International

Parity
Relationships

Assumptions of parity
relationships

Parity relationships hold only for perfect capital market

conditions:

No capital controls on flow of capital across countries

No transaction cost
No taxes on cross border movement of goods, services and capital
No political risk in transacting with different countries

Purchasing Power Parity

Law of one price states that price of the standard commodity

basket be the same across countries when measured in common
currency

Absolute version
s = Pa
Pb

Where s is a spot exchange rate between currencies. Pa and Pb are

prices of same commodity basket in two countries

PPP

Relative version
Et = (1+ Ia)t
E0

(1+ Ib)t

Where Et and E0 are spot exchange rates in time period t and in the
beginning of the period respectively indicating no of units of
currency of country a in terms of currency of country b
Example:
If inflation in India is 5% and 3% in US. What would be
the spot exchange rate of 60 INR per USD after two years?

Deviations to PPP

Transaction costs

Non tradable goods

Taxes and tariff

PPP usually holds in Long run

Interest rate parity

In efficient market, the interest rate differential should be

(approximately) equal to the forward differential.

country with lower interest rate

country with higher interest rate
F =

1+ Inta

1+ Intb

currency at forward premium

currency at forward discount

Where F and S are n month forward rate and spot rates respectively
expressed as direct quote for country a. Inta and Intb are n month
interest rates for countries a and b.

CIP

Two options to invest 1USD

(1)

Invest domestically at Ius;

(2)

maturity value= 1(1+Ius)

Invest in Indian market;

(i) convert 1 USD into INR; i.e. S, if S is the spot rate
(ii) Invest in India at Iind; i.e. maturity value= S(1+Iind)
(iii) Sell INR forward at Forward rate, F;
received dollar= S(1+Iind)
F

IRP says;

1(1+Ius) = S(1+Iind)
F

i.e. F =
S

1+ Iind
1+Ius

Covered Interest arbitrage

USD/CAD spot 1.317
USD/CAD 6 month forward 1.2950
Annual Interest rates; US 10% and Canada 6%
Is forward discount/premium is equal to interest rate differential ?
1)

Borrow CAD say 1000 at 6% p.a. for 6 months

2)

Convert it into USD; 1000/1.317= 759.3 USD

3)

Invest in US; maturity value after 6 months= 759.3(1+0.05)= 797.23 USD

4)

Sell USD forward and receive 797.23x1.295= 1032.4 CAD

5)

Repayment of CAD loan= 1000(1+ 0.03)= 1030

6)

Gain= CAD (1032.4-1030)= 2.4 CAD

Equilibrium reaches because;

Borrowing in canada will raise interest rates

Investing in USA lowers interest rate

Buying USD at spot rate will appreciate spot USD rate

Selling USD forward will depress forward rate

It narrows down the interest rate differential and widens forward

rate differential to reach parity

Determination of Forward rate

Based on IRP, forward rate can be easily determined:

If annual interest rate is 10% and 7% in India and US respectively.

The spot rate is 60 INR per USD. The 90 day forward rate would
be?

Fisher/ International Fisher Effect

An increase(decrease) in the expected inflation rate in a country

will cause a proportionate increase(decrease) in the interest rate
in the country.
1+ r = ( 1+ a) (1+ I)

Where r is nominal interest rate, a is real interest rate and I is

expected rate of inflation.
International Fisher Effect states that the interest rate differential
shall equal the inflation rate differential