Eun8e CH 006 PPT

International Parity Relationships and Forecasting
Exchange Rates
Chapter Six
Copyright © 2018 by the McGraw-Hill Companies,
Inc. All rights reserved.
Chapter Outline
• Interest Rate Parity
– Covered Interest Arbitrage
– IRP and Exchange Rate Determination
– Currency Carry Trade
– Reasons for Deviations from IRP
• Purchasing Power Parity
– PPP Deviations and the Real Exchange Rate
– Evidence on Purchasing Power Parity
• The Fisher Effects
• Forecasting Exchange Rates
– Efficient Market Approach
– Fundamental Approach
– Technical Approach
– Performance of the Forecasters
6-2
Interest Rate Parity Defined
• A theory in which the interest rate differential between
two countries is equal to the differential between the
forward exchange rate and the spot exchange rate.
• IRP is a “no arbitrage” condition. Interest rate and
exchange rates are in equilibrium.
• If IRP did not hold, then it would be possible for an astute
trader to make unlimited amounts of money exploiting
the arbitrage opportunity. (IR and ER not in equilibrium)
• Since we don’t typically observe persistent arbitrage
conditions, we can safely assume that IRP holds.

6-3
Consider 2 alternatives for one-year investments of $100,000:
1. Invest in the U.S. at i$. Future value = $100,000 × (1 + i$).
2. Trade your $ for £ at the spot rate and invest $100,000/S$/£
in Britain at i£ while eliminating any exchange rate risk by
selling the future value of the British investment forward.
F$/£
Future value = $100,000(1 + i£)×
S$/£
If these investments have the same risk, they must have the
same future value (otherwise an arbitrage would exist).
F$/£ (1 + i$)
(1 + i£) × = (1 + i$) or; F$/£ = S$/£ × (1 + i )
S$/£ £
Alternative 2: $1,000 IRP
Send your $ on
S$/£ Step 2:
a round trip to
Britain Invest those
pounds at i£
$1,000 Future Value =
$1,000
 (1+ i£)
S$/£
Step 3: Repatriate
Alternative 1: future value to the
Invest $1,000 at i$ U.S.A.
$1,000×(1 + i$) = $1,000
 (1+ i£) × F$/£
S$/£
IRP
Since both of these investments have the same risk, they must have the
same future value—otherwise an arbitrage would exist.
• If the amount is $1000;
$1,000
$1,000×(1 + i$) =  (1+ i£) × F$/£
S$/£
F$/£
(1 + i$) = × (1+ i£)
S$/£
• IRP is sometimes approximated as:
i$ – i£ ≈ F – S
S
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($/£) = $2.0000/£
360-day forward rate F360($/£) = $2.0100/£
U.S. discount rate i$ = 3.00%
British discount rate i£ = 2.49%
IRP and Covered Interest Arbitrage
• A trader with $1,000 could invest in the U.S. at

3.00%. In one year his investment will be worth:
$1,030 = $1,000  (1+ i$) = $1,000  (1.03)
• Alternatively, this trader could:

1. Exchange $1,000 for £500 at the prevailing spot rate.
2. Invest £500 for one year at i£ = 2.49%; earn £512.45.
3. Translate £512.45 back into dollars at the forward rate
F360($/£) = $2.01/£. The £512.45 will be worth $1,030.
IRP& Exchange Rate Determination
• According to IRP only one 360-day
forward rate F360($/£) can exist. It must be
the case that
F360($/£) = $2.01/£
• Why?
• If F360($/£)  $2.01/£, an astute trader
could make money with one of the
following strategies.
Arbitrage Strategy I
• If F360($/£) > $2.01/£:
1. Borrow $1,000 at t = 0 at i$ = 3%. (Why borrow
$? Because it is undervalued at >$2.01/£)
2. Exchange $1,000 for £500 at the prevailing spot
rate (note that £500 = $1,000 ÷ $2/£.); invest £500
at 2.49% (i£) for one year to achieve £512.45.
3. Translate £512.45 back into dollars; if F360($/£)
> $2.01/£, then £512.45 will be more than enough
to repay your debt of $1,030.
Step 2: Arbitrage I
Buy pounds
£500 Step 3:
£1
£500 = $1,000× Invest £500 at
$2.00
i£ = 2.49%.
$1,000 £512.45 In one year £500
will be worth
£512.45 =
Step 4: Repatriate £500 (1+ i£)
to the U.S.
Step 1:
Borrow $1,000. More F£(360)
Step 5: Repay than $1,030 $1,030 < £512.45 ×
£1
your dollar loan
with $1,030.
If F£(360) > $2.01/£, £512.45 will be more than enough to repay your
dollar obligation of $1,030. The excess is your profit.
Arbitrage Strategy II
• If F360($/£) < $2.01/£ (dollar overvalue, or pound
undervalue):
1. Borrow £500 at t = 0 at i£= 2.49%.
2. Exchange £500 for $1,000 at the prevailing spot
rate; invest $1,000 at 3% for one year to achieve
$1,030.
3. Translate $1,030 back into pounds; if F360($/£) <
$2.01/£, then $1,030 will be more than enough to
repay your debt of £512.45.
Step 2: Arbitrage II
Buy dollars £500
$2.00
$1,000 = £500× Step 1:
£1
Borrow £500.
$1,000
More Step 5: Repay
Step 3: your pound loan
Invest $1,000 than
£512.45 with £512.45.
at i$ = 3%.
Step 4:
Repatriate to
the U.K.
In one year $1,000
F£(360)
will be worth $1,030 $1,030 > £512.45 ×
£1
If F£(360) < $2.01/£, $1,030 will be more than enough to repay your
dollar obligation of £512.45. Keep the rest as profit.
Reasons for Deviations from IRP
• Transactions Costs
– The interest rate available to an arbitrageur 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.

