Financial Management in the International Corporation Exchange Rates and International Parity Condit

1

7. International Parity Conditions
2
Parity Conditions

• Exchange rates, interest rates, and prices must
  be linked.
• We start with prices...

3
Law of One Price

• In the absence of shipping costs, tariffs, and
  other frictions, identical goods should trade for
  the same real price in different economies
• Pi s Pi
• The Law of One Price holds perfectly for
  homogeneous goods with low transaction costs.
• Why?
• Examples precious metals, wheat, oil

4
Purchasing Power Parity

• Purchasing Power Parity is simply the extension
  of the Law of One Price to all products in two
  economies. It says that the overall real price
  levels should be identical
• P s P
• Example
• Costs 1400 to purchase a certain basket of U.S.
  consumption goods.
• If Swiss Franc trades at 2 ( per Franc), how
  many Swiss Francs will the same basket cost in
  Geneva?

5
The Big Mac Hamburger Standard

• The Economist developed the Big Mac Standard to
  track PPP
• Assuming that the Big Mac is identical in all
  countries, it serves as a comparison point as to
  whether or not currencies are trading at market
  prices
• Big Mac in Switzerland costs Sfr6.30 while the
  same Big Mac in the US costs 2.54
• The implied PPP of this exchange rate is

6
The Big Mac Hamburger Standard

• However, on the date of the survey, the actual
  exchange rate was Sfr1.73/, therefore the Swiss
  franc is overvalued by

7
Relative Purchasing Power Parity

• Because overall economy price levels consist of
  different goods in different countries, a more
  appropriate form of PPP is the relative form.
• Relative Purchasing Power Parity asserts that
  relative changes in price levels will be offset
  by changes in exchange rates
• DP - D?P D?s
• Or denoting inflation (DP) as ?
• ? - D? Ds
• RPPP asserts that differences in inflation rates
  will be offset by changes in the exchange rate.

8
Relative Purchasing Power Parity

• Example
• A year ago, the Brazilian Real traded at
  0.917/Real.
• For 2003, Brazils inflation was 4.1 and the
  U.S. inflation was 1.7.
• What should be the value of the Real today?

9
Relative Purchasing Power Parity
? - ?? ??s

• In general, how well does Relative PPP hold?
• O.K. in the long run (over 5 years) and under
  extreme conditions - not so well in the short
  run.
• Why?
• Arbitrage is not making all real prices the same
  across countries.
• What frictions exist?
• Traded vs. Non-traded goods.

10
Empirical Evidence onPrices and Exchange Rates

• In reality, seemingly homogeneous goods may
  differ in a number of important respects which
  undermine tests of the Law of One Price.
• One test of the Law of One Price is the Big Mac
  index, which has been published annually in The
  Economist since 1986.
• It was devised as a light-hearted guide to
  whether currencies are at their correct
  level, based on PPP.

11
Empirical Evidence onPrices and Exchange Rates
12
Empirical Evidence onPrices and Exchange Rates

• Empirical tests confirm that ...
• PPP is a poor descriptor of exchange rate
  behavior in the short run, where the rates are
  quite volatile and domestic prices are somewhat
  sticky.
• But in longer-run analysis, it appears that PPP
  offers a reasonably good guide.

13
Policy Matters - Private Enterprises

• If managers can identify the deviations from
  parity that are growing larger or likely to
  persist, then profit-maximizing decisions can be
  made.
• Knowing that deviations from parity occur,
  managers may adopt strategies that reduce their
  exposure to the risks of such deviations.

14
Policy Matters - Public Policymakers

• Deviations from PPP, by definition, measure
  changes in a countrys international
  competitiveness, and reveal whether a currency is
  overvalued or undervalued relative to a simple
  standard.
• However, there are limitations on the usefulness
  of PPP in policy decisions, as real macroeconomic
  disturbances call for a change in the real
  exchange rate.

15
Real Exchange Rate

• A currencys real, inflation-adjusted value can
  often be conveniently captured in a measure known
  as its real exchange rate (RER)

16
Real Exchange Rate

• A currencys real, inflation-adjusted value can
  often be conveniently captured in a measure known
  as its real exchange rate (RER)
• et st

Pt
Pt
17
Real Exchange Rate

• A currencys real, inflation-adjusted value can
  often be conveniently captured in a measure known
  as its real exchange rate (RER)
• et st
• PPP (P s P) says et 1.

