International Parity Relationships &

Forecasting Exchange Rates

Chapter Objective:

This chapter examines several key international

parity relationships, such as interest rate
parity and purchasing power parity.

0
Exchange rate determination
The exchange rate is determined by the demand for
and supply of a currency which influenced by
 Relative inflation rates

 Interest rates

 Economic growth rates

 Political factors

 Social factors

 Government controls

1
Interest Rate Parity Defined
IRP is an arbitrage condition.
If IRP did not hold, then it would be possible
for an astute trader to make unlimited
amounts of money exploiting the arbitrage
opportunity.
Since we don’t typically observe persistent
arbitrage conditions, we can safely assume
that IRP holds.

2
 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 = $100,000(F/S)(1 + i¥)
Since both of these investments have the same risk, they must
have the same future value—otherwise an arbitrage
would exist, therefore (F/S)(1 + i¥) = (1 + i$)
3
 Interest Rate Parity

$100,000 $100,000(1 + i$)

1. Trade $100,000 for £ at $100,000(F/S)(1 + i£)

S($/ £)
3. One year later,
trade £ for $ at
2. Invest £100,000 at i£ F ($/ £)
S 4
 Interest Rate Parity Defined
Formally,
(F/S)(1 + i¥) = (1 + i$)
or if you prefer,
1 + i$ F
=
1 + i¥ S
IRP is sometimes approximated as
i$ – i ¥ = F – S
S
5
Interest Rate Parity Carefully
Defined
Depending upon how you quote the exchange
rate (¥ per $ or $ per ¥) we have:
1 + i¥ F¥/$ 1 + i$ F$/¥
= or =
1 + i$ S¥/$ 1 + i¥ S$/¥

6
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(Rs./$) = Rs.42/$

360-day forward rate F360(Rs./$) = Rs. 45.60/$
India Interest rate iRs. = 14%
U.S. Interest rate i$ = 5%

7
 IRP and Covered Interest
Arbitrage
A trader with Rs.1,000 to invest could invest in the India, in
one year his investment will be worth
Rs.1140 = Rs.1,000(1+ iRs.) = Rs.1,000(1.14)
Alternatively, this trader could exchange
Rs.1,000 for $23.81 at the prevailing spot rate,
(note that $23.81 = Rs.1,000÷ Rs.42/$)
Invest $23.81 at i$ = 5% for one year
to achieve $25 =23.81(1.05)
Translate $25 back into Rupees at F360(Rs./$) = Rs.45.60/$,
the $25 will be exactly Rs.1140=25*45.60
8
 Interest Rate Parity
& Exchange Rate Determination
According to IRP only one 360-day forward rate,
F360(Rs./$), can exist.
It must be the case that
F360(Rs./$) = Rs.45.60/$
Why?
If F360(Rs./$)  Rs.45.60/$, an astute trader could
make money with one of the following
strategies:
9
 Arbitrage Strategy I
If F360(Rs./$) > Rs.45.60/$
i. Borrow Rs.1,000 at t = 0 at iRs. = 14%.
ii. Exchange Rs.1,000 for $23.81 at the prevailing
spot rate, (note that $23.81 = Rs.1,000÷Rs.42/$)
invest $23.81 at 5% (i$) for one year to achieve
$25
iii. Translate $25 back into Rs., if
F360(Rs./$) > Rs.45.60/$ , $25 will be more than
enough to repay your Rs. obligation of Rs.1,140.
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 Arbitrage Strategy II
If F360(Rs./$) < Rs.45.60/$
i. Borrow $23.81 at t = 0 at i$= 5% .

ii. Exchange $23.81 for Rs.1,000 at the prevailing spot

rate, invest Rs.1,000 at 14% for one year to achieve
Rs.1,140.
iii. Translate Rs.1,140 back into dollors, if
F360(Rs./$) < Rs.45.60/$ , Rs.1,140 will be more than
enough to repay your $ obligation of $25.

11
 IRP and Hedging Currency Risk
You are a U.S. importer of British woolens and have just
ordered next year’s inventory. Payment of £100M is due in
one year.
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%
IRP implies that there are two ways that you fix the cash outflow to a
certain U.S. dollar amount:
a) Put yourself in a position that delivers £100M in one year—a long
forward contract on the pound. You will pay (£100M)(1.2/£) =
$120M
b) Form a money market hedge as shown below.
12
 IRP and a Money Market Hedge
To form a money market hedge:
Borrow $112.05 million in the U.S. (in one year you
will owe $120 million).
Translate $112.05 million into pounds at the spot
rate S($/£) = $1.25/£ to receive £89.64 million.
Invest £89.64 million in the UK at i£ = 11.56% for
one year.
In one year your investment will have grown to
£100 million—exactly enough to pay your
supplier.
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 Money Market Hedge
Where do the numbers come from? We owe our supplier
£100 million in one year—so we know that we need to
have an investment with a future value of £100 million.
Since i£ = 11.56% we need to invest £89.64 million at the
start of the year.
£100
£89.64 
1.1156
How many dollars will it take to acquire £89.64 million at
the start of the year if S($/£) = $1.25/£?
$1.00
$112.05  £89.64 
£1.25
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 Reasons for Deviations from IRP
Transactions Costs
 The interest rate available to an arbitrager for
borrowing, ib, may exceed the rate he can lend at, il.
 There may be bid-ask spreads to overcome, Fb/Sa <
F/S
 Thus

