International Parity Conditions

Recollection

Introduction to Parity Conditions

Absolute & Relative Purchasing Power Parity
Real Exchange Rate
Fisher Effect (FE)
International Fisher Effect (IFE)
Unbiased Forward Rate (UFR)
Interest Rate Parity (IRP)
Covered Interest Arbitrage
Currency Forecasting => PROJECT

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 Introduction
Managers of multinational firms, international
investors, importers and exporters, and government
officials must deal with these fundamental issues:
Are changes in exchange rates predictable?
How are exchange rates related to interest rates?
What, at least theoretically, is the proper
exchange rate?

To answer these questions we need to first understand

the economic fundamentals of international finance,
known as parity conditions.
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 Parity Conditions
Parity Conditions provide an intuitive explanation of
the movement of prices and interest rates in different
markets in relation to exchange rates.
The derivation of these conditions requires the
assumption of Perfect Capital Markets (PCM).
no transaction costs
no taxes
complete certainty
NOTE Parity Conditions are expected to hold in the
long-run, but not always in the short term.
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 Purchasing Power Parity (PPP)

PPP is based on the notion of arbitrage across

goods markets and the basic building block of
PPP is the Law of One Price (LOP).
LOP states that the price of an identical good
should be the same in all markets (assuming no
transactions costs).
Otherwise, one could make profits by buying the
good in the cheap market and reselling it in the
expensive market.

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 The Law of One Price
LOP states that a products price may be stated in
different currency terms, but the price of the product
should remain the same.
Comparison of prices would only require conversion from
one currency to the other:

P$ = S$ P
Conversely, the exchange rate could be deduced from the
relative local product prices:
P$
S$ / =
P
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 LOP Example
Pwheat, Aust = $4/bushel and Pwheat, UK = 2.5/bushel
Spot rate (A$/) = 1.70

wheat wheat
PAust = S$ / PUK

A$ equivalent price of wheat in UK is A$1.70/ *2.5

= $4.25/bushel
Implication: The demand for Australian wheat will
increase forcing up its price. The price of UK wheat will
drop.
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 The Big Mac Index
The most famous test is The Economist magazines
Big Mac Hamburger standard.

First launched in 1986, updated ever since.

For example, see:

http://www.oanda.com/products/bigmac/bigmac.shtml

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 Research on the Big Mac Index
Pakko and Pollard (1996) conclude that Big Mac PPP
holds in the long-run, but currencies can deviate from it
for lengthy periods. They note several reasons why the
Big Mac index may be flawed:
It assumes that there are NO barriers to trade.
Prices are distorted by taxes.
Profit margins may vary according to competition.
Prices of non-traded goods (real estate, utilities, labor)
are also inputs that affect production costs.

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 Working for a Big Mac
Big Mac Net Hourly Minutes of work Big Mac Net Hourly Minutes of work
Price (US $) Wage (US $) to buy a Big Mac Price (US $) Wage (US $) to buy a Big Mac
Argentina 1.42 1.70 50 Mexico 2.18 2.00 65
Australia 1.86 7.80 14 New Zealand 2.22 6.80 20
Brazil 1.48 2.05 43 Peru 2.28 2.20 62
Britain 3.14 12.30 15 Philippines 2.24 1.20 112
Canada 2.21 9.35 14 Poland 1.62 2.20 44
Chile 1.96 2.80 42 Russia 1.32 2.60 30
China 1.20 2.40 30 Singapore 1.85 5.40 21
Colombia 2.13 1.90 67 South Africa 1.85 3.90 28
Czech Republic 1.96 2.40 49 South Korea 2.70 5.90 27
Denmark 4.09 14.40 17 Sweden 3.60 10.90 20
Euro area 2.98 9.59 19 Switzerland 4.60 17.80 16
Hong Kong 1.47 7.00 13 Taiwan 2.01 6.90 17
Hungary 2.19 3.00 44 Thailand 1.38 1.70 49
Indonesia 1.84 1.50 74 Turkey 2.34 3.20 44
Japan 2.18 13.60 10 United States 2.71 14.30 11
Malaysia 1.33 3.10 26 Venezuela 2.32 2.10 66

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A New Index Starbucks Index

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 Absolute PPP
A less extreme form of the Law of One Price is
ABSOLUTE PPP which says that the price of a basket
of goods should be the same in each market.
The PPP exchange rate between the two countries
should then be:
PI D ,t
Absolute PPP: S t
D/ F
=
PI F ,t

PID,t (PIF,t) is the domestic (foreign) price index (e.g., consumer

price index) at time t.

