University of Technology, Jamaica

International Financial Management (IFM)

Unit 5: Exchange Rate Behavior
Objectives:
At the end of this unit students should be able to:
Explain and work problems in:
Locational Arbitrage
Triangular Arbitrage
Covered Interest Arbitrage
Explain the conditions that will result in various forms of international
arbitrage, along with the realignments that will occur in response to
various forms of international arbitrage.
Explain the concept of Interest Rate Parity (IRP), how it prevents
arbitrage opportunities and its implications for pricing of forward
contracts.
Explain the concept of Purchasing Power Parity (PPP) and its
implications for exchange rate changes.
Explain the International Fisher Effect (IFE) Theory and its implications
for exchange rate changes.
Compare the PPP theory, IFE theory, and IRP theory
Topics:
International Arbitrage
o Locational Arbitrage
o Triangular Arbitrage
o Covered Interest Arbitrage
Interest Rate Parity (IRP) Theory
o Derivation of Interest Rate Parity
o Determining the Forward Premium/Discount
Purchasing Power Parity (PPP) Theory
o Absolute Purchasing Power Parity
o Relative Purchasing Power Parity
o Big Mac Index
o Derivation of Purchasing Power Parity
Fisher Effect
International Fisher Effect
o Derivation of the International Fisher Effect

Notes:
International Arbitrage
Arbitrage involves capitalizing on a discrepancy in quoted prices in different
markets. It therefore is a trading strategy based on the purchase of a
commodity, including foreign exchange, in one market at one price while
simultaneously selling it in another market at a more advantageous price, in
order to obtain a risk-free profit on the price differential. However, in the
foreign exchange market, as in any other free market, demand and supply
will quickly realign to prevent further risk-free profits. When this happens,
arbitrage is no longer possible and parity is said to exist.

Locational Arbitrage
When quoted spot exchange rates vary among locations, locational arbitrage
can be used to capitalize on the discrepancy. Locational Arbitrage is thus
possible when a banks (Bank A) buying price (bid price) is higher than
another banks (Bank B) selling price (ask price) for the same currency. Here
the investor will buy from Bank B and sell to Bank A and make a profit. This
would be done simultaneously at no risk to the investor. However, arbitrage
conditions will soon cause the bid price at Bank A to decrease due to
increased supply of currency, and the ask price at Bank B to increase due to
increased demand for currency. Thus prices would be realigned so that
arbitrage and risk-free profits are no longer possible.

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Locational arbitrage thus ensures that quoted spot rates are similar
across banks in different locations.

Triangular Arbitrage
If a quoted cross exchange rate differs from the appropriate cross rate,
triangular arbitrage can be used to exploit the discrepancy. Triangular
arbitrage is thus possible when a cross exchange rate quote differs from the
rate calculated from direct spot rates. When the exchange rates of the
currencies are not in equilibrium, triangular arbitrage will force them back
into equilibrium.
Example: Bid Ask
British pound () $1.60 $1.61
Malaysian ringgit (MYR) $.200 $.202
MYR8.1 MYR8.2
To conduct triangular arbitrage:
1. Buy @ $1.61
2. Convert @ MYR8.1/, then
3. Sell MYR @ $.200
Profit = $.01/. (8.1.2=1.62)

$
Value of Value of
in $ MYR in $

MYR
Value of
in MYR

When the exchange rates of the currencies are not in equilibrium, triangular
arbitrage will force them back into equilibrium.
Triangular arbitrage thus ensures that cross exchange rates are set
properly.

Covered Interest Arbitrage

Covered interest arbitrage is the process of capitalizing on the interest rate
differential between two countries, while covering for exchange rate risk.
Example:
spot rate = 90-day forward rate = $1.60
U.S. 90-day interest rate = 2%
U.K. 90-day interest rate = 4%

To conduct covered interest arbitrage:

1. Borrow $ at 2%, or use existing funds which are earning interest
at 2%.
2. Convert $ to at $1.60/ and
3. Engage in a 90-day forward contract to sell at $1.60/.
4. Lend/invest at 4%.
Covered interest arbitrage tends to force a relationship between forward rate
premiums and interest rate differentials.

