-power parity (PPP), the notion that in
the long run exchange rates should move towards the rate that would
equalize the prices of an identical basket of goods and services (in this
case, a burger) in any two countries. For example, the average price of a
Big Mac in America in July 2017 was $5.30; in China it was only $2.92 at
market exchange rates. So the "raw" Big Mac index says that the yuan
was undervalued by some 45% at that time.

15
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MSc. In Accounting and Finance

The Big Mac Index

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MSc. In Accounting and Finance

Interest Rate Parity (IRP)

Interest rate parity (IRP) is a theory according to which the interest
rate differential between two countries is equal to the differential
between the forward exchange rate and the spot exchange rate.
It governs the relationship between interest rates and currency
exchange rates.

The theory holds that the forward exchange rate should be equal to
the spot currency exchange rate times the interest rate of the home
country, divided by the interest rate of the foreign country
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MSc. In Accounting and Finance

• Suppose there is a spot exchange rate of 0.75

British pounds for every U.S. dollar. (£0.75/$1).
• interest rates in the U.K. are and 3% the
interest rate in the U.S. is 5%.
• forward exchange rate will be:
• (0.75 x 1.03) / (1 x 1.05) = 0.736
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Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

The Fisher Effect

The Simple Fisher Effect

The International Fisher Effect

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 Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

• Fisher Effect describes the relationship between interest rates and the rate of
inflation.
• the combination of the anticipated rate of inflation and the real rate of return are
represented in the nominal interest rates.
• It proposes that the nominal interest rate in a country is equal to the real interest
rate plus the inflation rate,
• which means that the real interest rate is equal to the nominal rate of interest
minus the rate of inflation.
• For example, if the nominal interest rate on a savings account is 4% and the
expected rate of inflation is 3%, then the money in the savings account is really
growing at 1%. 
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• The IFE expands on the Fisher Effect, suggesting

that because nominal interest rates reflect
anticipated inflation rates and currency
exchange rate changes are driven by inflation
rates, then currency changes are proportionate
to the difference between the two nations'
nominal interest rates.
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MSc. In Accounting and Finance

• The International Fisher Effect (IFE) is an economic theory stating that the
expected disparity between the exchange rate of two currencies is approximately
equal to the difference between their countries' nominal interest rates.
• differences in nominal interest rates between countries can be used to predict
changes in exchange rates.
• countries with higher nominal interest rates experience higher rates of inflation,
which will result in currency depreciation against other currencies.
• countries with lower interest rates will likely also experience lower levels of
inflation, which can result in increases in the real value of the associated currency
when compared to other nations.

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MSc. In Accounting and Finance

• For example, if country A's interest rate is 10% and country

B's interest rate is 5%, country B's currency should
appreciate roughly 5% compared to country A's currency.
• The rationale for the IFE is that a country with a higher
interest rate will also tend to have a higher inflation rate.
This increased amount of inflation should cause the
currency in the country with a higher interest rate to
depreciate against a country with lower interest rates.
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Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance

Thank you

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