International Parity

Relationships & Forecasting

Foreign Exchange Rates Chapter Six
6
INTERNATIONAL INTERNATIONAL
FINANCIAL Chapter Objective: FINANCIAL
MANAGEMENT MANAGEMENT
This chapter examines several key international
parity relationships, such as interest rate parity and
Fourth Edition Fourth Edition
purchasing power parity.
EUN / RESNICK EUN / RESNICK

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Chapter Outline Interest Rate Parity

z
z Interest Rate Parity z Interest Rate Parity Defined
z „ Covered Interest
z Purchasing PowerArbitrage
Parity z Covered Interest Arbitrage
z
„
z The
IRP
„ PPP and
Fisher Exchange
Deviations andRate
Effects Determination
the Real Exchange Rate z Interest Rate Parity & Exchange Rate
Reasons for Deviations from
„ Evidence on Purchasing Power
„ IRP
Parity Determination
z Forecasting Exchange Rates
z
z Purchasing
z The Fisher Power
Effects Parity
„ Efficient Market Approach z Reasons for Deviations from Interest Rate Parity
z The
z Fisher Effects
Forecasting
„ FundamentalExchange
ApproachRates
z Forecasting Exchange Rates
„ Technical Approach

„ Performance of the Forecasters

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Interest Rate Parity Defined Interest Rate Parity Carefully Defined

z IRP is an arbitrage condition. Consider alternative one year investments for $100,000:
1. Invest in the U.S. at i$. Future value = $100,000 × (1 + i$)
z If IRP did not hold, then it would be possible for
an astute trader to make unlimited amounts of 2. Trade your $ for £ at the spot rate, invest $100,000/S$/£ in
money exploiting the arbitrage opportunity. Britain at i£ while eliminating any exchange rate risk by
selling the future value of the British investment forward.
z Since we don’t typically observe persistent F$/£
Future value = $100,000(1 + i£)×
arbitrage conditions, we can safely assume that S$/£
IRP holds. Since these investments have the same risk, they must have
the same future value (otherwise an arbitrage would exist)
F$/£
(1 + i£) × = (1 + i$)
S$/£
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1
 Alternative 2: $1,000 IRP
Send your $ on a
round trip to
S$/£
Step 2:
Interest Rate Parity Defined
Britain
Invest those
pounds at i£ z The scale of the project is unimportant
$1,000 Future Value =
$1,000 $1,000
× (1+ i£) $1,000×(1 + i$) = × (1+ i£) × F$/£
S$/£ S$/£
Step 3: repatriate
Alternative 1: future value to the
invest $1,000 at i$ U.S.A. F$/£
$1,000
× (1+ i£) × F$/£ (1 + i$) = × (1+ i£)
$1,000×(1 + i$) = S$/£
S$/£
IRP

Since both of these investments have the same risk, they must
have6-6the same future value—otherwise an arbitrage
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Interest Rate Parity Defined Forward Premium

Formally, z It’s just the interest rate differential implied by
1 + i$ F$/¥
= forward premium or discount.
1 + i¥ S$/¥
z For example, suppose the € is appreciating from
S($/€) = 1.25 to F180($/€) = 1.30
IRP is sometimes approximated as
z The forward premium is given by:
i$ – i¥ ≈ F – S
S F180($/€) – S($/€) 360 $1.30 – $1.25
f180,€v$ = × = × 2 = 0.08
S($/€) 180 $1.25

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Interest Rate Parity Carefully Defined IRP and Covered Interest Arbitrage
z Depending upon how you quote the exchange rate If IRP failed to hold, an arbitrage would exist. It’s
($ per ¥ or ¥ per $) we have: easiest to see this in the form of an example.
Consider the following set of foreign and domestic
1 + i¥ F¥/$ 1 + i$ F$/¥ interest rates and spot and forward exchange rates.
= or =
1 + i$ S¥/$ 1 + i¥ S$/¥
Spot exchange rate S($/£) = $1.25/£
360-day forward rate F360($/£) = $1.20/£
…so be a bit careful about that U.S. discount rate i$ = 7.10%
British discount rate i£ = 11.56%

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2
 Alternative 2: Arbitrage I
buy pounds
IRP and Covered Interest Arbitrage £1
£800
Step 2:
£800 = $1,000×
$1.25 Invest £800 at
A trader with $1,000 could invest in the U.S. at 7.1%, in one i£ = 11.56%
year his investment will be worth $1,000 £892.48 In one year £800
$1,071 = $1,000 × (1+ i$) = $1,000 × (1,071) will be worth
Step 3: repatriate £892.48 =
Alternatively, this trader could to the U.S.A. at £800 ×(1+ i£)
1. Exchange $1,000 for £800 at the prevailing spot rate, F360($/£) =
Alternative 1: $1.20/£
2. Invest £800 for one year at i£ = 11,56%; earn £892,48. invest $1,000 $1,071 F£(360)
3. Translate £892,48 back into dollars at the forward rate at 7.1% $1,071 = £892.48 ×
£1
F360($/£) = $1,20/£, the £892,48 will be exactly $1,071. FV = $1,071