(Fb/Sa)(1 + i¥l)  (1 + i$ b)  0
Capital Controls
 Governments sometimes restrict import and export of
money through taxes or outright bans.
15
Purchasing Power Parity
Purchasing Power Parity and Exchange Rate
Determination
PPP Deviations and the Real Exchange Rate
Evidence on PPP

16
 Purchasing Power Parity and
Exchange Rate Determination
The exchange rate between two currencies should
equal the ratio of the countries’ price levels:
P$
S($/£) =
P£
 For example, if an ounce of gold costs $300 in
the U.S. and £150 in the U.K., then the price of
one pound in terms of dollars should be:
P$ $300
S($/£) = = = $2/£
P£ £150
17
 Purchasing Power Parity and
Exchange Rate Determination
Relative PPP states that the rate of change in
the exchange rate is equal to the differences
in the rates of inflation:
($ – £)
e= ≈ $ – £
(1 + £ )
If U.S. inflation is 5% and U.K. inflation is 8%, the pound
should depreciate by 2.78% or around 3%.

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 PPP Deviations and the
Real Exchange Rate
(1 + $)
The real exchange rate is q =
(1 + e)(1+ £)
(1 + $ )
If PPP holds, (1 + e) = then q = 1.
(1 + £ )
If q < 1 competitiveness of domestic country
improves with currency depreciations.
If q > 1 competitiveness of domestic country
deteriorates with currency depreciations.
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Evidence on PPP
PPP probably doesn’t hold precisely in the
real world for a variety of reasons.
 Haircuts cost 10 times as much in the developed
world as in the developing world.
 Shipping costs, as well as tariffs and quotas can
lead to deviations from PPP.
PPP-determined exchange rates still provide
a valuable benchmark.
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 The Fisher Effects
An increase (decrease) in the expected rate of inflation
will cause a proportionate increase (decrease) in the
interest rate in the country.
For the U.S., the Fisher effect is written as:
1 + i$ = (1+ $)(1 + E[$]) = 1 + $ + E[$] + $E[$]
i$ = $ + E($) + $E[$] ≈ $ + E[$]
Where
$ is the equilibrium expected “real” U.S. interest rate
E[$] is the expected rate of U.S. inflation
i$ is the equilibrium expected nominal U.S. interest rate
21
Expected Inflation
The Fisher effect implies that the expected inflation
rate is approximated as the difference between the
nominal and real interest rates in each country, i.e.

i$ = $ + (1 + $)E[$] ≈ $ + E[$]

(i$ – $)
E[$] = ≈ i$ – $
(1 + $)
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 International Fisher Effect
If the Fisher effect holds in the U.S.
i$ = (1+ $)(1 + E[$]) ≈ $ + E[$]
and the Fisher effect holds in Japan,
i¥ = (1+ ¥ )(1 + E[¥]) ≈ ¥ + E[¥]
and if the real rates are the same in each country
(i.e. $ = ¥ ), then we get the International Fisher
Effect
(i$ – i¥)
E(e) = ≈ i $ – i¥
(1 + i¥)
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 International Fisher Effect
If the International Fisher Effect holds,
(i$ – i¥)
E(e) =
(1 + i¥)
and if IRP also holds
F–S (i$ – i¥)
=
S (1 + i¥)

F–S
then forward parity holds. E(e) =
S 24
 Approximate Equilibrium
Exchange Rate Relationships

E(e)
≈ IFE ≈ FEP
≈ PPP F–S
(i$ – i¥) ≈ IRP
S
≈ FE ≈ FRPPP
E($ – £)

25
Forecasting Exchange Rates
Efficient Markets Approach
Fundamental Approach
Technical Approach
Performance of the Forecasters

26
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, thus:
St = E[St+1]
and
Ft = E[St+1| It]
Predicting exchange rates using the efficient markets
approach is affordable and is hard to beat.

27
 Fundamental Approach
Involves econometrics to develop models that use a
variety of explanatory variables like relative money
supplies, relative velocity of money and relative national
output. 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.

28
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 EMH

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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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 Quiz Time
1. Give a full definition of arbitrage.
2. Discuss the implications of the interest rate
parity for the exchange rate determination.
3. Explain the purchasing power parity, both the
absolute and relative versions.
4. Explain and derive the international Fisher
effect.

31
Quiz Time
Suppose that the treasurer of IBM has an extra cash
reserve of $100,000,000 to invest for six months.
The six-month interest rate is 8 percent per annum in
the United States and 7 percent per annum in
Germany. Currently, the spot exchange rate is €1.01
per dollar and the six-month forward exchange rate
is €0.99 per dollar. The treasurer of IBM does not
wish to bear any exchange risk. Where should he/she
invest to maximize the return?

