Topic 4:

International Parity
Relationship (Shapiro, Chapter 4)

Law of one price

Purchasing power parity (PPP)
Fisher effect
International Fisher effect
Interest rate parity (IRP)
Unbiased forward rates
Covered interest arbitrage (CIA)
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The law of one price: in competitive

markets identical commodity (say, FX) sold
in different countries must sell for the same
price when their price is expressed in terms
of the same currency

Purchasing Power Parity: Money supply

and price inflation: when growth in a
countrys money supply is faster than
growth in output, price inflation is fueled,
which will lead to depreciation in currency of
that country.
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(A)Purchasing power parity (PPP):

Money supply and price inflation: when growth in a
countrys money supply is faster than growth in
output, price inflation is fueled, which will lead to
depreciation in currency of that country.
PPP holds that the expected change in the exchange
rate is due to the difference in expected inflation
rates in the respective countries.

(1 i )t
h
et e0
t
(1 i )
f
3

where e0 is the spot exchange rate and et is

expected future spot rate in period t, ih and if the
expected home and foreign inflation rates,
respectively.
PPP states that the exchange rate between two
currencies will adjust to reflect the relative
inflation rates in the two countries. It is assumed
that the law of one price is valid.
Eg., the expected inflation rates for the US and
Australia in one year are 5% and 3%, respectively,
current spot exchange rate being
USD0.6000/AUD (or AUD1.6667/USD), what is
the expected future spot exchange rate in one
year?
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(1) When AUD is the commodity currency:

(1 ih ) t
0 (1 i f ) t

et e

0.6

(1 0.05 )1
(1 0.03 )1

USD 0.6117 / AUD

(2) When USD is the commodity currency:
(1 ih ) t
0 (1 i f ) t

et e

1
(
1

0
.
03
)
1
0.6 (1 0.05 )1

AUD1.6349 / USD
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Given that the U.S.s relative expected inflation

rate is higher, USD is expected to depreciate
from AUD1.6667/USD to AUD1.6349/USD.
Why?
Because American goods are relatively more
expensive, American will convert their USD to
get AUD so that they can buy goods in
Australia. The increases in the supply of
USD and the demand for AUD will drive up
the price of AUD. USD will continue to
depreciate until an equilibrium point is
reached (ie., AUD1.6349/USD in this case).
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Therefore, PPP states that the currency of

the country with higher inflation rate will
depreciate.
PPP is simple and easy to understand.
Empirical research shows that it does
not hold in reality, especially in the
short-run. If it does hold, it holds only in
the long-run

According to PPP, given the previous example,

AUD should appreciate against USD by 2%
roughly (ie., e = 2% roughly).

Mathematically:

(1 ih )
(1 e)
(1 if )

(1 5%)
(1 3%)

1.0194
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PPP Deviations & the Real Exchange Rate

Real exchange rate is the spot rate adjusted for
relative price level changes since a base period.
Specifically,

(1 i f ) (1 iC )
'
e1 e1
or
(1 i )
(1 i )
h

'
e1

is the real exchange rate at time 1

e1

is the nominal exchange rate at time 1

1 ih

is the domestic inflation rate from time

Where

0 to 1
1 i f is the foreign inflation rate from time
0 to 1
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Given

Let

(1 i f ) (1 iC )

or
e1 (1 ih )
(1 iT )
'
e1

'
e1

1 e e

Let

(1 i f )
(1 e)(1 ih )
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If PPP holds, (1 + e) = (1 + if)/(1 + ih), then q =

1. Competitiveness of domestic country in
international trade remains unchanged
If q < 1, competitiveness of domestic country
improves with currency depreciations
because domestic currency depreciated
more than required by PPP.
If q > 1, competitiveness of domestic
country deteriorates with currency
depreciations because domestic currency
depreciated less than required by PPP.
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(B) Fisher Theorem

Fisher equation maintains that, for any given
currency, the nominal interest rate (r) will be
set by the market such that it covers
expected inflation rate (E(i)) and provides a
required real rate of return (real interest rate,
r*).
Roughly, nominal interest rate
= Real interest rate + Expected inflation rate

Mathematically,

1 + r = (1+r*)(1 + E(i))

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International Fisher Theorem

If Fisher equation holds for both countries, A
and B, then

1 rA (1 r*)[1 E (iA )] and

1 rB (1 r*)[1 E (iB )]
We have

1 rA
1 rB

(1 r *) [1 E ( i A )]
(1 r *) [1 E ( iB )]
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Nominal interest rates are rates quoted

in the market. Real interest rates are
nominal rates adjusted for expected
inflation
(C) International Fisher Effect
Tthe expected change in spot exchange
rate between two currencies is the
difference in the interest rates between
the two currencies.
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If real interest rates are equal across

countries, then

1 rA
1 rB

[1 E ( i A )]
[1 E ( iB )]

Given PPP,

E ( S ) 1 E (i A )

S
1 E (iB )

we have,

E ( S ) 1 E (i A ) 1 rA

S
1 E (iB ) 1 r B
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(D) Unbiased Forward Rates

Since forward rate is an unbiased predictor
for future spot rate, we have

f
s

E (s)
s

And interest rate parity is derived, ie.,

1i A 1 rT
f

s 1iB 1 rC
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(E) Interest rate parity (IRP):

The IRP states that relative interest rates
between two countries, say UK and USA,
determine the relativity between the forward
exchange rate (f) and spot exchange rate
(s):

1 rh
1 rT
f

or
s 1 rC
1 r f
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The IRP simply states that at the equilibrium

exchange rates, returns from investing in the
two currencies must be equal, otherwise
there will be arbitrage opportunity.
Arbitrage activity will ensure that the exchange
rates will go back to the equilibrium. This is
the so-called law of one price.
The IRP relationship: the higher (lower)
interest rate currency will sell at a discount
(premium) in the forward markets.