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Covered interest arbitrage thus ensures that forward exchange rates
are set properly.

Interest Rate Parity

Because the present international monetary system is characterized by a mix
of freely floating, managed float, and fixed exchange rates, no single general
theory is available to forecast exchange rates under all conditions.
Nevertheless, certain basis economic relationships, called parity conditions,
help to explain exchange rate movements.
Under a freely floating exchange rate system, future spot exchange rates are
theoretically determined by the interplay of differing national rates of
inflation, interest rates, and the forward premium or discount on each
currency.
The interest rate parity (IRP) theory provides the linkage between the foreign
exchange markets and the international money markets. The difference in
interest rates for securities of similar risk and maturity should be equal to,
but opposite in sign to, the forward rate discount or premium for the foreign
currency, except for transaction costs. The theory is only applicable to
securities with maturities of one year or less, as forward contracts are not
routinely available for periods longer than one year.
Forward premium/discount = Interest rate differential
(Forward Spot)/Spot = (kh kf)
Where kh = the home interest rate
kf = the foreign interest rate
Once market forces cause interest rates and exchange rates to adjust such
that covered interest arbitrage is no longer feasible, there is an equilibrium
state and Interest Rate Parity (IRP) is said to exist.
In equilibrium, the forward rate differs from the spot rate by a sufficient
amount to offset the interest rate differential between two currencies.
With Covered Interest Arbitrage:
Interest rate differential does not equal the forward premium or
discount
Funds will move to a country with a more attractive rate
Market pressure develops as one currency is more demanded spot and
sold forward
Inflows of funds to the country with the higher interest rate depresses
interest rates
Parity is eventually reached
With Interest Rate Parity:
Interest rate differential is equal to the forward premium of discount
Higher interest rates on a currency are offset by forward discounts.
Lower interest rates are offset by forward premiums.
Covered interest arbitrage is no longer feasible
Derivation of Interest Rate Parity &
Forward Premium/Discount
When IRP exists, the rate of return achieved from covered interest arbitrage
should equal the rate of return available in the home country.
End-value of a $1 investment in covered interest arbitrage:
= (1/S) (1+kf) F
= (1/S) (1+ kf) [S (1+p)]
= (1+ kf) (1+p)
where p = forward premium
End-value of a $1 investment in the home country: = 1 + kh
Equating the two and rearranging terms:
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 p = (1+ kh) 1
(1+ kf)
i.e. forward premium, p = (1 + home interest rate) 1
(1 + foreign interest rate)
When IRP exists, it does not mean that both local and foreign investors will
earn the same returns. What it means is that investors cannot use covered
interest arbitrage to achieve higher returns than those achievable in their
respective home countries.
Various empirical studies indicate that IRP generally holds. While there are
deviations from IRP, they are often not large enough to make covered
interest arbitrage worthwhile. This is due to the characteristics of foreign
investments, including transaction costs, political risk, and differential tax
laws.

Purchasing Power Parity (PPP) Theory

The oldest method of defining long-term exchange rate equilibrium is
purchasing power parity (PPP). This theory is based on the notion that goods
and services should cost the same in different countries when measured in a
common currency. The exchange rate between two currencies then in the
long-run should equalize the price of an identical basket of goods and
services in the two countries.
A popular version of the PPP is The Economists Big Mac Index.
Big Mac used as a basket of goods
Big Mac sold in 116 countries around the world and is basically the same
in all locations.
The cost of a Big Mac should be the same worldwide when converted to a
common currency.
When converted to US dollars, those currencies where it costs more than
in the US are said to be overvalued in relation to the US, and vice versa.
The Big Mac Index is therefore based on the principle of the law of one price,
which states that identical goods will sell for the same price worldwide.
Theoretically, if the price after exchange-rate adjustment were not equal,
arbitrage in the goods worldwide ensures that eventually it will. The law of
one price is therefore enforced by international arbitrage.
When one countrys inflation rate rises relative to that of another country,
decreased exports and increased imports depress the countrys currency.
The theory of purchasing power parity (PPP) attempts to quantify this
inflation-exchange rate relationship.
The theory of PPP states that spot exchange rates between
currencies will change to the differential in inflation rates between
countries.
Absolute form of PPP:
law of one price similar products in different countries should be
equally priced when measured in the same currency
One unit of currency has the same purchasing power globally
Relative form of PPP:
Accounts for the possibility of market imperfections
The exchange rate of one currency against another will adjust to
reflect changes in the price levels of the two countries.
The rate of change in prices of products should be somewhat similar
when measured in a common currency, as long as the transportation
costs and trade barriers are unchanged.
Derivation of PPP:
If we assume that the home countrys price index is equal to the foreign
countrys price index, then when inflation occurs, the exchange rate will
adjust to maintain PPP:

