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International Parity Relationships and Forecasting Foreign Exchange Rates

Chapter Objective:

Chapter Six

This chapter examines several key international parity p y relationships, p , such as interest rate parity p y and purchasing power parity.

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Chapter Outline
Interest Interest Rate Rate Parity Parity
Covered Interest Arbitrage Purchasing Purchasing Power Power Parity Parity PPP Deviations and Fisher The The Fisher Fisher Effects Effects Effects

International Forecasting ForecastingExchange Fisher Exchange Effects Rates Rates Purchasing Power Parity The Fisher Market Effects Efficient Approach

IRP and Exchange Rate Determination the Real Exchange Rate Reasons for Deviations from IRP Evidence on Purchasing Power Parity

The Fisher F Forecasting i Effects E Exchange h Rates R Fundamental Approach Forecasting Exchange Rates Technical Approach

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Interest Rate Parity

Interest Rate Parity Defined Covered Interest Arbitrage Interest Rate Parity & Exchange Rate Determination Reasons for Deviations from Interest Rate Parity

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Interest Rate Parity Defined

IRP is an no arbitrage condition. If IRP did not hold, then it would be possible for a trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we dont typically observe persistent arbitrage conditions, conditions we can safely assume that almost all of the time! IRP holds.

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Variable Definitions
iH : Interest Rate in the home country iF : Interest Rate in the foreign country S = Current spot rate for the foreign currency (in direct quote) F = 1 year forward rate for the foreign currency (in direct quote) FPH = one year forward premium from the home countrys viewpoint = (F-S) / S FPF = one year forward premium from the foreign countrys viewpoint = (S- F) / F or (1/ FPH 1) iCH : Covered rate of interest, from the home countrys viewpoint iCF : Covered rate of interest, from the foreign countrys viewpoint (1 + i ) F\$/ = S\$/ (1 + i\$)
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Interest Rate Parity Carefully Defined

Consider two alternative one-year investments for \$1 1. You could invest in the US at iH. Future value of this investment in \$ will be: \$1 (1 + iH) = (1 + iH) 2. Or you could convert \$1 into the foreign currency at the going spot rate (S) and invest 1/S in the foreign country at iF whose future value will be: [1/S (1 + iH)]. In order to eliminate any exchange rate risk, you will have to sell this amount at forward rate (F) to get you money back in \$: F x [1/S (1 + iH)]

Since these investments have the same risk, they must have the same future value (otherwise an arbitrage would exist) (1 + i\$) F F = S \$/ \$/ (1 + iF) = (1 + iH) (1 + i)
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Interest Rate Parity Defined

Formally, y,

1 + iH F = S 1 + iF 1 + iH 1 + iF -1 = FS S = FP

Or

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Interest Rate Parity Carefully Defined

Depending upon how you quote the exchange rates, direct (S, F) or indirect (SI, FI), we have:

1 + iF FI = 1 + iH SI

or

1 + iH F = 1 + iF S

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Interest Rate Parity Carefully Defined

No matter how you quote the exchange rate (direct or indirect) to find a forward rate, increase the dollars by the dollar rate and the foreign currency by the foreign currency rate:

FI = SI

1 + iF 1 + iH

or

F= S

1 + iH 1 + iF

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Covered Rate of Interest

Home Countrys viewpoint (iCH) = (1 + iF) x (1 + FPH ) - 1 F i Countrys Foreign C viewpoint i i (iCF) =
(1 + i\$) (1 + iH) x (1 + FP )-1 F F \$/ = S\$/
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(1 + i)

IRP & Covered Interest Arbitrage (CIA)

CIA is possible when: iCH > iH iCF > iF When CIA is possible, iH, iF , and FP will have to adjust to eliminate arbitrage. IRP holds when CIA is not possible: iCH = iH (1 + i\$) iCF = iF F\$/ = S\$/ (1 +i )
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IRP and Covered Interest Arbitrage

If IRP failed to hold, , an arbitrage g would exist. It is easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.
Spot exchange rate for GBP 360-day forward rate for GBP US interest rate British interest rate S = \$2.0000 \$2 0000 F = \$1.9700 iH = 5.00% iF = 8.00%