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Interest Rate Parity

& Exchange Rate Determination
Arbitrage Strategy I
According to IRP only one 360-day forward rate, If F360($/£) > $1.20/£
F360($/£), can exist. It must be the case that i. Borrow $1,000 at t = 0 at i$ = 7.1%.
ii. Exchange $1,000 for £800 at the prevailing spot
F360($/£) = $1.20/£
rate, (note that £800 = $1,000÷$1.25/£) invest
Why? £800 at 11.56% (i£) for one year to achieve
£892.48
If F360($/£) ≠ $1.20/£, an astute trader could make
money with one of the following strategies: iii. Translate £892.48 back into dollars, if
F360($/£) > $1.20/£, then £892.48 will be more
than enough to repay your debt of $1,071.
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Step 2: Arbitrage I
buy pounds
£1
£800
Step 3:
Arbitrage Strategy II
£800 = $1,000×
$1.25 Invest £800 at
i£ = 11.56% If F360($/£) < $1.20/£
$1,000 £892.48 In one year £800
will be worth i. Borrow £800 at t = 0 at i£= 11.56% .
£892.48 =
£800 ×(1+ i£)
ii. Exchange £800 for $1,000 at the prevailing spot
Step 4: repatriate
to the U.S.A.
rate, invest $1,000 at 7.1% for one year to achieve
Step 1: $1,071.
borrow $1,000 More F£(360)
Step 5: Repay than $1,071 $1,071 < £892.48 ×
£1
iii. Translate $1,071 back into pounds, if
your dollar loan
with $1,071.
F360($/£) < $1.20/£, then $1,071 will be more
If F£(360) > $1.20/£ , £892.48 will be more than enough to repay
than enough to repay your debt of £892.48.
your dollar obligationCopyright
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3
 Step 2:
buy dollars Arbitrage II
$1.25
£800 IRP and Hedging Currency Risk
$1,000 = £800× Step 1:
£1
borrow £800
$1,000 You are a U.S. importer of British woolens and have just ordered next
More Step 5: Repay year’s inventory. Payment of £100M is due in one year.
Step 3: your pound loan
Invest $1,000 than Spot exchange rate S($/£) = $1.25/£
£892.48 with £892.48 . 360-day forward rate F360($/£) = $1.20/£
at i$
Step 4: U.S. discount rate i$ = 7.10%
repatriate to British discount rate i£ = 11.56%
the U.K.
In one year $1,000 IRP implies that there are two ways that you fix the cash outflow to a
F£(360)
will be worth $1,071 $1,071 > £892.48 × certain U.S. dollar amount:
£1 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 in one year.
If F£(360) < $1.20/£ , $1,071 will be more than enough to repay b) Form a forward market hedge as shown below.
your dollar obligationCopyright
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IRP and a Forward Market Hedge Forward Market Hedge

To form a forward market hedge: Where do the numbers come from? We owe our supplier
£100 million in one year—so we know that we need to
Borrow $112.05 million in the U.S. (in one year you have an investment with a future value of £100 million.
Since i£ = 11.56% we need to invest £89.64 million at the
will owe $120 million). start of the year.
Translate $112.05 million into pounds at the spot £100
£89.64 =
rate S($/£) = $1.25/£ to receive £89.64 million. 1.1156
Invest £89.64 million in the UK at i£ = 11.56% for How many dollars will it take to acquire £89.64 million at
the start of the year if S($/£) = $1.25/£?
one year.
In one year your investment will be worth £100 $1.00
$112.05 = £89.64 ×
million—exactly enough to pay your supplier. £1.25
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Reasons for Deviations from IRP Transactions Costs Example

z Transactions Costs z Will an arbitrageur facing the following prices be
„ The interest rate available to an arbitrageur for able to make money?
borrowing, ib,may exceed the rate he can lend at, il. Borrowing Lending 1 + i$ F$/ €
There may be bid-ask spreads to overcome, Fb/Sa < F/S =
„
$ 5% 4.50% 1 + i € S$/ €
„ Thus
€ 6% 5.50% Bid Ask
(Fb/Sa)(1 + i¥l) − (1 + i¥ b) ≤ 0
Spot $1.00=€1.00 $1,01=€1,00
z Capital Controls
Forward $0.99=€1.00 $1.00=€1.00
„ Governments sometimes restrict import and export of
money through taxes or outright bans.
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 Transactions Costs Example Purchasing Power Parity
z Try borrowing $1.000 at 5%: z Purchasing Power Parity and Exchange Rate
z Trade for € at the ask spot rate $1.01 = €1.00 Determination
Invest €990.10 at 5.5% PPP Deviations and the Real Exchange Rate

Now try this backwards

z z

z Hedge this with a forward contract on z Evidence on PPP

€1,044.55 at $0.99 = €1.00
z Receive $1.034.11
z Owe $1,050 on your dollar-based borrowing
z Suffer loss of $15.89
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Purchasing Power Parity and Purchasing Power Parity and

