WEB APPENDIX

INTERNATIONAL PARITY CONDITIONS

INTRODUCTION
Chapter 6 of the textbook focused on long-term trends of exchange rates and international trade ows. This appendix sketches the forces that determine the short-term ows of international capital. Further discussion of the equilibrium conditions in international nance can be found in Chapter 22 of R. Charles Moyer, James R. McGuigan, and William J. Kretlow, Contemporary Financial Management, 10th ed. (Mason, OH: South-Western/Thomson Learning, 2006). Between 2000 (Q2) and 2001 (Q3), U.S. business loan demand collapsed, and as a result, the price of short-term loanable funds borrowed by the U.S. Treasury shrank dramatically from 6.5 percent to 3.7 percent. This downward interest rate trend continued so that by 2002 (Q3), the nominal yield on 90-day Treasury bills (T-bills) had fallen below 200 basis points (i.e., 2%) to just 1.7 percent. In other words, the 90-day promissory obligations of the U.S. Treasury to repay in $1,000 units up to $1 million sold at such a small discount relative to their face value that the implied yield fell to 1.7 percent.1 In contrast, 90-day euro area government bills in 2002 (Q3) yielded 3.3 percent interest. Because these debt contracts obligate the issuer to make a certain known interest payment when due, and because neither the U.S. Treasury nor any of the euro area governments have any signicant default risk, 1.7 percent and 3.3 percent are characterized as risk-free returns. For a foreign investor, however, one risk of cash ow loss remained. To obtain the higher eurobills 3.3 percent interest, a foreign investor (perhaps an American) could invest $100,000 for 90 days in eurobills and expect a (1 .033).25 return. However, the eurobill would pay its interest obligation in euros! So, unless the American investor had previously planned a summer vacation in Europe (or had some other use for the euros), two foreign exchange transactions would be necessary to obtain the higher 3.3 percent eurobill interest. First, the American investor would convert the initial $100,000 to euros at the spot exchange rate (e0), say at par 1.0 US$ per euros in August 2002. Using the euros () to buy a 100,000 eurobill for 99,192,2 the investor would then be entitled 90 days later to receive the 100,000 principal plus interest. At the end of the transaction, the investor then converts the euros back to U.S. dollars at whatever exchange rate existed on day t 90. And of course, the value of the 100,000 receivables due could well have declined over the 90-day holding period of the investment, cutting into the 3.3 percent interest return or even making the net return in U.S. dollars turn negative. To avoid this exchange rate risk exposure, the American investor could engage in covered interest arbitrage. After spending $99,192 in the spot market to acquire euros at the $1/ spot rate e0 and then buying the eurobill, the investor could immediately sell the 100,000 receivables due in 90 days in the forward market for euros to reacquire U.S. dollars. With all this selling forward of euros by foreign investors pouring

An auction sale price of $99,579 for a $100,000 T-bill implies a 1.7 percent interest return if the principal is repaid 1/4 of a year later because $100,000/$99,579 $(1 .017).25.
2

99,192

100,000/(1

0.033).25

WB-1

WB-2

WEB APPENDIX B

International Parity Conditions

into the eurobills and desiring to cover their long position in euro receivables, the forward rate $/ (the price of the euro) will decline. Just how much it will now decline is a function of how much the spot rate rose earlier as foreign capital bought euros in the spot market to secure the higher eurobill interest. That amount, in turn, depends on how divergent the interest rates between the U.S. T-bill and the eurobill became before setting off a oodtide of covered interest arbitrage. The interest rate parity condition says that the equilibrium exchange rate emergent from 90-day-forward buying and selling transactions f90 will differ from the spot rate as a percentage of the spot rate by approximately the difference in the two yields: (f90 e0) e0 [rUS rEMU] [WB.1]

where f and e are the U.S. dollar value of the euro, $/. That is, (f90 1.0) 1.0 [1.017 1.033] .016 (i.e., the forward rate f90 for the dollar value of the euro will fall until it becomes 1.6 percent lower than the current spot exchange).3 Under the expectation theory of interest rates, this forward rate for day 90 is an unbiased estimate of the expected future spot rate on day 90. So, the dollar value of the euro $/, which had previously risen sharply as divergent interest rates set off a ow of international capital into euro-denominated investments, is expected to fall 1.6 percent over the next 90 days. Across developed countries with free movement of capital within well-established capital markets, therefore, nominal interest rate differentials for investments of comparable risk seldom persist. The reason is that covered interest arbitrage sets off a oodtide of capital into those economies with higher interest rates and out of those economies with lower real interest rates. Increased supply of loanable funds in the euro area in our previous example and decreased supply of loanable funds in the United States raises the nominal interest rate (the price of loanable funds) in the euro area and lowers it in the United States. At times the daily ow of such capital transactions exceeds $1.5 trillion.4 Because of this enormous mobility of short-term capital investment across international borders, divergent interest rates quickly converge, often within a few hours or days. In summary, if EMU-member governments have been paying 3.3 percent on 90-day bills and the U.S. Treasury has been paying 1.7 percent on 90-day T-bills, and everything else that might matter is the same, the spot rate of the euro will be expected to depreciate by approximately 1.6 percent against the U.S. dollar over the next 90 days. These relationships between interest rate differentials and expected future changes in spot exchange rates are described on the left side of Figure WB.1. In the previous example, we said little about why the 90-day T-bill and 90-day eurobill rates might have differed by as much as 1.6 percent. A famous monetary economist, Irving Fisher, hypothesized that nominal interest rates for risk-free investments differ primarily because of differences in expected ination rates. The international Fisher effect states that a nominal interest rate r in one currency area equals the real rate of interest i plus the expected consumer ination rate in that currency area: r i Ex(% CPI) [WB.2]