6-14
PPP 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
• This is called absolute PPP
• Law of one price

6-15
• Suppose the spot exchange rate is $1.25 =
€1.00. If the inflation rate in the U.S. is expected
to be 3% in the next year and 5% in the euro
zone, then the expected exchange rate in one
year (F($/€)) should be
$1.25 x (1+$) / €1.00x(1 + €)
$1.25×(1.03) / €1.00×(1.05), or
$1.2875 / €1.05 = $1.2262/1.00 €
• Will € be traded at discount or premium against
dollar for 1-yr forward?
• The euro will trade at a 1.90% discount in the forward
market: $1.25×(1.03)
F($/€) €1.00×(1.05) 1.03 1 + $
= = =
S($/€) $1.25 1.05 1 + €
€1.00
Relative PPP states that the rate of change in the exchange
rate is equal to differences in the rates of inflation—roughly 2%.
So pound is expected to depreciate in value by roughly about
2% relative to dollar in one year’s time.
6-17
PPP and IRP
• Notice that our two big equations equal
each other:
PPP IRP
F($/€) 1 + $ 1 + i$ F($/€)
= = =
S($/€) 1 + € 1 + i€ S($/€)

6-18
Expected Rate of Change in Exchange Rate (E(e))
as Inflation Differential
• We could also reformulate our equations as inflation or
interest rate differentials: F($/€) 1 + $
=
S($/€) 1 + €
F($/€) – S($/€) 1 + $ 1 + $ 1 + €
= –1= –
S($/€) 1 + € 1 + € 1 + €
F($/€) – S($/€)  –  €
= 1 + € ≈  $ –  €
$
E(e) =
S($/€) (Relative PPP)

6-19
Expected Rate of Change in Exchange Rate (E(e))
as Interest Rate Differential
F($/€) – S($/€) i$ – i€
E(e) = = ≈ i$ – i€
S($/€) 1 + i€
 Given the difficulty in measuring expected inflation,
managers often use a “quick and dirty” shortcut:
$ – € ≈ i$ – i€

6-20
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.
– Film, on the other hand, is a highly standardized
commodity that is actively traded across borders.
– Shipping costs, as well as tariffs and quotas, can lead
to deviations from PPP.
• PPP-determined exchange rates still provide a
valuable benchmark.

