Chapter 6

International
Parity Conditions
 Learning Objectives

• Examine how price levels and price level changes

(inflation) in countries determine the exchange
rate at which their currencies are traded
• Show how interest rates reflect inflationary forces
within each country and currency
• Explain how forward markets for currencies reflect
expectations held by market participants about
the future spot exchange rate
• Analyze how, in equilibrium, the spot and forward
currency markets are aligned with interest
differentials and differentials in expected inflation

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 International Parity Conditions

• Fundamental questions in international finance:

– What are the determinants of exchange rates?
– Are changes in exchange rates predictable?
• The economic theories which link exchange rates,
price levels, and interest rates together are called
international parity conditions
• These theories may not always work out to be
“true” in the real world

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 Prices and Exchange Rates

• The Law of one price states that all else being

equal (no transaction costs or restrictions) a
product’s price should be the same in all markets
• When prices are in different currencies

P$  S = P¥

P$ - price of the product in US dollars

S - spot exchange rate (S, yen per dollar)
P¥ - price of the product in Japanese yen

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 Prices and Exchange Rates

• Conversely, if the prices were stated in local

currencies, and markets were efficient, the
exchange rate could be deduced from the relative
local product prices

P¥
S $
P

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 Purchasing Power Parity &
The Law of One Price

• If the Law of One Price were true for all goods, the
purchasing power parity (PPP) exchange rate
could be found from any set of prices
• Through price comparison, prices of individual
products can be determined through the PPP
exchange rate
• This is the absolute theory of purchasing power
parity
• Absolute PPP states that the spot exchange rate is
determined by the relative prices of similar basket
of goods

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 Purchasing Power Parity &
The Law of One Price

• The “Big Mac Index” by The Economist is a prime

example of this law of one price:
– Assuming that the Big Mac is identical in all countries,
– It serves as a comparison point as to whether or not
currencies are trading at market prices
– Big Mac costs Yuan 16 in China and $4.56 in the US
– Actual exchange rate Yuan 6.1341/$

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 Purchasing Power Parity &
The Law of One Price

– The price of a Big Mac in Chinese Yuan in U.S.

dollar-terms was therefore:
Yuan 16
= $2.61
Yuan 6.1341/$

– The Economist then calculates the implied

purchasing power parity rate of exchange
using the actual price of the Big Mac in China
over the price of the Big Mac in U.S. dollars:
Yuan 16
= Yuan 3.509/$
$4.56

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 Purchasing Power Parity &
The Law of One Price

• Now comparing the implied PPP rate of exchange,

Yuan 3.509/$, with the actual market rate of
exchange at that time, Yuan 6.1341/$, the degree
to which the Chinese Yuan is either undervalued
or overvalued versus the U.S. dollar is calculated:

Yuan 3.509/$ - Yuan 6.1341/$ = -42.8%

Yuan 6.1341/$

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 Exhibit 6.1 Selected Rates from
the Big Mac Index

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 Relative Purchasing Power
Parity

• PPP is not particularly helpful in determining the

spot rate, but that the relative change in prices
between countries over a period of time
determines the change in exchange rates (relative
PPP)

• Any change in the differential rate of inflation

between 2 countries tends to be offset over the
long run by an equal but opposite change in the
spot rate

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 Exhibit 6.2 Relative Purchasing
Power Parity

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 Empirical Tests of Purchasing
Power Parity

• Empirical tests of both relative and absolute PPP

show
– PPP tends to not be accurate in predicting future
exchange rates
– PPP holds up well over the very long term but is poor for
short term estimates
– The theory holds better for countries with relatively high
rates of inflation and underdeveloped capital markets

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 Exchange Rate Indices:
Real and Nominal

• In order to evaluate a single currency’s value

against all other currencies in terms of whether or
not the currency is “over” or “undervalued,”
exchange rate indices were created
• This problem is often dealt with through the
calculation of exchange rate indices such as the
nominal effective exchange rate index

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 Exchange Rate Indices:
Real and Nominal