Pt
Pt
18
Real Exchange Rate

• This suggests that firms should primarily be
  concerned with changes in the real value of their
  dollar in foreign country. That is, the
  inflation-adjusted, or real, exchange rate
• et st
• PPP (P s P) says et 1.
• RPPP ( ??P - ??P ??s) says et is
  constant.

Pt
Pt
19
Calculating Real Exchange Rates
Pt
et st
Pt
Year st Pt Pt et 1995 0.13 100 100 0.1
3 1996 0.125 128 102 0.157 1997 0.12 154 10
4 0.178
20
Exchange Rates and Asset Prices
Exchange rates are determined by the relative
supplies and demands for currencies. Since
buyers and sellers are ultimately interested in
purchasing something with the currency - goods,
services, or investments - their prices and
returns must indirectly influence the demand for
a given currency. So, prices, exchange rates,
and interest rates must be linked.
21
Forward Market Basics
Forward Contract involves contracting today for
the future purchase or sale of foreign
exchange.
22
Forward Market Basics
90 - day Swiss franc contract
You buy Swiss Francs (long position)
0
S90(/SF)
23
Forward Market Basics
90 - day Swiss franc contract
F90(/SF) .8446
0
S90(/SF)
24
Forward Market Basics
90 - day Swiss franc contract
Profit
Y -axes measures profits or losses in .
0
S90(/SF)
Forward price a buyer will pay in dollars for
Swiss franc in 90 days
X- axes shows the spot price on maturity date of
the forward contract
25
Forward Market Basics
90 - day Swiss franc contract Long Contract
Profit
0
S90(/SF)
F90(/SF) .8446
If price drops to 0 then the buyer will pay
.8446 while he could pay 0. His loss then is
-.8446
26
Forward Market Basics
90 - day Swiss franc contract Long Contract
Profit
If price is .8446 then his profit is then 0.
0
S90(/SF)
F90(/SF) .8446
-F90(/SF)
27
Forward Market Basics
90 - day Swiss franc contract
Profit
Long position
0
S90(/SF)
F90(/SF) .8446
-F90(/SF)
28
Forward Market Basics
90 - day Swiss franc contract
Profit
F90(/SF)
0
S90(/SF)
F90(/SF) .8446
Short position
29
Law of One Price for Assets
Absent frictions, identical goods must trade for
identical prices in different countries when
converted into a common currency. The same
condition should hold for assets. One important
difference between goods and assets Price is
not paid immediately - it is paid over time in
the form of returns. This introduces the primary
friction for exchanging assets - a friction not
found in goods. Risk.
30
Law of One Price for Assets
Hence, there must exist a corresponding version
of LOP for assets which requires returns to be
identical across countries once this friction has
been removed Covered Interest Parity Exactly
like the Law of One Price, Covered Interest
Parity requires frictionless markets to offer
identical rates of returns for identical
assets. How do make assets in two countries
identical? Eliminate risk 1. Eliminate
exchange rate risk with forward contracts. 2.
Compare assets whose other risks are minimal
(i.e. default).
31
Law of One Price for Assets
Arbitrageurs will guarantee that the following
two strategies will generate the exact same
common-currency return 1. a. Purchasing 1 worth
of U.S. short-term treasuries.
32
Law of One Price for Assets
Arbitrageurs will guarantee that the following
two strategies will generate the exact same
common-currency return 1. a. Purchasing 1 worth
of U.S. short-term treasuries. b. Obtain an
n-period return of 1Rt,tn.
33
Law of One Price for Assets
Arbitrageurs will guarantee that the following
two strategies will generate the exact same
common-currency return 1. a. Purchasing 1 worth
of U.S. short-term treasuries. b. Obtain an
n-period return of 1Rt,tn. 2. a. Convert 1
into foreign currency at rate 1/st (FC/).
34
