International Parity Conditions

2
Introduction
Managers of multinational firms, international
investors, importers and exporters, and government
officials must deal with these fundamental issues:
Are changes in exchange rates predictable?
How are exchange rates related to interest rates?
What, at least theoretically, is the proper
exchange rate?

To answer these questions we need to first understand
the economic fundamentals of international finance,
known as parity conditions.
3
Parity Conditions
Parity Conditions provide an intuitive explanation of the
movement of prices and interest rates in different
markets in relation to exchange rates.
The derivation of these conditions requires the
assumption of Perfect Capital Markets (PCM).
no transaction costs
no taxes
complete certainty
NOTE Parity Conditions are expected to hold in the
long-run, but not always in the short term.


4
Purchasing Power Parity (PPP)
PPP is based on the notion of arbitrage across
goods markets and the basic building block of
PPP is the Law of One Price (LOP).
LOP states that the price of an identical good
should be the same in all markets (assuming no
transactions costs).
Otherwise, one could make profits by buying the
good in the cheap market and reselling it in the
expensive market.
5
The Law of One Price
LOP states that a products price may be stated in
different currency terms, but the price of the product
should remain the same.
Comparison of prices would only require conversion from
one currency to the other:


Conversely, the exchange rate could be deduced from the
relative local product prices:

$
/ $
P
P
S =
$ $
P S P =
6
LOP Example
P
wheat, Aust
= $4/bushel and P
wheat, UK
= 2.5/bushel
Spot rate (A$/) = 1.70


A$ equivalent price of wheat in UK is A$1.70/ *2.5
= $4.25/bushel
Implication: The demand for Australian wheat will
increase forcing up its price. The price of UK wheat will
drop.
wheat
UK
wheat
Aust
P S P =
/ $
7
The Big Mac Index
The most famous test is The Economist magazines
Big Mac Hamburger standard.

First launched in 1986, updated ever since.
For example, see:
http://www.oanda.com/products/bigmac/bigmac.shtml


8
9
Research on the Big Mac Index
Pakko and Pollard (1996) conclude that Big Mac PPP
holds in the long-run, but currencies can deviate from it
for lengthy periods. They note several reasons why the
Big Mac index may be flawed:
It assumes that there are NO barriers to trade.
Prices are distorted by taxes.
Profit margins may vary according to competition.
Prices of non-traded goods (real estate, utilities, labor)
are also inputs that affect production costs.
10
Working for a Big Mac


Big Mac
Price (US $)
Net Hourly
Wage (US $)
Minutes of work
to buy a Big Mac
Big Mac
Price (US $)
Net Hourly
Wage (US $)
Minutes of work
to buy a Big Mac
Argentina 1.42 1.70 50 Mexico 2.18 2.00 65
Australia 1.86 7.80 14 New Zealand 2.22 6.80 20
Brazil 1.48 2.05 43 Peru 2.28 2.20 62
Britain 3.14 12.30 15 Philippines 2.24 1.20 112
Canada 2.21 9.35 14 Poland 1.62 2.20 44
Chile 1.96 2.80 42 Russia 1.32 2.60 30
China 1.20 2.40 30 Singapore 1.85 5.40 21
Colombia 2.13 1.90 67 South Africa 1.85 3.90 28
Czech Republic 1.96 2.40 49 South Korea 2.70 5.90 27
Denmark 4.09 14.40 17 Sweden 3.60 10.90 20
Euro area 2.98 9.59 19 Switzerland 4.60 17.80 16
Hong Kong 1.47 7.00 13 Taiwan 2.01 6.90 17
Hungary 2.19 3.00 44 Thailand 1.38 1.70 49
Indonesia 1.84 1.50 74 Turkey 2.34 3.20 44
Japan 2.18 13.60 10 United States 2.71 14.30 11
Malaysia 1.33 3.10 26 Venezuela 2.32 2.10 66