• The real effective exchange rate index indicates

how the weighted average purchasing power of
the currency has changed relative to some
arbitrarily selected base period
$
C
E  E x
$
R
$
N FC
C
E$R – USD real effective exchange rate index
E$N – USD nominal rate index
C$ - USD costs
CFC - foreign currency costs

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 Exhibit 6.3 IMF’s Real Effective Exchange
Rate Indexes for the United States, Japan,
and the Euro Area

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 Exchange Rate Indices:
Real and Nominal

– If changes in exchange rates just offset

differential inflation rates – if purchasing power
parity holds – all the real effective exchange
rate indices would stay at 100
– If a rate strengthened (overvalued) or
weakened (undervalue) then the index value
would be ± 100

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 Exchange Rate Pass-
Through
• The degree to which the prices of imported &
exported goods change as a result of exchange
rate changes is termed exchange rate pass-
through
• Incomplete exchange rate pass-through is one
reason that country’s real effective exchange rate
index can deviate from it’s PPP equilibrium point

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 Exhibit 6.4 Exchange Rate Pass-
Through

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 Interest Rates and Exchange
Rates
• The Fisher Effect states that nominal interest rates in each
country are equal to the required real rate of return plus
compensation for expected inflation. As a formula, The
Fisher Effect is

i = r + + r

i - nominal rate of interest

r - real rate of interest
 - expected rate of inflation
r  - cross-product term (usually minor value)

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 Interest Rates and Exchange
Rates

• The international Fisher effect, or Fisher-open,

states that the spot exchange rate should change
in an amount equal to but in the opposite direction
of the difference in interest rates between
countries
– the expected change in the spot exchange rate between
the dollar and yen should be (in approximate form)

S1  S2
x 100  i  i
$ ¥

S2

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 Interest Rates and Exchange
Rates

• Justification for the IFE is that investors must be

rewarded or penalized to offset the expected
change in exchange rates
• The IFE predicts that with unrestricted capital
flows, an investor should be indifferent between
investing in dollar or yen bonds, since investors
worldwide would see the same opportunity and
compete it away

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 Interest Rates and Exchange
Rates
• A forward rate is an exchange rate quoted for
settlement at some future date
• A forward exchange agreement between currencies
states the rate of exchange at which a foreign
currency will be bought forward or sold forward at a
specific date in the future

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 Interest Rates and Exchange
Rates

• The forward rate is calculated for any specific

maturity by adjusting the current spot exchange
rate by the ratio of euro currency interest rates of
the same maturity for the two subject currencies

  FC 90 
 1   i x 360 
  
F90FC/$  SFC/$ x
  $ 90 
 1   i x 360 
  

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 Interest Rates and Exchange
Rates

• Forward Rate example with spot rate of

Sfr1.4800/$, a 90-day euro Swiss franc deposit
rate of 4.00% p.a. and a 90-day euro-dollar
deposit rate of 8.00% p.a.

  90 
 1   0.400x 360 
Sfr/$
F90  Sfr1.4800x
   Sfr1.4800x
1.01
 Sfr1.4655/$
  90  1.02
 1   0.800x 360 
 

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 Interest Rates and Exchange
Rates

• The forward premium or discount is the

percentage difference between the spot and
forward rates stated in annual percentage terms
– When stated in indirect terms (foreign currency per home
currency units, FC/$) then formula is

Spot - Foward 360

f FC
 x x 100
Foward days

– For direct quotes ($/FC), then [(F-S)/S] should be applied

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 Exhibit 6.5 Currency Yield Curves
and the Forward Premium

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 Interest Rates and Exchange
Rates
– Using the previous Sfr example, the forward
discount or premium would be as follows:

Spot - Foward 360

f FC
 x x 100
Foward days

Sfr1.4800 - Sfr1.4655 360

f Sfr
 x x 100   3.96% p.a.
Sfr1.4655 90

– The Swiss franc is selling forward at a premium

of 3.96% per annum (it takes 3.96% more
dollars to get a franc at the 90-day forward
rate)
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 Interest Rates and Exchange
Rates
• The theory of Interest Rate Parity (IRP), states that
the difference in the national interest rates for
securities of similar risk and maturity should be
equal to, but opposite in sign to, the forward rate
discount or premium for the foreign currency,
except for transaction costs