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 (1 + If ) (1 + ef ) = (1 + Ih )
where Ih = inflation rate in the home country
If = inflation rate in the foreign country
ef = % change in the value of the foreign currency

Solving for ef gives:

ef = (1 + Ih ) 1
(1 + If )
If Ih > If , ef > 0 (foreign currency appreciates)
If Ih < If , ef < 0 (foreign currency depreciates)
If Ih = 5% & If = 3%, ef = 1.05/1.03 1 = 1.94%
From the home countrys perspective, both price indexes rise by 5%.
When the inflation differential is small, the PPP relationship can be simplified
as ef Ih - If
Suppose IU.S. = 9%, IU.K. = 5%. Then PPP suggests that e 4%.
Then, U.K. goods will cost 5+4=9% more to U.S. consumers, while
U.S. goods will cost 9-4=5% more to U.K. consumers, i.e. the same as if
purchased in their own home country.

In practice, PPP has proved a poor guide to exchange rate forecasting.

Currencies can deviate from their PPP for long periods. Some reasons for
this include:
This method ignores capital flows it was fine when trade flows
dominated foreign-currency transaction, however, today capital flows
largely determine the size of current account balances, rather than the
other way around.
Lack of substitutes for traded goods; also many goods and services are
not tradable or are not the same quality across countries, reflecting
the differences in tastes and resources of the countries of their
manufacture and consumption.
Exchange rates are also affected by differentials in interest rates,
income levels, and risk, as well as government controls.

International Fisher Effect

The Fisher Effect states that nominal interest rates are a function of
the real interest rate and a premium for inflation expectations.
k = k* + IP
Real interest rates should tend to be equal everywhere as a result of
arbitrage. However, this is only achievable with a fully freely floating
exchange rate regime, with no government intervention.
If there is no government interference, nominal rates will vary by
inflation differential
kh kf = Ih - If
According to the Fisher Effect, countries with higher inflation rates
have higher interest rates
The International Fisher Effect (IFE) theory suggests that currencies
with higher interest rates will depreciate because the higher interest
rates reflect higher expected inflation. Hence, investors hoping to
capitalize on a higher foreign interest rate should earn a return no
better than what they would have earned domestically.
The spot rate adjusts to the interest rate differential between two
countries.

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 The expected effective return on a foreign money market investment,
rf, should equal the effective return on a domestic investment, r h.
rf = (1 + kf ) (1 + ef ) 1
kf = interest rate in the foreign country
ef = % change in the foreign currencys value
rh = kh = interest rate in the home country

Setting rf = rh : (1 +kf ) (1 + ef ) 1 = kh
Solving for ef : ef = (1 + kh ) _ 1
(1 + kf )
If kh > kf , ef > 0 (foreign currency appreciates)
If kh < kf , ef < 0 (foreign currency depreciates)
If kh = 8% & kf = 9%, ef = 1.08/1.09 1 = - .92%
This will make the return on the foreign investment equal to the domestic
return.

Since the IFE is based on PPP, it will not hold when PPP does not hold. For
example, if there are factors other than inflation that affect exchange rates,
the rates will not adjust in accordance with the inflation differential.

References:
- Multinational Financial Management Slides by Gary A. Patterson
- Multinational Business Finance by Eiteman, Stonehill & Moffett
- International Financial Management by Jeff Madura

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 University of Technology, Jamaica
International Financial Management (IFM)
Unit 5: Exchange Rate Behavior
Tutorial Questions:
Chapter 7
1. Explain the concept of locational arbitrage and the scenario necessary for it to be
plausible.