Law of One Price for Assets
Arbitrageurs will guarantee that the following
two strategies will generate the exact same
common-currency return 1. a. Purchasing 1 worth
of U.S. short-term treasuries. b. Obtain an
n-period return of 1Rt,tn. 2. a. Convert 1
into foreign currency at rate 1/st (FC/). b.
Purchase corresponding foreign short-term
treasuries.
35
Law of One Price for Assets
Arbitrageurs will guarantee that the following
two strategies will generate the exact same
common-currency return 1. a. Purchasing 1 worth
of U.S. short-term treasuries. b. Obtain an
n-period return of 1Rt,tn. 2. a. Convert 1
into foreign currency at rate 1/st (FC/). b.
Purchase corresponding foreign short-term
treasuries. c. Receive an n-period foreign
currency return of 1Rt,tn.
36
Law of One Price for Assets
Arbitrageurs will guarantee that the following
two strategies will generate the exact same
common-currency return 1. a. Purchasing 1 worth
of U.S. short-term treasuries. b. Obtain an
n-period return of 1Rt,tn. 2. a. Convert 1
into foreign currency at rate 1/st (FC/). b.
Purchase corresponding foreign short-term
treasuries. c. Receive an n-period foreign
currency return of 1Rt,tn. d. Eliminate the
currency risk of the foreign return by locking
in an exchange rate of Ft,tn (/FC).
37
Law of One Price for Assets
Arbitrageurs will guarantee that the following
two strategies will generate the exact same
common-currency return 1. a. Purchasing 1 worth
of U.S. short-term treasuries. b. Obtain an
n-period return of 1Rt,tn. 2. a. Convert 1
into foreign currency at rate 1/st (FC/). b.
Purchase corresponding foreign short-term
treasuries. c. Receive an n-period foreign
currency return of 1Rt,tn. d. Eliminate the
currency risk of the foreign return by locking
in an exchange rate of Ft,tn (/FC). e. Obtain
an overall n-period return of Ft,tn
(1Rt,tn) / st
38
Synthetic Forward Contract
Another way to derive the forward price of FC is
replicate it synthetically 1. Borrow
39
Synthetic Forward Contract
Another way to derive the forward price of FC is
replicate it synthetically 1. Borrow 2.
Convert to FC (at St)
40
Synthetic Forward Contract
Another way to derive the forward price of FC is
replicate it synthetically 1. Borrow 2.
Convert to FC (at St) 3. Lend the FC.
41
Synthetic Forward Contract
Another way to derive the forward price of FC is
replicate it synthetically 1. Borrow 2.
Convert to FC (at St) 3. Lend the FC. I now
effectively have a forward contract. I have
committed to pay a certain quantity of in the
future in return for receiving a certain quantity
of FC in the future.
42
Synthetic Forward Contract
Another way to derive the forward price of FC is
replicate it synthetically 1. Borrow 2.
Convert to FC (at St) 3. Lend the FC. I now
effectively have a forward contract. I have
committed to pay a certain quantity of in the
future in return for receiving a certain quantity
of FC in the future. Through exchange rate and
money markets, we can synthetically deposit,
lend, exchange currency spot, or exchange
currency forward.
43
Synthetic Forward Contract
Another way to derive the forward price of FC is
replicate it synthetically 1. Borrow 2.
Convert to FC (at St) 3. Lend the FC. I now
effectively have a forward contract. I have
committed to pay a certain quantity of in the
future in return for receiving a certain quantity
of FC in the future. Through exchange rate and
money markets, we can synthetically deposit,
lend, exchange currency spot, or exchange
currency forward. We just need to keep proper
track of differences between bid and ask prices
and borrowing and lending rates.
44
Spot, Forward, and Money Market Relationships
Time Dimension
t
tn
Borrow at loan rate

