Vicentiu Covrig International Financial Management

International Parity
Relationships
(chapter 5)

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The following topics or sections in chapter 5 are not

required for the exam:
- The real exchange rate (p. 108-109)
-The Fisher effect (p. 113 to 114)

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Interest Rate Parity Defined

Suppose you have $100,000 to invest for one year.
You can either
1. invest in the U.S. at i$. Future value = $100,000(1 + i$)
or
2. trade your dollars for yen at the spot rate, invest in Japan at i¥ and hedge your exchange rate risk by selling the future value of the Japanese investment forward. The future value = $100,000(F/S)(1 + i¥)
Since both of these investments have the same risk, they must have the same future value—otherwise an arbitrage would exist, therefore (F/S)(1 + i¥) = (1 + i$)

Both the spot and forward rate are defined as $/FC

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Interest Rate Parity Defined
Formally,
(F/S)(1 + i¥) = (1 + i$)
or if you prefer,
1 + i$ F
=
1 + i¥ S
IRP is sometimes approximated as

i$ – i ¥ = F – S
S

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IRP and Covered Interest Arbitrage

If IRP failed to hold, an arbitrage would exist. It’s easiest to
see this in the form of an example.
Consider the following set of foreign and domestic interest
rates and spot and forward exchange rates.

Spot exchange rate S($/£) = $1.25/£

360-day forward rate F360($/£) = $1.20/£
U.S. discount rate i$ = 7.10%
British discount rate i£ = 11.56%

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IRP and Covered Interest Arbitrage
A trader with $1,000 to invest could invest in the U.S., in one
year his investment will be worth $1,071 = $1,000(1+ i$)
= $1,000(1.071)
Alternatively, this trader could exchange $1,000 for £800 at
the prevailing spot rate, (note that £800 = $1,000÷$1.25/£)
invest £800 at i£ = 11.56% for one year to achieve
£892.48. Translate £892.48 back into dollars at F360($/£) =
$1.20/£, the £892.48 will be exactly $1,071.

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Interest Rate Parity
& Exchange Rate Determination

According to IRP only one 360-day forward rate,

F360($/£), can exist. It must be the case that
F360($/£) = $1.20/£
Why?
If F360($/£)  $1.20/£, an astute trader could make money
with one of the following strategies:

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Arbitrage Strategy I
If F360($/£) > $1.20/£ (For example F360($/£) = 1.30$/£ )
i. Borrow $1,000 at t = 0 at i$ = 7.1%.

ii. Exchange $1,000 for £800 at the prevailing spot rate, (note that
£800 = $1,000÷$1.25/£) invest £800 at 11.56% (i£) for one year to
achieve £892.48

iii. Translate £892.48 back into dollars, if F360($/£) = 1.30$/£ ,

£892.48 x 1.3 $/£ = $1,160 will be more than enough to repay your
dollar obligation of $1,071.

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Arbitrage Strategy II
If F360($/£) < $1.20/£ (For example F360($/£) =1.1 $/£ )
i. Borrow £800 at t = 0 at i£= 11.56% .

ii. Exchange £800 for $1,000 at the prevailing spot rate,

invest $1,000 at 7.1% for one year to achieve $1,071.

iii. Translate $1,071 back into pounds, if

F360($/£) = 1.10$/£ , $1,071/1.1 = £974 will be more than
enough to repay your £ obligation of £892.48.

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Absolute Purchasing Power Parity
 The exchange rate between two currencies should equal the ratio of the countries’
price levels:
P$
S($/£) =
P£
The Law of one price: Identical goods sell for the same price, in the same currency,
worldwide.
Theoretical basis: if the price after exchange-rate adjustment were not equal,
arbitrage in the goods worldwide ensures eventually it will.
Arbitrage: simultaneously purchase and sale of the same assets on different markets
to profit from price discrepancies

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Relative Purchasing Power Parity
 Relative PPP states that the rate of change in the exchange rate is equal to the
differences in the rates of inflation:
($ – £)
e= ≈ $ – £
(1 + £ )
 If U.S. inflation is 5% and U.K. inflation is 8%, the pound should depreciate by
2.78% or around 3%
 PPP says that currencies with high rates of inflation should devalue relative to
currencies with lower rates of inflation

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Evidence on PPP
 PPP doesn’t hold precisely in the real world. Why?

 Relative PPP is used in practice as a exchange rate forecasting

tool

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Forecasting Exchange Rates

 Efficient Markets Approach
 Fundamental Approach
 Technical Approach
 Performance of the Forecasters

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Efficient Markets Approach
 Financial Markets are efficient if prices reflect all available and relevant
information.
 If this is so, exchange rates will only change when new information arrives
Ft = E[St+1| It]

 Market efficiency requires that investors process information and form

reasonable expectation; doesn’t require the above relation to hold
 In reality the forward rate is a biased and poor predictor of the future spot
rate
 Predicting exchange rates using the efficient markets approach is
affordable and is hard to beat.

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Fundamental Approach
 Involves econometrics to develop models that use a variety of
explanatory variables. This involves three steps:
- step 1: Estimate the structural model.
- step 2: Estimate future parameter values.
- step 3: Use the model to develop forecasts.

 The downside is that fundamental models do not work any better

than the forward rate model or the random walk model.

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Technical Approach
 Technical analysis looks for patterns in the past behavior of
exchange rates.
 Clearly it is based upon the premise that history repeats itself.
 Thus it is at odds with the Efficient Markets Hypothesis

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Performance of the Forecasters
 Forecasting is difficult, especially with regard to the future.
 As a whole, forecasters cannot do a better job of forecasting
future exchange rates than the forward rate.
 The founder of Forbes Magazine once said:
“You can make more money selling financial advice than
following it.”

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Learning outcomes
•Calculate a forward rate under the assumptions of covered Interest Rate Parity
• Determine whether an arbitrageur can profit from given interest rates, and spot and
forward rates. If yes, explain in detail the arbitrage strategy and calculate the profits.
•Define and discuss the law of one price; absolute and relative PPP
• Forecasting models
• Recommended end-of-chapter questions: 3, 4, 7, 10, 11
problems: 1, 2, 3, 4

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