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 Exhibit 6.6 Interest Rate Parity
(IRP)

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 Interest Rates and Exchange
Rates

• Because the spot and forward markets are not

always in a state of equilibrium as described by
IRP, the opportunity for “risk-less” or arbitrage
profit exists
• The arbitrageur who recognizes this imbalance can
invest in the currency that offers the higher return
on a covered basis
• This is known as covered interest arbitrage (CIA)

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 Exhibit 6.7 Covered Interest
Arbitrage (CIA)

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 Interest Rates and Exchange
Rates

• A deviation from CIA is uncovered interest

arbitrage (UIA), wherein investors borrow in
currencies exhibiting relatively low interest rates
and convert the proceeds into currencies which
offer higher interest rates
• The transaction is “uncovered” because the
investor does not sell the currency forward, thus
remaining uncovered to any risk of the currency
deviating

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 Interest Rates and Exchange
Rates

• Rule of Thumb:
– If the difference in interest rates is greater than
the forward premium (or expected change in
the spot rate), invest in the higher yielding
currency.
– If the difference in interest rates is less than the
forward premium (or expected change in the
spot rate), invest in the lower yielding currency.

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 Exhibit 6.8 Uncovered Interest Arbitrage
(UIA): The Yen Carry Trade

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 Exhibit 6.9 Interest Rate Parity
(IRP) and Equilibrium

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 Forward Rates as an
Unbiased Predictor

• If the foreign exchange markets are thought to be

“efficient” then the forward rate should be an
unbiased predictor of the future spot rate
• The forward rate predicts the future spot
exchange rate, and it will often “miss” the actual
future spot rate, but it will miss with equal
probabilities (directions) and magnitudes
(distances)

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 Exhibit 6.10 Forward Rate as an Unbiased
Predictor for Future Spot Rate

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 Prices, Interest Rates and
Exchange Rates in Equilibrium
• (A) Purchasing power parity
– forecasts the change in the spot rate based on differences in
expected rates of inflation
• (B) Fisher effect
– nominal interest rates are the required real rate of return (r)
plus expected inflation ()
• (C) International Fisher effect
– the spot exchange rate should change in an amount equal to
but in the opposite direction of the difference in interest rates
between countries

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 Prices, Interest Rates and
Exchange Rates in Equilibrium
• (D) Interest rate parity
– the difference in the national interest rates should be equal to,
but opposite in sign to, the forward rate discount or premium
for the foreign currency, except for transaction costs
• (E) Forward rate as an unbiased predictor
– the forward rate is an efficient predictor of the future spot rate

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 Exhibit 6.11 International Parity
Conditions in Equilibrium (Approximate
Form)

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 Summary of Learning Objectives

• Under freely floating rates, the expected rate of

change in the spot exchange rate, differential rates of
national inflation and interest, and the forward
discount or premium are all directly proportional to
each other and mutually determined
• Law of one price – if identical products or services
can be sold in two different markets, and there are
no restrictions on its sale or transportation costs, the
product’s price should be the same in both markets

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 Summary of Learning Objectives

• Absolute PPP - the spot exchange rate is

determined by the relative prices of similar
baskets of goods
• Relative PPP - any change in the differential rate
of inflation between two countries tends to be
offset over the long run by an equal but
opposite change in the spot exchange rate
• Fisher effect - nominal interest rates in each
country are equal to the required real rate of
return plus compensation for expected inflation

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 Summary of Learning Objectives

• IFE - the spot exchange rate should change in an

equal amount but in the opposite direction to the
difference in interest rates between two countries
• IRP - the difference in the national interest rates
for securities of similar risk and maturity should
be equal to, but opposite in sign to, the forward
rate discount or premium for the foreign currency,
except for transaction costs

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 Summary of Learning Objectives

• CIA - the potential for arbitrage profit when the

spot and forward exchange markets are not in
equilibrium as described by interest rate parity
• Some forecasters believe that for the major
floating currencies, foreign exchange markets are
“efficient” and forward exchange rates are
unbiased predictors of future spot exchange rates

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