A
D
Currency Dimension
Buy FC Spot at ask
Sell FC Forward at bid
FC
B
C
Lend at FC deposit rate
45
Spot, Forward, and Money Market Relationships
Time Dimension
t
tn

A
D
Lend at deposit rate
Currency Dimension
Buy FC Forward at ask
Sell FC Spot at bid
Borrow at FC loan rate
FC
B
C
46
Spot, Forward, and Money Market Relationships
Time Dimension
t
tn
Borrow at loan rate

A
D
Lend at deposit rate
Currency Dimension
Buy FC Forward at ask
Buy FC Spot at ask
Sell FC Forward at bid
Sell FC Spot at bid
Borrow at FC loan rate
FC
B
C
Lend at FC deposit rate
47
Spot, Forward, and Money Market Relationships
Time Dimension
t
tn
1/(1Rt,tn)
L
A
D

Currency Dimension
A
Ft,tn
1/st
B
B
C
FC
(1Rt,tn)
D
48
Spot, Forward, and Money Market Relationships
Time Dimension
t
tn
A
D

D
(1Rt,tn)
Currency Dimension
B
A
st
1/Ft,tn
1/(1Rt,tn)
L
B
C
FC
49
Spot, Forward, and Money Market Relationships
Time Dimension
t
tn
1/(1Rt,tn)
L
A
D

D
(1Rt,tn)
Currency Dimension
A
B
A
Ft,tn
1/st
st
1/Ft,tn
B
1/(1Rt,tn)
L
B
C
FC
(1Rt,tn)
D
50

• An arrow from FC to , can be thought of
• as SELLING FC or BUYING .
• (2) The reverse arrow from to FC represents
• the reverse transaction, SELLING or BUYING FC.
• (3) An arrow from right to left (from the future
  to the present),
• can be thought of as borrowing - taking cash from
  the future
• and bringing it to the present.
• (4) The reverse arrow from left to right (from
  the present
• to the future), can be thought of as investing -
  taking cash
• that you have now and putting it away until the
  future.

51
Long-Dated Forward Contracts
For maturities less than one year, the convention
is to convert linearly. If Rt is the annual
interest rate Rt,tn Rt x n/365 For
maturities of more than one year, the convention
is to use compounding 1Rt,ty (1
Rt)y where y is the number of years. This gives
us the price of a y-year synthetic forward rate
as Ft,ty st (1Rt)y / (1Rt)y Note the
annual interest rate Rt must correspond to annual
interest rates specific to a n-day or y-year
maturity.
52
Exchange Rate Risk
Covered Interest Parity says that if we lock in
the forward rate to eliminate exchange rate risk,
the common-currency return to otherwise riskless
deposits in two currencies will be
identical 1Rt,tn Ft,tn (1Rt,tn) /
st What happens if we dont lock in the forward
rate? How will the returns compare if we use an
unhedged or uncovered version and just convert
returns at the future spot rate? 1Rt,tn
vs. stn (1Rt,tn) / st
53
Exchange Rate Risk
If exchange rate risk is not priced (if investors
do not require compensation for bearing exchange
rate risk) then expected returns are
equal 1Rt,tn vs. E stn (1Rt,tn) /
st and, if those expectations are rational, on
average they are right 1Rt,tn stn
(1Rt,tn) / st Alternatively, this says that on
average the forward rate equals the future spot
rate Ft,tn stn . This is known as the
unbiased forward hypothesis.
54
Uncovered Interest Parity
Put differently, if exchange rate risk is not
priced, an unhedged version of covered interest
parity should hold as well. 1Rt,tn
Ft,tn (1Rt,tn) st
55
Uncovered Interest Parity
Put differently, if exchange rate risk is not
priced, an unhedged version of covered interest
parity should hold as well. On
average 1Rt,tn stn (1Rt,tn)
st
56
Uncovered Interest Parity
Put differently, if exchange rate risk is not
priced, an unhedged version of covered interest
parity should hold as well. On
average 1Rt,tn stn (1Rt,tn)
st Which can be closely approximated by the
Uncovered Interest Parity equation Rt,tn -
Rt,tn D st,tn.
57

• The Intuition of Covered and Uncovered Interest
  Parity
• In CIP, if FC interest rates are low, how can we
  get US based investors to hold FC assets? The
  answer is that we offer them a more favorable
  forward rate (higher F in terms of /FC) to
  offset the low FC interest rate. So the market is
  working by pricing F to offset a known low FC
  interest rate.
• (2) In UIP (the international Fisher effect), if
  we expect the US to be weaker in the future
  (meaning more per FC) how would we get
  investors to willingly hold US assets? The
  answer is, we offer them an added bonus in the
  form of a higher interest rate - just high
  enough to offset the loss of a weaker US. So the
  market is working by setting a high interest
  rate to offset an expected depreciation of the
  US.