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IRP relationship is derived from PPP and

works through the international Fisher
theorem.
PPP: The currency with higher inflation
will depreciate
Fisher Theorem: The currency with
higher inflation rate will have higher
nominal interest rate. Therefore:
IRP: The currency with higher interest
rate will have a lower forward rate.
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IRP is derived from PPP through the Fisher theorem.

It is a very simple model that assumes exchange
rate is only determined by relative inflation rates of
the two countries. There are many other factors
that help to determine exchange rate.
IRP is useful because it provides an equation to
allow forward rates to be calculated. All banks
use IRP to calculate forward rates.
For the forward rates that banks quote, banks can
hedge their FX position using IRP.

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Integrating Parity & Equilibrium Conditions

Direct FX rates: d/f (domestic/foreign currency)
FRP

IFE

DFE

(1 + rh)
(1 + r*h)(1 + ih)
F = E[S] = S
=
f
(1 + r ) S (1 + r*f) (1 + if)
IRP
(1 + ih)
= S (1 + if)
RPPP

IFEC

IRP: Interest Rate Parity

FRP: Forward Rate Parity
DFE: Domestic Fisher Effect
IFE: International Fisher Effect
RPPP: Relative Purchasing Power Parity
IFEC: International Fisher Relation Corollary (equality of real returns)
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Integrating Parity & Equilibrium Conditions

Indirect FX rates: f/d (foreign/domestic currency)
FRP

IFE

DFE

(1 + if)
(1 +i*f)(1 + pf)
F = E[S] = S (1 + id) = S
(1 +i*d)(1 + pd)
IRP
RPPP

(1 + pf)
= S (1 + pd)

IFEC

IRP: Interest Rate Parity

FRP: Forward Rate Parity
DFE: Domestic Fisher Effect
IFE: International Fisher Effect
RPPP: Relative Purchasing Power Parity
IFEC: International Fisher Effect Corollary (equality of real returns)
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From IRP:

(1 rT )
f s
(1 rC )

Example: Given that interest rates for USD and

GBP are 7.1% and 11.56% p.a. respectively
and the spot exchange rate is
USD1.2500/GBP, calculate the 1-year forward
rate.

(1 0.071)
f 1.25 (1 0.1156) 1.2000
The equilibrium forward rate is USD1.2000/GBP.
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If IRP does not hold, the situation gives rise to

a covered interest arbitrage (CIA)
opportunity.
For example, what if the bank quotes you the
1-year forward rate as USD1.1950/GBP in
the above example?
What would you do? Conduct a secret CIA
operation!!!

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Covered Interest Arbitrage

(1 0.071)
1.2500 (1 0.1156)

1.2000 1.1950
The calculated f is higher than the quoted f. To
conduct the CIA operation, one would buy
low and sell high in order to make an
arbitrage profit, ie., sell GBP spot and buy
GBP forward.
25

Three steps in the CIA operation:

1. Borrow GBP at 11.56% pa for one year
and sell it (ie., buy USD) at
USD1.2500/GBP
2. Invest the USD to earn 7.1% for one year
3. Sell the USD 1-year forward (ie., buy
GBP forward) at USD1.1950.

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Calculation:
Borrow GBP1 at 11.56% for one year and you
payback GBP1(1+0.1156) = GBP1.1156
Convert into USD at 1.2500, invest the sum to
earn 7.1% pa for one year, you get
USD1.2500(1+ 0.071) = USD1.33875;
Sell USD1.33875 1-year forward at 1.1950,
you get GBP1.1203.
Arbitrage profit = 1.1203 1.1156 =
GBP0.0047.
Arbitrage profit is GBP0.0047 per GBP in one
year.
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Another example on CIA: Given that USD

interest rate: 5% pa, GBP interest rate 8% pa,
Spot exchange rate: USD1.5000/GBP, Oneyear forward: USD1.4800/GBP

(a) First, calculate the effective

rUSD

F
(1 rUSD ) (1 rGBP )
S
1.48

(1.08) 1.0656
1.50
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Since 1.0656 > 1.05, IRP is violated.

The effective interest rate of USD is still lower that that
of GBP at 8%, one should borrow USD at 5% and
lend in GBP to arbitrage.
This approach is easier, but it is better if you
understand the following approach in (b)
(b) Alternately, calculate the forward rate:

F S (1 rUSD ) /(1 rGBP )

1.50(1.05) / 1.08) 1.4583 1.48
So sell GBP forward (ie., buy GBP spot). To buy GBP,
one must borrow USD.
The two approaches would give the same answer. 29

Effective Exchange Rate (called Trade

Weighted Index in Australia, TWI)
Effective exchange rate, is a multilateral
exchange rate which is a weighted average of
exchange rates of home and foreign
currencies, with the weight for each foreign
country equal to its share in trade. It measures
the average price of a home good relative to
the average price of goods of trading partners,
using the share of trade with each country as
the weight for that country.
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The trade weighted index is an economic

instrument used by economies to compare their
exchange rate against those of their major trading
partners. Those trading partners that constitute a
larger portion of an economy's exports and
imports receives a higher index.

The trade weighted index is used to make a

complete comparison between one economy's
currency and other currencies it interacts with. It is
a much more comprehensive analysis than
comparing two currencies, for example, the
Australian dollar and the U.S. dollar.
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The interpretation of the effective exchange

rate is that if the index increases, the
purchasing power of that currency is higher
(the currency strengthened against those of
the country's or area's trading partners).
A lower index means that the currency
depreciated (devaluation) so that you need
more of that currency to pay for imports.
(See Wikipedia:
http://en.wikipedia.org/wiki/Exchange_rate)
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