32
 Solution
The market conditions are summarized as follows:
I$ = 4%; i€ = 3.5%; S = €1.01/$; F = €0.99/$.
If $100,000,000 is invested in the U.S., the maturity value in six
months will be
$104,000,000 = $100,000,000 (1 + .04).
Alternatively, $100,000,000 can be converted into euros and invested
at the German interest rate, with the euro maturity value sold
forward. In this case the dollar maturity value will be
$105,590,909 = ($100,000,000 x 1.01)(1 + .035)(1/0.99)
Clearly, it is better to invest $100,000,000 in Germany with
exchange risk hedging.
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 Quiz Time
While you were visiting London, you purchased a Jaguar for £35,000,
payable in three months. You have enough cash at your bank in New
York City, which pays 0.35% interest per month, compounding
monthly, to pay for the car. Currently, the spot exchange rate is
$1.45/£ and the three-month forward exchange rate is $1.40/£. In
London, the money market interest rate is 2.0% for a three-month
investment. There are two alternative ways of paying for your Jaguar.
(a) Keep the funds at your bank in the U.S. and buy £35,000 forward.
(b) Buy a certain pound amount spot today and invest the amount in
the U.K. for three months so that the maturity value becomes equal to
£35,000.
Evaluate each payment method. Which method would you prefer?
Why?
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 Solution
The problem situation is summarized as follows:
A/P = £35,000 payable in three months, iNY = 0.35%/month, compounding
monthly
iLD = 2.0% for three months, S = $1.45/£; F = $1.40/£.
Option a:
When you buy £35,000 forward, you will need $49,000 in three months to
fulfill the forward contract. The present value of $49,000 is computed as
follows:
$49,000/(1.0035)3 = $48,489. Thus, the cost of Jaguar as of today is $48,489.
Option b:
The present value of £35,000 is £34,314 = £35,000/(1.02). To buy £34,314
today, it will cost $49,755 = 34,314x1.45. Thus the cost of Jaguar as of today
is $49,755.
You should definitely choose to use “option a”, and save $1,266, which is the
difference between $49,755 and $48489.
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 Quiz Time
Currently, the spot exchange rate is $1.50/£ and the three-
month forward exchange rate is $1.52/£. The three-month
interest rate is 8.0% per annum in the U.S. and 5.8% per
annum in the U.K. Assume that you can borrow as much
as $1,500,000 or £1,000,000.
a. Determine whether the interest rate parity is currently
holding.
b. If the IRP is not holding, how would you carry out
covered interest arbitrage? Show all the steps and
determine the arbitrage profit.
c. Explain how the IRP will be restored as a result of
covered arbitrage activities. 36
 Solution
Let’s summarize the given data first:
S = $1.5/£; F = $1.52/£; I$ = 2.0%; I£ = 1.45% , Credit = $1,500,000 or £1,000,000.
a. (1+I$) = 1.02, (1+I£)(F/S) = (1.0145)(1.52/1.50) = 1.0280
Thus, IRP is not holding exactly.
b. (1) Borrow $1,500,000; repayment will be $1,530,000.
(2) Buy £1,000,000 spot using $1,500,000.
(3) Invest £1,000,000 at the pound interest rate of 1.45%;
maturity value will be £1,014,500.
(4) Sell £1,014,500 forward for $1,542,040
Arbitrage profit will be $12,040
c. Following the arbitrage transactions described above,
The dollar interest rate will rise;
The pound interest rate will fall;
The spot exchange rate will rise;
The forward exchange rate will fall.
These adjustments will continue until IRP holds.
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 Quiz Time
In the issue of October 23, 1999, the Economist reports that the interest
rate per annum is 5.93% in the United States and 70.0% in Turkey.
Why do you think the interest rate is so high in Turkey? Based on the
reported interest rates, how would you predict the change of the
exchange rate between the U.S. dollar and the Turkish lira?
Solution:
A high Turkish interest rate must reflect a high expected inflation in
Turkey. According to international Fisher effect (IFE), we have
E(e) = i$ - iLira
= 5.93% - 70.0% = -64.07%
The Turkish lira thus is expected to depreciate against the U.S. dollar
by about 64%.
38
 Quiz Time
As of November 1, 1999, the exchange rate between the Brazilian real
and U.S. dollar is R$1.95/$. The consensus forecast for the U.S. and
Brazil inflation rates for the next 1-year period is 2.6% and 20.0%,
respectively. How would you forecast the exchange rate to be at around
November 1, 2000?
Solution:
Since the inflation rate is quite high in Brazil, we may use the
purchasing power parity to forecast the exchange rate.
E(e) = E($) - E(R$)
= 2.6% - 20.0%
= -17.4%
E(ST) = So(1 + E(e))
= (R$1.95/$) (1 + 0.174)
= R$2.29/$ 39