58
Exchange Rate Arbitrage
Rt,tn - Rt,tn ?st,tn If s generally
doesnt change sufficiently to offset interest
differential, (say RUSt,tn gt RJt,tn and
RUSt,tn -RJt,tn gt ? st,tn) speculators will
59
Exchange Rate Arbitrage
Rt,tn - Rt,tn ?st,tn If s generally
doesnt change sufficiently to offset interest
differential, (say RUSt,tn gt RJt,tn and
RUSt,tn -RJt,tn gt ? st,tn) speculators
will 1. Borrow in low-interest rate currency
(Yen).
60
Exchange Rate Arbitrage
Rt,tn - Rt,tn ?st,tn If s generally
doesnt change sufficiently to offset interest
differential, (say RUSt,tn gt RJt,tn and
RUSt,tn -RJt,tn gt ? st,tn) speculators
will 1. Borrow in low-interest rate currency
(Yen). 2. Convert to the high-interest rate
currency (Dollars).
61
Exchange Rate Arbitrage
Rt,tn - Rt,tn ?st,tn If s generally
doesnt change sufficiently to offset interest
differential, (say RUSt,tn gt RJt,tn and
RUSt,tn -RJt,tn gt ? st,tn) speculators
will 1. Borrow in low-interest rate currency
(Yen). 2. Convert to the high-interest rate
currency (Dollars). 3. Deposit in the
high-interest rate currency.
62
Exchange Rate Arbitrage
Rt,tn - Rt,tn ?st,tn If s generally
doesnt change sufficiently to offset interest
differential, (say RUSt,tn gt RJt,tn and
RUSt,tn -RJt,tn gt ? st,tn) speculators
will 1. Borrow in low-interest rate currency
(Yen). 2. Convert to the high-interest rate
currency (Dollars). 3. Deposit in the
high-interest rate currency. 4. Convert back to
repay low-interest rate loan at an
insufficiently appreciated exchange rate.
63
Exchange Rate Arbitrage
Rt,tn - Rt,tn ?st,tn If s generally
doesnt change sufficiently to offset interest
differential, (say RUSt,tn gt RJt,tn and
RUSt,tn -RJt,tn gt ? st,tn) speculators
will 1. Borrow in low-interest rate currency
(Yen). 2. Convert to the high-interest rate
currency (Dollars). 3. Deposit in the
high-interest rate currency. 4. Convert back to
repay low-interest rate loan at an
insufficiently appreciated exchange rate. 5.
Earn a profit - on average - of
64
Exchange Rate Arbitrage
Rt,tn - Rt,tn ?st,tn If s generally
doesnt change sufficiently to offset interest
differential, (say RUSt,tn gt RJt,tn and
RUSt,tn -RJt,tn gt ? st,tn) speculators
will 1. Borrow in low-interest rate currency
(Yen). 2. Convert to the high-interest rate
currency (Dollars). 3. Deposit in the
high-interest rate currency. 4. Convert back to
repay low-interest rate loan at an
insufficiently appreciated exchange rate. 5.
Earn a profit - on average - of RUSt,tn -
RJt,tn - ?st,tn
65
Exchange Rate Arbitrage
Rt,tn - Rt,tn ?st,tn Example RUS
5.31 RJ 0.03 st .00964 /
Yen. Stn says Yen should appreciate to .0101 /
Yen. But if, on average, stn st, can a
speculator can make profits, on average? Of
course By borrowing in Yen at 0.03, depositing
in Dollars at 5.31, and converting after 1 year
back into yen at the same exchange rate. This
will earn - on average - 5.28 on a zero-wealth
investment.
66
Exchange Rate Arbitrage
This activity - if widespread - will have the
following effects
67
Exchange Rate Arbitrage
This activity - if widespread - will have the
following effects 1. Increase demand for dollars
currency at time t - causing st (/Yen) to
decline.
68
Exchange Rate Arbitrage
This activity - if widespread - will have the
following effects 1. Increase demand for dollars
currency at time t - causing st (/Yen) to
decline. 2. Increase demand for U.S. deposits -
causing RUSt,tn to decline.
69