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 Relative Purchasing Power Parity
Relative PPP claims that exchange rate movements
should exactly offset any inflation differential between
two countries:
Percentage

SD/F 1+ D change in
Relative PPP: t +1
= domestic prices
D/F
St 1+ F
SD/F S D/F
D F
t +1 t
=
D/F
St 1+ F

1+ D
We can also write: S PPP
t +1 =S D/F
t
1+ F
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 Relative PPP
Relative PPP implies that the change in the exchange rate
will offset the difference between the relative inflation of
two countries.
The previous formula can be approximated as:
s = D F
where, D and F refers to the percentage change in
domestic and foreign price levels respectively and s to
the percentage change in the exchange rate.
If domestic inflation > (<) foreign inflation, PPP predicts
the domestic currency should depreciate (appreciate).
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 Relative PPP Example
Given inflation rates of 5% and 10% in Australia and the UK
respectively, what is the prediction of PPP with regards to $A/GBP
exchange rate?
Relative PPP
S t S t 1 D F
=
S t 1 1+ F

= (0.05 0.10)/(1 + 0.10) = - 0.045 = - 4.5%

The general implication of relative PPP is that countries with
high rates of inflation will see their currencies depreciate
against those with low rates of inflation.

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 How well does PPP work?
We have seen that the strictest version of PPP that all
goods and financial assets obey the law of one price is
demonstrably false.
However, there is clearly a relationship between relative
inflation rates and changes in exchange rates.
Currencies that have had the largest relative decline
(gain) in purchasing power see the sharpest erosion
(appreciation) in their foreign exchange values.

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 Relative Purchasing Power Parity

Applications of Relative PPP:

1. Forecasting future spot exchange rates.
2. Calculating appreciation in real exchange rates.
This will provide a measure of how expensive a
countrys goods have become (relative to another
countrys).

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 Forecasting Future Spot Rates
Suppose the spot exchange rate and expected inflation
rates are:

S/$, t0 = 90 / $; U .S . = 5%; Japan = 2%

What is the expected /$ exchange rate if relative PPP
holds?
1+
S / $, t1 = S / S ,t 0
PPP


1 + $

1.02
= ( 90 / $ ) = 87.43 / $
1.05
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 Real Exchange Rate
By definition, the real exchange rate measures
deviations from PPP.
That is, changes in the spot exchange rate that do not
reflect differences in inflation rates between the two
currencies in question.

S t +1
Real Exchange Rate: E = PPP
S t +1

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 Real Exchange Rate
Appreciation/depreciation in the real exchange rate
measures deviations from PPP.
When E = 1, the denominator currency is valued correctly.
The competitiveness of this country is unaltered.
When E < 1, the denominator currency is undervalued.
Products from the other country seem expensive relative to
the base year. That is, the competitiveness of the
denominator country improves.
When E > 1, the denominator currency is overvalued.
Products from the other country seem cheap relative to the
base year. That is, the competitiveness of the denominator
country deteriorates.

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 The Fisher Effect
The international Fisher relation is inspired by the
domestic relation postulated by Irving Fisher (1930).
The Fisher effect (also called Fisher-closed) states:

(1 + i ) = (1 + r ) (1 + ) i = r + + r
This relation is often presented as a linear
approximation stating that the nominal interest rate is
equal to a real interest rate plus expected inflation:
i r +
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 Contd.
Fisher Effect

This equation tells us that, all things being

equal, a rise in a country's expected
inflation rate will eventually cause an equal
rise in the interest rate (and vice versa).

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 The Fisher Effect

Applied to two different countries, like Australia and

Japan, The Fisher Effect would be stated as:

i r +
$ $ $
i r +

It should be noted that this requires a forecast of the

future rate of inflation, not what inflation has been in
the past.

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 What Does International Fisher Effect - IFE Mean?

An economic theory that states that an expected change in the current

exchange rate between any two currencies is approximately equivalent
to the difference between the two countries' nominal interest rates for
that time.

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 rational 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 the high
interest rate to depreciate against a country with lower interest rates.

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 The International Fisher Effect

The International Fisher Effect (also called Fisher-open)

states that the spot exchange rate should change to
adjust for differences in interest rates between two
countries:

S tD+1/ F 1 + iD
=
St D/F
1 + iF

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 The International Fisher Effect
The Fisher effect applied to two different countries like
Australia and Japan would be:
(1) (1+i$) = (1+r$)(1+$)
(2) (1+i) = (1+r)(1+)

Dividing (1) by (2), we get:

1 + i $ 1 + r$ 1 + $
(3) =
1 + i 1 + r 1 +

=1

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 The International Fisher Effect

If real interest rates are equalized across countries, then

for equation (3) we get r$ = r:

1 + i $ 1 + $ International Fisher:
(4) =
1 + i 1 +
St +1 St iD iF
i$ i $ =
(5) = St 1 + iF
1 + i 1+

Remember this?
E(St+1)
St +1 St D F
=
St 1+ F
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 Tests of the International Fisher Effect
Empirical tests lend some support to the relationship
postulated by the international Fisher effect (currencies
with high interest rates tend to depreciate and currencies
with low interest rates tend to appreciate), although
considerable short-run deviations occur.