2. Assume the following information:

Bank X Bank Y
Bid price of New Zealand dollar $.401 $.398
Ask price of New Zealand dollar $.404 $.400

Given this information, is locational arbitrage possible? If so, explain the steps
involved in locational arbitrage, and compute the profit from this arbitrage if you
had $1,000,000 to use.

3. Based on the information in the previous question, what market forces would
occur to eliminate any further possibilities of locational arbitrage?

4. Explain the concept of triangular arbitrage and the scenario necessary for it to be
plausible.

5. Assume the following information for a particular bank:

Quoted Price
Value of Canadian dollar in U.S. dollars $.90
Value of New Zealand dollar in U.S. dollars $.30
Value of Canadian dollar in New Zealand dollars NZ$3.02

Given this information, is triangular arbitrage possible? If so, explain the steps
that would reflect triangular arbitrage, and compute the profit from this strategy
if you had $1,000,000 to use.

6. Based on the information in the previous question, what market forces would
occur to eliminate any further possibilities of triangular arbitrage?

7. Explain the concept of covered interest arbitrage and the scenario necessary for it
to be plausible.

8. Assume the following information:

Quoted Price
Spot rate of Canadian dollar $.80
90-day forward rate of Canadian dollar $.79
90-day Canadian interest rate 4%
90-day U.S. interest rate 2.5%

Given this information, what would be the yield (percentage return) to a U.S.
investor who used covered interest arbitrage? (Assume the investor invests
$1,000,000.)

9. Based on the information in the previous question, what market forces would
occur to eliminate any further possibilities of covered interest arbitrage?

10. Assume the following information:

Spot rate of Mexican peso = $.100

180-day forward rate of Mexican peso = $.098
180-day Mexican interest rate = 6%
180-day U.S. interest rate = 5%
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 Given this information, is covered interest arbitrage worthwhile for Mexican
investors who have pesos to invest? Explain your answer.
11. Explain the concept of interest rate parity. Provide the rationale for its
possible existence and describe a method for testing whether interest
rate parity exists. Use actual currencies and interest rates to illustrate
your answer. (Student Presentation)

12. Assume that the existing U.S. one-year interest rate is 10 percent and the
Canadian one-year interest rate is 11 percent. Also assume that interest rate
parity exists. Should the forward rate of the Canadian dollar exhibit a discount or
a premium? If U.S. investors attempt covered interest arbitrage, what will be
their return? If Canadian investors attempt covered interest arbitrage, what will
be their return?

13. Why would U.S. investors consider covered interest arbitrage in France when the
interest rate on euros in France is lower than the U.S. interest rate?

14. Consider investors who invest in either U.S. or British one-year Treasury bills.
Assume zero transaction costs and no taxes.

a) If interest rate parity exists, then the return for U.S. investors who use
covered interest arbitrage will be the same as the return for U.S. investors
who invest in U.S. Treasury bills. Is this statement true or false? If false,
correct the statement.

b) If interest rate parity exists, then the return for British investors who use
covered interest arbitrage will be the same as the return for British investors
who invest in British Treasury bills. Is this statement true or false? If false,
correct the statement.

15. Assume that the Japanese yens forward rate currently exhibits a premium of 6
percent, and that interest rate parity exists. If U.S. interest rates decrease, how
must this premium change to maintain interest rate parity? Why might we
expect the premium to change?

16. The one-year interest rate in New Zealand is 6 percent. The one-year U.S.
interest rate is 10 percent. The spot rate of the New Zealand dollar (NZ$) is
$.50. The forward rate of the New Zealand dollar is $.54. Is covered interest
arbitrage feasible for U.S. investors? Is it feasible for New Zealand investors? In
each case, explain why covered interest arbitrage is or is not feasible.

To determine the yield from covered interest arbitrage by U.S. investors, start
with an assumed initial investment, such as $1,000,000.

17. Assume that the one-year U.S. interest rate is 11 percent, while the one-year
interest rate in a specific less developed country (LDC) is 40 percent. Assume
that a U.S. bank is willing to purchase the currency of that country from you one
year from now at a discount of 13 percent. Would covered interest arbitrage be
worth considering? Is there any reason why you should not attempt covered
interest arbitrage in this situation? (Ignore tax effects.)