Exchange Rate Arbitrage
This activity - if widespread - will have the
following effects 1. Increase demand for dollars
currency at time t - causing st (/Yen) to
decline. 2. Increase demand for U.S. deposits -
causing RUSt,tn to decline. 3. Increase
demand for Japanese borrowing - causing RJt,tn
to increase.
70
Exchange Rate Arbitrage
This activity - if widespread - will have the
following effects 1. Increase demand for dollars
currency at time t - causing st (/Yen) to
decline. 2. Increase demand for U.S. deposits -
causing RUSt,tn to decline. 3. Increase
demand for Japanese borrowing - causing RJt,tn
to increase. 4. Increase demand for Yen at time
tn - causing stn to increase.
71
Exchange Rate Arbitrage
Putting this together, we have Violation of
UIP RUSt,tn - RJt,tn gt st,tn
72
Exchange Rate Arbitrage
Putting this together, we have Violation of
UIP RUSt,tn - RJt,tn gt ? st,tn Risky
arbitrage activity causing st
RUSt,tn RJt,tn stn
73
Exchange Rate Arbitrage
Putting this together, we have Violation of
UIP RUSt,tn - RJt,tn gt ? st,tn Risky
arbitrage activity causing st
RUSt,tn RJt,tn stn Hence,
profits to the arbitrage strategy
falling RUSt,tn - RJt,tn - ? st,tn
74
Exchange Rate Arbitrage
Putting this together, we have Violation of
UIP RUSt,tn - RJt,tn gt ? st,tn Risky
arbitrage activity causing st
RUSt,tn RJt,tn stn Hence,
profits to the arbitrage strategy
falling RUSt,tn - RJt,tn - ?
st,tn And reaching zero when UIP
holds RUSt,tn - RJt,tn ?st,tn
75
Uncovered Interest Parity
Empirically, the performance of UIP is mixed.
? Like RPPP, it works extremely well when
interest rate differentials are large. ? When
interest rate differentials are low, UIP (i.e.
the forward rate) is a biased predictor of the
future spot rate. Regressions of the following
form ?st,tn ? ? (Rt,tn - Rt,tn)
?t yield ?s which are consistently less than
1. High interest rate currencies dont, on
average, depreciate sufficiently.
76
Uncovered Interest Parity
High interest rate currencies dont, on average,
depreciate sufficiently. There are 3 possible
explanations 1. Risk Premia The high interest
rates of discount currencies are not only
compensating investors for an expected decline
in the exchange rate, but also for the bearing
risks associated with that currency. 2. Peso
Problem Remember, UIP holds on average. We
may have difficulty observing the true average in
the data. High interest rate currencies may
include the possibility of extremely large
depreciations which have not occurred during the
sample period. 3. Irrational Expectations
investors systematically get the future
exchange rate wrong.
77
Another Way to Derive UIP The International
Fisher Effect
Why? (a) An active forward market does not exist
for most currencies. (b) Many restrictions
prevent capital from freely flowing across
borders to directly match nominal interest rate
differentials with currency changes. Why do we
care? We will need to understand when - even in
the presence of (a) or (b) - UIP still holds, and
when it fails to understand the sources of its
failure.
78
Another Way to Derive UIP The International
Fisher Effect
(Domestic) Fisher Effect 1R (1r)(1P)
Recall that the nominal interest rate reflects
a. The real rate of return. b. An adjustment
for expected changes in the nominal prices of
consumption.
79
Another Way to Derive UIP The International
Fisher Effect
If we divide nominal interest rates in two
countries 1R (1r)(1P)