11
A New Index Starbucks Index


12
Absolute PPP
A less extreme form of the Law of One Price is
ABSOLUTE PPP which says that the price of a basket
of goods should be the same in each market.
The PPP exchange rate between the two countries
should then be:

Absolute PPP:
t F
t D F D
t
PI
PI
S
,
, /
=
PI
D,t
(PI
F,t
) is the domestic (foreign) price index (e.g., consumer
price index) at time t.
13
Relative Purchasing Power Parity
Relative PPP claims that exchange rate movements
should exactly offset any inflation differential between
two countries:

Relative PPP:
F
D
t
t
+
+
=
+
1
1
S
S
D/F
t
D/F
1 t
We can also write:
F
D
t
t
+
+
=
+
1
1
S S
D/F
t
PPP
1 t
Percentage
change in
domestic prices
F
F D
t
t t
+

+
1 S
S S
D/F
t
D/F
t
D/F
1 t
14
Relative PPP
Relative PPP implies that the change in the exchange rate
will offset the difference between the relative inflation of
two countries.
The previous formula can be approximated as:

where,
D
and
F
refers to the percentage change in
domestic and foreign price levels respectively and As to
the percentage change in the exchange rate.
If domestic inflation > (<) foreign inflation, PPP predicts
the domestic currency should depreciate (appreciate).
F D
s t t = A
15
Relative PPP Example
Given inflation rates of 5% and 10% in Australia and the UK
respectively, what is the prediction of PPP with regards to $A/GBP
exchange rate?




= (0.05 0.10)/(1 + 0.10) = - 0.045 = - 4.5%
The general implication of relative PPP is that countries with
high rates of inflation will see their currencies depreciate
against those with low rates of inflation.

F
F D
t
t t
S
S S
t
t t
+

1
1
1
Relative PPP
16
How well does PPP work?
We have seen that the strictest version of PPP that all
goods and financial assets obey the law of one price is
demonstrably false.
However, there is clearly a relationship between relative
inflation rates and changes in exchange rates.
Currencies that have had the largest relative decline
(gain) in purchasing power see the sharpest erosion
(appreciation) in their foreign exchange values.
17
Relative Purchasing Power Parity
Applications of Relative PPP:
1. Forecasting future spot exchange rates.
2. Calculating appreciation in real exchange rates.
This will provide a measure of how expensive a
countrys goods have become (relative to another
countrys).

18
Forecasting Future Spot Rates
Suppose the spot exchange rate and expected inflation
rates are:


What is the expected /$ exchange rate if relative PPP
holds?

2% 5%; $; / 90 S
. . t0 /$,
= = =
Japan S U
t t
( ) $ / 43 . 87
05 . 1
02 . 1
$ / 90
1
1
$

0 , / 1 $, /
=
|
.
|

\
|
=
|
|
.
|

\
|
+
+
=
t
t
t S
PPP
t
S S
19
Real Exchange Rate
By definition, the real exchange rate measures
deviations from PPP.
That is, changes in the spot exchange rate that do not
reflect differences in inflation rates between the two
currencies in question.


Real Exchange Rate:
PPP
1 t
1 t
S
S
E
+
+
=
20
Real Exchange Rate
Appreciation/depreciation in the real exchange rate
measures deviations from PPP.
When E = 1, the denominator currency is valued correctly.
The competitiveness of this country is unaltered.
When E < 1, the denominator currency is undervalued.
Products from the other country seem expensive relative to
the base year. That is, the competitiveness of the
denominator country improves.
When E > 1, the denominator currency is overvalued.
Products from the other country seem cheap relative to the
base year. That is, the competitiveness of the denominator
country deteriorates.

