1

Parity Conditions in
International Finance
and Currency
Forecasting
Chapter 4
2
ARBITRAGE AND THE
LAW OF ONE PRICE
Five Parity Conditions Result From
Arbitrage Activities

1. Purchasing Power Parity (PPP)
2. The Fisher Effect (FE)
3. The International Fisher Effect
(IFE)
4. Interest Rate Parity (IRP)
5. Unbiased Forward Rate (UFR)
3
Inflation
Changes in
Exchange
rates
Changes in
Interest
rates
PPP
FE
Changes in
Forward
Rates
IRP UFR
IFE
4
ARBITRAGE AND THE
LAW OF ONE PRICE
A. Five Parity Conditions Linked by

the adjustment of

rates and prices

to inflation


5
INFLATION

(M
s
) > ( M
D
)
6
ARBITRAGE AND THE
LAW OF ONE PRICE
B. Inflation and home currency
depreciation are:

1. jointly determined by the
growth of domestic money
supply (M
s
) and

2. relative to the growth of
domestic money demand (M
D
).
7
PART II.
PURCHASING POWER
PARITY
I. THE THEORY OF PURCHASING
POWER PARITY
states that spot exchange rates
between currencies will change to
the differential in inflation rates
between countries.
8
Purchasing Power Parity:
Conditions
In order to exist PPP we assume:

1. All goods and services are tradable

2. Transportation and other Trading costs
are zero

3. Consumers in all countries consume the
same proportions of goods and services

4. The LAW OF ONE PRICE prevails
9
PART I.
ARBITRAGE AND THE LAW
OF ONE PRICE
II. THE LAW OF ONE PRICE
A. Law states:
Identical goods sell for the
same price worldwide.
B. Theoretical basis:
If the price after exchange-rate
adjustment was not equal,
arbitrage worldwide ensures that
eventually it will.
C. Absolute Purchasing Power Parity
10
PURCHASING POWER
PARITY
III. RELATIVE PURCHASING
POWER PARITY
A. states that the exchange rate of
one currency against another
will adjust to reflect changes in
the price levels of the two
countries.

11
PURCHASING POWER
PARITY
1. In mathematical terms:





where e
t
= future spot rate
e
0
= spot rate
i
h
= home inflation expected
i
f
= foreign inflation exp
t = time period

( )
( )
0
1
1
t
h
t
t
f
i
e
e
i
+
=
+
12
PURCHASING POWER
PARITY
2. If purchasing power parity is
expected to hold, then the
best
prediction for the one-period
spot rate should be



( )
( )
0
1
1
t
h
t
t
f
i
e e
i
+
=
+
13
PURCHASING POWER
PARITY
3. A more simplified but less precise
relationship is




that is, the percentage change in
rates should be approximately equal to
the inflation rate differential.
0
0
t
h f
e e
i i
e

=
14
PURCHASING POWER
PARITY
4. PPP says
the currency with the higher
inflation rate is expected to
depreciate relative to the
currency with the lower rate of
inflation.

15
Sample Problem
Projected inflation rates for the U.S. and Germany
for the next twelve months are 10% and 4%,
respectively. If the current exchange rate is
$.50/dm, what should the future spot rate be at the
end of next twelve months?


( )
( )
0
1
1
t
h
t
t
f
i
e e
i
+
=
+
( )
( )
1
1
1
1.10
.50
1.04
e =
1
.50(1.0577) e =
1
$.529 e =
16
PART III.
THE FISHER EFFECT
I. THE FISHER EFFECT
states that nominal interest rates
(r) are a function of the real
interest rate (a) and a premium (i)
for inflation expectations.
R = a + i
17
PART IV. THE
INTERNATIONAL FISHER
EFFECT
A. Real Rates of Interest
1. Should tend toward equality
everywhere through arbitrage.
2. With no government interference
nominal rates vary by inflation
differential or
r
h
- r
f
= i
h
- i
f

18
THE INTERNATIONAL
FISHER EFFECT
B. According to the IFE,
countries with higher
expected inflation rates
have higher interest rates.


19

THE INTERNATIONAL
FISHER EFFECT
II. IFE STATES:
A. the spot rate adjusts to the interest rate
differential between two countries.

B. IFE = PPP + FE

( )
( )
0
1
1
t
h
t
t
f
r
e
e
r
+
=
+
20
THE INTERNATIONAL
FISHER EFFECT
C. Fisher postulated
1. The nominal interest rate
differential should reflect
the inflation rate differential.

21
THE INTERNATIONAL
FISHER EFFECT
D. Simplified IFE equation:

0
0
t
h f
e e
r r
e

=
22
THE INTERNATIONAL
FISHER EFFECT
E. Implications if IFE is at work:

1. Currency with the lower
interest rate expected to
appreciate relative to one
with a higher rate.

23
The International Fisher
Effect
If the /$ spot rate is 108/$ and the interest
rates in Tokyo and New York are 6% and 12%,
respectively, what is the future spot rate two
years from now?
( )
( )
0
1
1
t
h
t
t
f
r
e e
r
+
=
+
( )
( )
2
2
2
1.06
108
1.12
e =
( )
( )
2
1.1236
108
1.2544
e =
2
96.74/ $ e =
24
PART V.
INTEREST RATE PARITY
THEORY
I. INTRODUCTION
A. The Theory states:
the forward rate (F) differs from
the spot rate (S) at equilibrium
by an amount equal to the interest
differential (r
h
- r
f
) between two
countries.
25
INTEREST RATE PARITY
THEORY
B. The forward premium or discount equals
the interest rate differential.

(F S)/S = (r
h
- r
f
)

where r
h
= the home rate
r
f
= the foreign rate
F = the forward rate
S = the spot rate
26
INTEREST RATE PARITY
THEORY
C. In equilibrium, returns on currencies will
be the same

i. e. No profit will be realized and
interest rate parity exists which can be written



( )
( )
1
1
h
f
r
F
S
r
+
=
+
27
INTEREST RATE PARITY
THEORY
D. Covered Interest Arbitrage
1. Conditions required:
interest rate differential does
not equal the forward
premium or discount.

2. Funds will move to a country
with a more attractive rate.
28
INTEREST RATE PARITY
THEORY
3. Market pressures develop:
a. As one currency is more
demanded spot and sold
forward.
b. Inflow of funds depresses
interest rates.

c. Parity eventually reached.
29
INTEREST RATE PARITY
If the Swiss franc is $.68/SF on the spot market and
the annualized interest rates in the U.S. and Switzerland,
respectively, are 7.94% and 2%, what is the 180 day
forward rate under parity conditions?


( )
( )
0
1
1
h
t
f
r
f e
r
+
=
+
180
.0794
1
2
.68
.02
1
2
f
| |
+
|
\ .
=
| |
+
|
\ .
180
$.70/ f SF =
30
INTEREST RATE PARITY
THEORY
E. Summary:
Interest Rate Parity states
1. Higher interest rates on a
currency offset by forward
discounts.
2. Lower interest rates are offset
by forward premiums.
31
PART VI. THE RELATIONSHIP
BETWEEN THE FORWARD AND THE
FUTURE SPOT RATE
I. THE UNBIASED FORWARD RATE
A. States that if the forward rate is
unbiased, then it should reflect the
expected future spot rate.
B. Stated as
f
t
= e
t