80
Another Way to Derive UIP The International
Fisher Effect
If we divide nominal interest rates in two
countries 1R (1r)(1P)

1R (1r)(1P)
81
Another Way to Derive UIP The International
Fisher Effect
If we divide nominal interest rates in two
countries 1R (1r)(1 P)

1R (1r)(1P)
This approximately equals R - R r - r P -
P If real interest rates are equal in the two
countries - if Real Interest Parity holds - then
this reduces to R - R P - P
82
Another Way to Derive UIP The International
Fisher Effect
R - R P - P If inflation expectations are
rational, then we have R - R P - P Remember
relative PPP claims that inflation differentials
will be offset by exchange rate changes P - P
Ds So if RPPP holds, then we have Uncovered
Interest Parity R - R Ds
83
What are we saying here?
The following two sets of conditions are
equivalent (A) 1. Covered Interest Parity 2.
Unbiased Forward Hypothesis and... (B) 1. Fisher
Effect (Domestic) 2. Real Interest Parity 3.
Relative Purchasing Power Parity
84
Key International Relationships
85
Key International Relationships
Relative Inflation Rates
Exchange Rate Change
86
Key International Relationships
RPPP P - P Ds Inflation differentials are
offset by changes in spot exchange rate.
Relative Inflation Rates
Exchange Rate Change
87
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Exchange Rate Change
88
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Forward Exchange Rates
89
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
CIP Ft,tn / st (1 R) /(1 R) Forward
differs from spot by interest rate differential
Forward Exchange Rates
90
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Covered Interest Parity
Forward Exchange Rates
91
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Covered Interest Parity
Forward Exchange Rates
92
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Ft,tn E(stn) Forward is
expectation of spot
Covered Interest Parity
Forward Exchange Rates
93
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Rates
94
Key International Relationships
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Rates
95
Key International Relationships
Fisher Effect 1R (1r)(1P) Interest rate
equals real rate plus expected inflation
Relative Inflation Rates
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Rates
96
Key International Relationships
1R (1r)(1E(P))
Relative Inflation Rates
R - R P - P With RIP, interest rates reflect
expected inflation differential.
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Rates
97
Key International Relationships
Relative Inflation Rates
Fisher Effect and Real Interest Parity
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Rates
98
Key International Relationships
Relative Inflation Rates
Fisher Effect and Real Interest Parity
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Forward Exchange Rates
Ft,tn / st (1 R) /(1 R)
99
Key International Relationships
Relative Inflation Rates
Fisher Effect and Real Interest Parity
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Forward Exchange Rates
Ft,tn E(stn)
Ft,tn / st (1 R) /(1 R)
100
Key International Relationships
Relative Inflation Rates
Fisher Effect and Real Interest Parity
Purchasing Power Parity
Uncovered Interest Parity R - R Ds Exchange
rate changes offset interest differentials
Relative Interest Rates
Exchange Rate Change
Forward Exchange Rates
Ft,tn E(stn)
Ft,tn / st (1 R) /(1 R)
101
Key International Relationships
Relative Inflation Rates
1R (1r)(1P)
R - R P - P
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Rates
102
Key International Relationships
Relative Inflation Rates
1R (1r)(1P) R - R P - P
P - P Ds
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Rates
103
Key International Relationships
Relative Inflation Rates
1R (1r)(1P) R - R P - P
P - P Ds
Uncovered Interest Parity R - R Ds Exchange
rate changes offset interest differentials
Relative Interest Rates
Exchange Rate Change
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Rates
104
Key International Relationships
Relative Inflation Rates
Fisher Effect and Real Interest Parity
Purchasing Power Parity
Relative Interest Rates
Exchange Rate Change
Uncovered Interest Parity
Unbiased Forward Rate
Covered Interest Parity
Forward Exchange Rates
105
Policy Matters

• Application 1 Least cost financing
• One-way arbitrage is picking the better-priced
  alternative for a transaction in the presence of
  transaction costs.
• Application 2 Country Risk Premium
• The deviations of government securities from the
  parities provides a measure of the political risk
  differences among countries.
• Application 3 Are Deviations from the Parities
  Excessive?
• Under a system of pegged exchange rates, any
  interest rate differential represents a
  deviation.
• A speculator may (1) invest in the high R
  currency when the peg is expected to hold, or (2)
  borrow the high R currency when the peg is
  expected to change by more than the interest
  differential.

106
Key Points
1. CIP says the return or cost of FC deposits or
loans must equal those in if forward contracts
are used to eliminate exchange rate
risk. 2. Using the CIP relationship, any spot
transaction, forward transaction, deposit, or
loan can be synthetically replicated using the
other 3 legs from CIP. 3. CIP can be used to
determine least-cost/maximum return transactions
and to identify arbitrage opportunities. 4. If
exchange rate risk is not priced, the forward
rate will equal the future spot rate - on
average. 5. Uncovered interest parity says
interest differentials will be offset by exchange
rate changes - on average.

107
Key Points

• 6. Uncovered Interest Parity is either
• a. Covered Interest Parity Unbiased Forward
  Rate
• b. Fisher Effect Real Interest Parity RPPP
• 7. Uncovered Interest Parity holds because of
  either
• a. Risky arbitrage across international money
  markets, or,
• b. Risky arbitrage across international real
  investment markets, across international goods
  markets, and between domestic money and goods
  markets.