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IRP and Covered Interest Arbitrage

If IRP failed to hold, , an arbitrage g would exist. It is easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.
Spot exchange rate for GBP 360-day forward rate for GBP US interest rate British interest rate S = \$2.0000 \$2 0000 F = \$1.9100 iH = 5.00% iF = 8.00%

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IRP and Covered Interest Arbitrage

If IRP failed to hold, , an arbitrage g would exist. It is easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.
Spot exchange rate for BP 360-day forward rate for BP US interest rate British interest rate S = \$2.0000 \$2 0000 F = \$2.0400 iH = 8.00% iF = 4.00%

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IRP and Covered Interest Arbitrage

If IRP failed to hold, , an arbitrage g would exist. It is easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.
Spot exchange rate for BP 360-day forward rate for BP US interest rate British interest rate S = \$2.000 \$2 000 F = \$2.090 iH = 8.00% iF = 4.00%

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Reasons for Deviations from IRP

Transactions Costs

The interest rate available to an arbitrageur for borrowing, ib may exceed the rate he can lend at, il. There may be bid-ask spreads to overcome, Fb/Sa < F/S

Capital Controls

Governments sometimes restrict import and export of money through taxes or outright bans.

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Reasons for Deviations from IRP

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The concept of Absolute and Relative Purchasing Power Parity (PPP) PPP and Exchange Rate Determination PPP Deviations and the Real Exchange Rate Consequences of PPP Violations Evidence on PPP

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A dollar should buy the same quantities of goods and services in all countries According to absolute PPP, in the long run, currencies should move towards the rate which equalizes the prices of an identical basket of goods and services in each country The exchange rate (direct quote) between two (S) currencies should equal the ratio of the countries price levels in the home (PH) and foreign (PF) country: S = (PH / (PF) Examples
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Absolute Purchasing Power Parity and Exchange Rate Determination

PH PF For example, if an ounce of gold costs \$1200 in the U.S. and 800 in Europe, then the price of one euro in terms of dollars should be: \$1200 \$1 50/ S = 800 = \$1.50/ S= What happens if S = 1.25 or S = 1.75?
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Evidence on Absolute PPP

Absolute PPP probably doesnt hold precisely in the h real l world ld for f a variety i of f reasons:

Haircuts cost 10 times as much in the developed world as in the developing world. Film, on the other hand, is a highly standardized commodity that is actively traded across borders.

Shipping costs, as well as tariffs and quotas can lead to deviations from PPP.

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PPP: Evidence

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Does PPP Hold? The Case of Big Mac

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Even if the dollar does not buy the same basket of goods in other countries, the purchasing power of the h d dollar ll in i these h countries i could ld remain i stable bl over time. We can show that according to Relative PPP:

If two countries have different inflation rates, then the exchange rates between the two countries will adjust to maintain equality of relative purchasing power for the citizens of both countries. The real exchange rate will remain constant

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Variable Definition
S= Current spot rate (price of foreign currency) in direct quote S1 = Actual spot rate, 1 year from now F = 1-year forward rate FP = the forward premium = [(F-S) / S] = [(F/S) - 1] H = Inflation rate in the home country F = Inflation rate in the foreign country E(S1) = Expected spot rate, 1 year from now, based on PPP E(e) = [E(S1)/S] 1 = The expected percentage change, or rate of change, in the spot rate, based on PPP e = (S1/S) 1 = The actual percentage change, or rate of change, in the spot rate Sr= real spot rate
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Absolute Purchasing Power Parity and Exchange Rate Determination

PH PF For example, if an ounce of gold costs \$1200 in the U.S. and 800 in Europe, then the price of one euro in terms of dollars should be: \$1200 \$1 50/ S = 800 = \$1.50/ S= What happens if S = 1.25 or S = 1.75?
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Purchasing Power Parity and Exchange Rate Determination

Suppose the spot exchange rate (S) is \$1.50 = 1.00 If the inflation rate in the U.S. (H) is expected to be 5% in the next year and 3% in the euro zone(F), Then the expected exchange rate in one year E(S) should be such that \$1.50(1.05) = 1.00(1.03)