Exchange Rate Determination Exchange Rate Determination
z The exchange rate between two currencies should z Suppose the spot exchange rate is $1.25 = €1.00
equal the ratio of the countries’ price levels: z If the inflation rate in the U.S. is expected to be
P$ 3% in the next year and 5% in the euro zone,
S($/£) =
P£ z Then the expected exchange rate in one year
z For example, if an ounce of gold costs $300 in should be $1.25×(1.03) = €1.00×(1.05)
the U.S. and £150 in the U.K., then the price of
one pound in terms of dollars should be: F($/€) = $1.25×(1.03) = $1.23
P$ $300 €1.00×(1.05) €1.00
S($/£) = = = $2/£
P£ £150
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Purchasing Power Parity and Purchasing Power Parity

Exchange Rate Determination and Interest Rate Parity
z The euro will trade at a 1.90% discount in the forward z Notice that our two big equations today equal each
market: other:
$1.25×(1.03)
F($/€) €1.00×(1.05) 1.03 1 + π$ PPP IRP
= = =
S($/€) $1.25 1.05 1 + π€ F($/€) 1 + π$ 1 + i$ F($/€)
= = =
€1.00 S($/€) 1 + π€ 1 + i€ S($/€)

Relative PPP states that the rate of change in the

exchange rate is equal to differences in the rates of
inflation—roughly 2%
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5
Expected Rate of Change in Exchange Expected Rate of Change in Exchange
Rate as Inflation Differential Rate as Interest Rate Differential
z We could also reformulate
our equations as inflation or F($/€) 1 + π$ F($/€) – S($/€) i$ – i€
= = ≈ i$ – i€
interest rate differentials: S($/€) 1 + π€ E(e) = S($/€) 1 + i€

F($/€) – S($/€) 1 + π$ 1 + π$ 1 + π€
= –1= –
S($/€) 1 + π€ 1 + π€ 1 + π€

F($/€) – S($/€) π – π€
E(e) = = $ ≈ π$ – π€
S($/€) 1 + π€
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Quick and Dirty Short Cut Evidence on PPP

z Given the difficulty in measuring expected z PPP probably doesn’t hold precisely in the real
inflation, managers often use world for a variety of reasons.
„ Haircuts cost 10 times as much in the developed world
π$ – π€ ≈ i$ – i€ 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.
z PPP-determined exchange rates still provide a
valuable benchmark.
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Approximate Equilibrium Exchange

The Exact Fisher Effects
Rate Relationships
z An increase (decrease) in the expected rate of inflation
E(e) will cause a proportionate increase (decrease) in the
≈ IFE ≈ FEP interest rate in the country.
z For the U.S., the Fisher effect is written as:
≈ PPP F–S
(i$ – i¥) ≈ IRP 1 + i$ = (1 + ρ$ ) × E(1 + π$)
S Where
ρ$ is the equilibrium expected “real” U.S. interest rate
≈ FE ≈ FRPPP
E(π$) is the expected rate of U.S. inflation
E(π$ – π£) i$ is the equilibrium expected nominal U.S. interest rate

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6
 International Fisher Effect International Fisher Effect
If the Fisher effect holds in the U.S. If the International Fisher Effect holds,
1 + i$ = (1 + ρ$ ) × E(1 + π$) 1 + i¥ E(1 + π¥)
=
and the Fisher effect holds in Japan, 1 + i$ E(1 + π$)
1 + i¥ = (1 + ρ¥ ) × E(1 + π¥)
and if the real rates are the same in each country and if IRP also holds
1 + i¥ F¥/$
ρ$ = ρ¥ =
1 + i$ S¥/$
then we get the F E(1 + π¥)
1 + i¥ E(1 + π¥) then forward rate PPP holds: ¥/$ =
International Fisher Effect: 1 + i = E(1 + π ) S¥/$ E(1 + π$)
$ $
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Exact Equilibrium Exchange Rate

Forecasting Exchange Rates
Relationships
E (S ¥ / $ ) z Efficient Markets Approach
S¥ /$ z Fundamental Approach
IFE FEP
z Technical Approach
1 + i¥ PPP F¥ / $ z Performance of the Forecasters
IRP
1 + i$ S¥ /$
FE FRPPP
E(1 + π¥)
E(1 + π$)

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Efficient Markets Approach Fundamental Approach

z Financial Markets are efficient if prices reflect all z Involves econometrics to develop models that use
available and relevant information. a variety of explanatory variables. This involves
z If this is so, exchange rates will only change when three steps:
new information arrives, thus: „ step 1: Estimate the structural model.
„ step 2: Estimate future parameter values.
St = E[St+1]
„ step 3: Use the model to develop forecasts.
and
z The downside is that fundamental models do not
Ft = E[St+1| It] work any better than the forward rate model or
z Predicting exchange rates using the efficient the random walk model.
markets approach is affordable and is hard to beat.
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7
 Technical Approach Performance of the Forecasters
z Technical analysis looks for patterns in the past z Forecasting is difficult, especially with regard to
behavior of exchange rates. the future.
z Clearly it is based upon the premise that history z As a whole, forecasters cannot do a better job of
repeats itself. forecasting future exchange rates than the forward
z Thus it is at odds with the EMH rate.
z The founder of Forbes Magazine once said:
“You can make more money selling financial
advice than following it.”

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End Chapter Six

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