21
The Fisher Effect
The international Fisher relation is inspired by the
domestic relation postulated by Irving Fisher (1930).
The Fisher effect (also called Fisher-closed) states:


This relation is often presented as a linear
approximation stating that the nominal interest rate is
equal to a real interest rate plus expected inflation:
( ) ( )( ) t t t r r i r i + + = + + = + 1 1 1
t + ~r i
22
The Fisher Effect
Applied to two different countries, like Australia and
Japan, The Fisher Effect would be stated as:



It should be noted that this requires a forecast of the
future rate of inflation, not what inflation has been in
the past.
$ $ $
i r t ~ +

t + ~ r i
23
The International Fisher Effect
The International Fisher Effect (also called Fisher-open)
states that the spot exchange rate should change to
adjust for differences in interest rates between two
countries:



F
D
F D
t
F D
t
i
i
S
S
+
+
=
+
1
1
/
/
1
24
The International Fisher Effect
The Fisher effect applied to two different countries like
Australia and Japan would be:
(1) (1+i
$
) = (1+r
$
)(1+t
$
)
(2) (1+i

) = (1+r

)(1+t

)
Dividing (1) by (2), we get:
(3)


|
|
.
|

\
|
t +
t +
|
|
.
|

\
|
+
+
=
+
+

$
1
1
r 1
r 1
i 1
i 1
= 1
25
The International Fisher Effect
If real interest rates are equalized across countries, then
for equation (3) we get r
$
= r

:


(4)

$
1
1
i 1
i 1
t +
t +
=
+
+
(5)

$
1 1 t
t t
+

=
+

i
i i
Remember this?
F
F D
t
t t
S
S S
t
t t
+

+
1
1
F
F D
t
t t
i
i i
S
S S
+

+
1
1
International Fisher:
E(S
t+1
)
26
Tests of the International Fisher Effect
Empirical tests lend some support to the relationship
postulated by the international Fisher effect (currencies
with high interest rates tend to depreciate and currencies
with low interest rates tend to appreciate), although
considerable short-run deviations occur.





27
Interest Rate Parity
Interest rate parity (IRP) is an arbitrage condition that
provides the linkage between the foreign exchange
markets and the international money markets.

f
d
t
t t
i
i
S
F
+
+
=
+
1
1
1 ,
where, F
t
and S
t
are the forward and spot rates and i
d

and i
f
are domestic and foreign interest rates
respectively.
Interest Rate Parity (IRP)
28
Interest Rate Parity
The approximate form of IRP says that the % forward
premium equals the difference in interest rates.


f d
t
t t
i i
S
F
~
+
1
1 ,
In general, the currency trading at a forward premium
(discount) is the one from the country with the lower
(higher) interest rate.
Approximation of IRP
f d
t
t t t
i i
S
S F
~

+1 ,
29
Interest Rate Parity An Example
Basic idea: Two alternative ways to invest funds over
same time period should earn the same return.

Suppose the 3-month money market rate is 8% p.a. (2%
for 3-months) in the U.S. and 4% p.a. (1% for 3-
months) in Switzerland, and the spot exchange rate is
SFr1.48/$.

The 3-month forward rate must be SFr1.4655/$ to
prevent arbitrage opportunities (i.e., interest rate parity
must hold).

30
The Example Continued
90 days
S = SF 1.4800/$
SF 1,480,000
Dollar money market
$1,000,000 $1,020,000 1.02
Start End
i
$
= 8.00 % per annum
(2.00 % per 90 days)
Swiss franc money market
SF 1,494,800 1.01
i
SF
= 4.00 % per annum
(1.00 % per 90 days)
F
90
= SF 1.4655/$
$1,019,993
*

* Rounding error.
31
Interest Rate Parity: Why It Holds
This must hold by arbitrage. Otherwise riskless profits
could be made. This is known as covered interest
arbitrage (CIA) and occurs whenever IRP does not
hold. CIA can involve the following steps:
Borrow the domestic currency;
Exchange the domestic currency for the
foreign currency in the spot market;
Invest the foreign currency in an interest-
bearing instrument; and then
Sign a forward contract to lock in a future exchange rate
at which to convert the foreign currency proceeds back to
the domestic currency.