\$1.50(1.05) 50 (1 05) \$1.575 \$1 575 = \$1.5291 E(S1) = \$1 = 1.00(1.03) 1.03 E(e) = [E(S1)/S 1] = \$1.5291 - 1 = .019 = 1.94% \$1.50
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Purchasing Power Parity and Exchange Rate Determination

Because of the inflation differential, the euro is expected to appreciate by 1.94% in the spot market by the end of the year:

E(S1) = S

\$1.50(1.05) 1.00(1.03) \$1.50 1.00

1.05 1 + H = 1.03 1 + F

Relative PPP states that the rate of change in the exchange rate is equal to differences in the rates of inflationroughly 2% Also remember that E(S1) = F So that: expected rate of change in the exchange rate = forward premium, or E(e) = FP
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Real Exchange Rate

Real exchange rate is the spot rate adjusted for inflation, let us call it Sr . It is supposed to tell us if a foreign currency has appreciated or depreciated, after adjusting for inflation.

Sr

S1

Under PPP, real exchange rates should remain constant Suppose the US the current spot rate for is 1.50 and US inflation rate is 5% while the inflation rate is 3% in the euro zone If the spot rate next year turns out to be 1.52, zone. 1 52 the real exchange rate is: 1.52*(1.03/1.05) = \$1.491
We can say that although the spot rate for appreciated in nominal terms from \$1.50 to \$1.54, it actually depreciated in real terms from \$1.50 to \$1.491 This would weaken the USs competitive position against Europe
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PPP & Competitiveness

We can also use PPP to determine the competitiveness of the home countrys currency

= = = E(S1)/S1

q = 1: Competitiveness of home country is unchanged q < 1: Competitiveness of home country has improved q > 1: Competitiveness of home country has deteriorated
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PPP Conditions Summarized

PPP is Violated PPP Holds Foreign g currency y has Foreign g currency y has appreciated (USD has depreciated (USD has depreciated) in real appreciated) in real terms terms
No Change US exports more competitive US exports less competitive

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S1 < E(S1) e < E(e) S< Sr q>1

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PPP: EXAMPLE 1

Inflation rate in the US is 5%; H = 0.05 Inflation rate in the Europe is 3%; F = 0.03 Current spot rate for is \$1.50; S = 1.50 To maintain relative PPP PPP, the expected percentage change in the spot exchange rate for , E(e) = (1.05) / (1.03) - 1 = 1.9417 % To maintain relative PPP, the expected spot exchange rate for , at the end of the year, E(S1) = \$1.50 ( 1 + 0.019417)= \$1.5291 per
\$1.54 higher 2 027 % 2.027 \$1.5107 0.9929 increased appreciated improved \$1.52 lower 1 333 % 1.333 \$1.4910 1.0060 decreased depreciated deteriorated

If, 1 year latter the actual spot rate, S1 for turns out to be Compared to E(S1) of \$1.5291, S1 is Actual % change in S: e = (S1/S) -1 1 The real rate for , Sr = S1 *[1.03/1.05] q is equal to: [1+E(e)] / [1 + e ] = E(S1)/S1 The real rate (Sr) has: In real terms, has: USs competitiveness has:
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PPP: EXAMPLE 2

Inflation rate in the US is 5%; H = 0.05 Inflation rate in the Switzerland is 2%; F = 0.08 Current spot rate for SF is \$0.90; S = 0.90 To o maintain relative e ve PPP, , the e expected pe percentage ce tage c change a ge i in t the e spot exchange rate for SF, E(e) = (1.05) / (1.08) - 1 = - 2.778 % To maintain relative PPP, the expected spot exchange rate for SF, at the end of the year, E(S1) = \$0.90 ( 1 + 0.02941)= \$0.875 per SF
\$0.88 higher - 2.222 2 222 % \$0.9051 0.994 increased appreciated improved

If, 1 year latter the actual spot rate, S1 for SF turns out to be \$0.86 Compared to E(S1) of \$0.875, S1 is Actual % change in S: e = (S1/S) -1 1 The real rate for SF, Sr =S1*[1.08/1.05] q is equal to: [1+E(e)] / [1 + e ] = E(S)/S1 The real rate (Sr) has: In real terms, SF has: USs competitiveness has:
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Purchasing Power Parity and Interest Rate Parity