3 4

Or, more precisely, e90 /e0

[(1

rEMU)/(1

rUS)] 1.015733, where e is the US$ value of the euro ($/).

Just ten days of international capital ow across all currency markets is the same order of magnitude as the capitalized value of all the NYSE-listed stocks, $15 trillion.

WEB APPENDIX B

International Parity Conditions

WB-3

Figure WB.1

International Parity Conditions: An Integrative Look

Forecasted Future Spot Exchange Rate ($ per ) 1.6% ( weakens; $ strengthens)

Forward Rate as an Unbiased Estimator of the Future Spot Rate

Relative Purchasing Power Parity

Forward Premium or Discount on Foreign Currency (observed) 1.6%

International Fisher Effect

Difference in Expected Inflation Rates E.U. U.S. (forecasted) +1.6%

Interest Rate Parity Difference in Nominal Interest Rates E.U. U.S. (observed) +1.6%

Fisher Effect

Assume: U.S. nominal interest rate = 1.7% EU nominal interest rate = 3.3% Time horizon = 90 days

Perhaps, in the example, the expected ination rate in the euro area was 1.6 percent higher than the expected ination rate in the United States. In that case, the ination-adjusted real rate of interest in the two currency areas would be identical. For example, if the Ex(% CPI)US 0.5 percent and the Ex(% CPI)EMU 2.1 percent, then the real rate of interest in the United States would be 1.7 0.5 1.2 percent, whereas the real rate of interest in the euro area would be 3.3 2.1 also 1.2 percent. This ination-adjusted real rate of interest ultimately motivates foreign investors to move capital from one currency area to another. This motivation is a rational basis for interest rate arbitrage because, as we have seen, the net return to a foreign capital investment is the nominal interest return minus the expected change in the spot exchange rate at the time the bill is redeemed. And it turns out that the ination

WB-4

WEB APPENDIX B

International Parity Conditions

differential is a good forecast of the expected change in the spot exchange rate over the holding period of an investment. Another international parity condition denes this relationship between ination rates and future changes in the spot exchange rate. In particular, relative purchasing power parity (relative PPP) states that arbitrage in traded goods between currency areas will cause spot exchange rates to change by the difference in the ination rates in the two currency areas: (e90 e0) e0 [Ex(% CPI)US Ex(% CPI)EMU] [WB.3]

So, if 2.1 percent ination were forecast for the next 90 days in the euro currency area and 0.5 percent ination were forecast for the next 90 days in the United States, relative PPP implies that the American investor in the previous example should anticipate losing 1.6 percent of any return upon redemption when converting the euro principal and interest back into U.S. dollars at the end of 90 days. With this information, an investor would have little or no reason for the foreign capital investment in the rst place because the real rates of interest in the two currencies were identical. Again, in the example, the real rate of interest in the United States would be 1.7 0.5 1.2 percent, whereas the real rate of interest in the euro area would be 3.3 2.1 also 1.2 percent. These relationships between ination rate differentials and expected future changes in spot exchange rates are described on the right side of Figure WB.1. All three international adjustment processes are simultaneously at work achieving the international parity conditions that characterize international capital ows. Covered interest arbitrage will cause forward exchange rates and expected future spot exchange rates to reect interest rate differentials in accordance with interest rate parity, goods arbitrage will cause expected future spot exchange rates to reect ination differentials in accordance with relative purchasing power parity, and international capital ows will cause divergent interest rates on investments of comparable risk to converge. The timing goes like this: Spot exchange rates for the higher-interest currency will rise to reect the oodtide of foreign investment capital into the higher-interest currency area. Forward rates for the higher-interest currency will then decline to reect the foreign investors covering their long positions in the higher-interest currency. All of these adjustments will happen quickly, and once they do, the ow of international capital will stop, because no further covered interest parity can be protable. More gradually, if the higher interest rates in the euro area are reecting higher expected ination, then the euro spot exchange rates will in fact decline over time to reect the expected ination and reduced exports from the higher-interest currency area. If, instead, the higher interest rates in the euro area are reecting new investment opportunities, then the euro quickly appreciates in the spot market; the euro spot rate then gradually drifts lower as interest rates fall, reecting the increased supply of investment capital into the euro area. In both cases, the time path of the $/ exchange rate is an early spike in the value of the euro followed by a gradual descent.