6-21
Evidence on PPP
Big Mac prices Implied Actual dollar Under or over
In local PPPa of exchange rate valuation against
currency In dollars the dollara 7/13/2009 the dollar, %
United States $4.33 4.33 − 1.00 −
Argentina Peso 19 4.16 4.39 4.57 -4
Australia A$ 4.56 4.68 1.05 0.97 8
Brazil Real 10.08 4.94 2.33 2.04 14
Britain £ 2.69 4.16 1.61c 1.55c -4
Canada C$ 3.89 3.82 0.90 1.02 -12
China Yuan 15.65 2.45 3.62 6.39 -43
Egypt Pound 16 2.64 3.70 6.07 -39
Euro area € 3.58 4.34 1.21e 1.21e 0
Japan Yen 320 4.09 73.95 78.22 -5
Mexico Peso 37 2.70 8.55 13.69 -38
Russia Ruble 75 2.29 17.33 32.77 -47
Sweden SKr 48.4 6.94 11.18 6.98 60
Switzerland SFr 6.5 6.56 1.52 0.99 52
6-22
A Guide to World Prices: March 2013
Hamburger Aspirin Man’s Haircut Movie Ticket
Location (1 unit) (20 units) (1 unit) (1 unit)
Athens $3.81 $2.09 $58.72 $13.24
Copenhagen $7.00 $4.86 $55.50 $13.82
Hong Kong $2.82 $2.39 $80.13 $9.62
London $5.71 $1.39 $56.60 $20.49
Los Angeles $3.57 $2.72 $27.33 $11.90
Madrid $5.40 $5.76 $20.43 $9.87
Mexico City $4.02 $0.91 $21.72 $4.72
Munich $4.71 $5.01 $17.25 $10.70
Paris $5.97 $3.70 $68.49 $12.63
Rio de Janeiro $5.56 $5.63 $44.70 $10.64
Rome $5.14 $7.99 $42.19 $9.64
Sydney $5.38 $4.34 $53.77 $16.29
Tokyo $3.29 $8.24 $77.00 $18.91
Toronto $5.32 $2.20 $40.28 $12.20
Average $4.82 $4.15 $46.89 $12.48
6-23
Approximate Equilibrium Exchange Rate Relationships
E(e)
≈ IFE ≈ FEP
≈ PPP F–S
(i$ – i¥) ≈ IRP
S
≈ FE ≈ FRPPP
E($ – £)

6-24
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 + $ ) × E(1 + $)
Where:
$ 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.
• Or approximately i$ ≈ $ + $
6-25
International Fisher Effect
If the Fisher effect holds in the U.S.,
1 + i$ = (1 + $ ) × E(1 + $)
and the Fisher effect holds in Japan,
1 + i¥ = (1 + ¥ ) × E(1 + ¥)
and if the real rates are the same in each country,
$ = ¥
then we get the International Fisher Effect:
1 + i¥ E(1 + ¥)
=
1 + i$ E(1 + $)
6-26
International Fisher Effect
If the International Fisher Effect holds,
1 + i¥ E(1 + ¥)
=
1 + i$ E(1 + $)
and if IRP also holds,
1 + i¥ F¥/$
=
1 + i$ S¥/$
then forward rate PPP holds:
F¥/$ E(1 + ¥)
=
S¥/$ E(1 + $)
6-27
Exact Equilibrium Exchange Rate Relationships
E (S ¥ / $ )
IFE S¥ /$ FEP
1 + i¥ PPP F¥ / $
IRP
1 + i$ S¥ /$
FE FRPPP
E(1 + ¥)
E(1 + $)
6-28
Forecasting Exchange Rates: Efficient
Markets Approach
• Financial markets are efficient if prices reflect all
available and relevant information.
• If this is true, 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.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved. 6-29
Forecasting Exchange Rates: 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.
Forecasting Exchange Rates: Technical
Approach
• Technical analysis looks for patterns in the past
behavior of exchange rates.
• It is based upon the premise that history repeats
itself.
• Thus, it is at odds with the EMH.
EXHIBIT 6.11 Moving Average Crossover
Rule: Golden Cross vs. Death Cross
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
forecast implied by the forward rate.
• The founder of Forbes Magazine once said,
“You can make more money selling financial
advice than following it.”
Summary
• Interest rate parity (IRP) holds that the forward premium
or discount should be equal to the interest rate
differential between two countries.
– IRP represents an arbitrage equilibrium condition that should
hold in the absence of barriers to international capital flows.
• If IRP is violated, one can lock in guaranteed profit by
borrowing in one currency and lending in another, with
exchange risk hedged via forward contract.
– As a result of this covered interest arbitrage, IRP will be restored.
Summary (continued)
• IRP implies that in the short run, the exchange rate
depends on
– (a) the relative interest rates between two countries, and
– (b) the expected future exchange rate
– Other things being equal, a higher (lower) domestic interest rate
will lead to appreciation (depreciation) of the domestic currency.
People’s expectations concerning future exchange rates are self-
fulfilling.
Summary (concluded)
• Purchasing power parity (PPP) states that the exchange
rate between two countries’ currencies should be equal
to the ratio of their price levels.
– The relative version of PPP states that the rate of change in the
exchange rate should be equal to the inflation rate differential
between countries. The existing empirical evidence, however, is
generally negative on PPP. This implies that substantial barriers
to international commodity arbitrage exist.
• There are three distinct approaches to exchange rate
forecasting:
– (a) the efficient market approach,
– (b) the fundamental approach, and
– (c) the technical approach.

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International Parity Relationships and Forecasting

Copyright © 2014 by the McGraw-Hill Companies,

• If IRP failed to hold, an arbitrage would

• A trader with $1,000 could invest in the U.S. at

• Alternatively, this trader could:

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

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