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 Unbiased Forward Rate (UFR)

Some forecasters believe that for the major floating

currencies, foreign exchange markets are efficient
and forward exchange rates are unbiased predictors of
future exchange rates.

The unbiased forward rate (UFR) concept states that

the forward exchange rate, quoted at time t for
delivery at time t+1, is equal to the expected value of
the spot exchange rate at time t+1.

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 Unbiased Forward Rate (UFR)
UFR can be written as:
Ft t+1 = Et[St+1]

An unbiased predictor, however, does not mean the

future spot rate will actually be equal to what the
forward rate predicts.

Unbiased prediction means that the forward rate will,

on average, overestimate and underestimate the actual
future spot rate in equal frequency and degree.
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 Empirical Tests of UFR

A consensus is developing that rejects the efficient

market hypothesis.
It appears that the forward rate is not an unbiased
predictor of the future spot rate and that it does pay to
use resources in an attempt to forecast exchange rates.
The existence and success of foreign exchange
forecasting services suggest that managers are willing to
pay a price for forecast information even though they
can use the forward rate to forecast at no cost.

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 Interest Rate Parity
Interest rate parity (IRP) is an arbitrage condition that
provides the linkage between the foreign exchange
markets and the international money markets.

Interest Rate Parity (IRP)

Ft ,t +1 1 + id
=
St 1 + if

where, Ft and St are the forward and spot rates and id

and if are domestic and foreign interest rates
respectively.
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 Interest Rate Parity
The approximate form of IRP says that the % forward
premium equals the difference in interest rates.
Approximation of IRP

Ft ,t +1 Ft ,t +1 St
1 id i f id i f
St St

In general, the currency trading at a forward premium

(discount) is the one from the country with the lower
(higher) interest rate.

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 Interest Rate Parity An Example
Basic idea: Two alternative ways to invest funds over
same time period should earn the same return.

Suppose the 3-month money market rate is 8% p.a. (2%

for 3-months) in the U.S. and 4% p.a. (1% for 3-
months) in Switzerland, and the spot exchange rate is
SFr1.48/$.

The 3-month forward rate must be SFr1.4655/$ to

prevent arbitrage opportunities (i.e., interest rate parity
must hold).

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 The Example Continued
i $ = 8.00 % per annum
(2.00 % per 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 = 4.00 % per annum

(1.00 % per 90 days)

* Rounding error.
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 Interest Rate Parity: Why It Holds
This must hold by arbitrage. Otherwise riskless profits
could be made. This is known as covered interest
arbitrage (CIA) and occurs whenever IRP does not
hold. CIA can involve the following steps:
Borrow the domestic currency;
Exchange the domestic currency for the
foreign currency in the spot market;
Invest the foreign currency in an interest-
bearing instrument; and then
Sign a forward contract to lock in a future exchange rate
at which to convert the foreign currency proceeds back to
the domestic currency.
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 Covered Interest Arbitrage: Example
The annual interest rate in the AUS and UK are 5% and 8%
respectively. The current spot rate is $1.50/ and the 1 year
forward rate is $1.48/. Can arbitrage profits be made?
Ft ,t +1 1.48
1 + id = (1 + i f ) 1.05 = (1.08) ??
St 1.50
1.05 1.0656
1. Borrow $1m (at 5%)
2. Purchase 666,667 using $1m
3. Invest at 8% (will receive 720,000 in one years time)
4. Simultaneously sell 720,000 forward ($1,065,600)
5. Repay loan + interest of $1,050,000
6. ARBITRAGE PROFIT = $15,600
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 The Example Continued

1 Borrow for 1 year

$1,000,000 <$1,050,000>
at i$ = 5%
$1,065,600

2 Convert Profit = $15,600 Cover

Spot Forward 4
at $1.50/ at $1.48/
3
Invest for 1 year
666,667 720,000
at i = 8%

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 Covered Interest Arbitrage
Covered interest arbitrage should continue until
interest rate parity is re-established, because the
arbitrageurs are able to earn risk-free profits by
repeating the cycle.
But their actions nudge the foreign exchange and
money markets back toward equilibrium:
1. Purchase of Pounds in the spot market and sale of in the
forward market narrow the premium on forward pounds.
2. The demand for pound-denominated securities causes pound
interest rates to fall, while the higher level of borrowing in
Australia causes dollar interest rates to rise.
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 Uncovered Interest Arbitrage

A deviation from covered interest arbitrage is uncovered

interest arbitrage (UIA).
In this case, investors borrow in countries and currencies
exhibiting relatively low interest rates and convert the
proceed into currencies that offer much higher interest
rates.
The transaction is uncovered because the investor does
no sell the higher yielding currency proceeds forward,
choosing to remain uncovered and accept the currency risk
of exchanging the higher yield currency into the lower
yielding currency at the end of the period.

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 Currency Forecasting
What have we learnt about currency forecasting
this week?
Unbiased forward rate
Long-term equilibrium relationships (RPPP and
IFE)

More methodologies next week.

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