Notice that the PPP & IRP equations are equal because E(S) = F or E(e) = FP: IRP PPP F 1 + iH E(S) 1 + H = = 1+i = S S 1 + F F

E(e) =

1 + H -1 = 1 + F

1 + iH -1 = FP 1 + iF

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PPP: Evidence

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We could also reformulate our equations as inflation or interest rate differentials:

F(\$/) 1 + \$ = S(\$/) 1 +

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F(\$/) S(\$/) \$ = \$ S(\$/) 1 +

Fisher Effect
The nominal interest rate is composed of a real interest rate and an expected inflation rate.
Nominal interest rate: i; Real rate: ; Expected inflation:

(1 + i) = (1 + ) (1 + ) i = + + Approximately: i = + If real rates are equal across countries, or: H = F Then: (1 + iH) / (1 + iF) = (1 + H) / (1 + F) Approximately : iH - iF = H - F
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International Fisher Effect (IFE)

The concept of IEF IFE Conditions Deviations of from IFE: uncovered rates of interest: from the home and foreign countrys view point

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In an integrated global money and capital markets:

(1) Domestic fisher effect holds in each country. (2) All investors have the same real rate of return worldwide. (3) Therefore all nominal interest rate differences must be due to inflation differences

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International Fisher Effect (IFE)

The exchange rate of a country with a higher (lower) interest rate than its trading partner should depreciate (appreciate) by the amount of the interest rate difference to maintain equality of real rates of return.

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IFE: Terminology
iH = Nominal interest rate for the home country g country y iF = Nominal interest rate for the foreign S = Current spot rate (direct quote) for the foreign currency (in home currency units) S1 = Next years spot rate (direct quote) for the foreign currency

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Uncovered Rate: Home Countys View point

The uncovered rate from the home countys point of view (iUH) is the rate earned by the holders of dollars by: 1. Converting DOLLARS into FOREIGN CURRENCY today at the current spot exchange rate (S), and 2. Investing the FOREIGN CURRENCY at the FOREIGN INTEREST RATE (iF), and 3. Converting FOREIGN CURRENCY back into DOLLARS at maturity using the future spot exchange rate (S1) This return is affected by two factors: whether the foreign currency appreciates or depreciates against the dollar = % change in direct quote (DQ) = (S1 - S) / S The rate of interest you earn in the foreign country = iF iUH = (1 + % change in DQ)*(1 + iF) 1

You calculate it as:

Profit making Strategy: If iUH > iH then borrow in dollars and invest in foreign currency If iUH < iH then borrow in foreign currency and invest in dollars If iUH = iH then you cannot make any profit
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Uncovered Rate: Foreign Countys View point

The uncovered rate from the foreign countys point of view (iUF) is the rate earned by the holders of foreign currency by: 1. Converting FOREIGN CURRENCY into DOLLARS today at the current spot exchange rate (S), (S) and 2. Investing the DOLLARS at the US INTEREST RATE (iH), and 3. Converting DOLLARS back into FOREIGN CURRENCY at maturity using the future spot exchange rate (S1) This return is affected by two factors: whether the US Dollars appreciates or depreciates against the foreign currency = % change in indirect quote (IQ) = (S0 - S1) / S1 The rate of interest you earn in the home country (US) = iH iUF = (1 + % change in IQ)*(1 + iH) 1

You calculate it as:

Profit making strategy : If iUF > iF then borrow in foreign currency and invest in dollars If iUF < iF then borrow in dollars and invest in foreign currency If iUF = iF then you cannot make any profit
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IFE Conditions

According to IFE one should not be able to make money by consistently borrowing in one country and investing in another These conditions are met when: iUH = iH or iUF = iF According to IFE the above conditions will hold only when the expected percentage change in the spot rate, E(e): E(e)= (1 + iH) / (1 + iF) 1 Approximately: E(e)= iH - iF According to IFE IFE, the expected spot rate 1 year from now, now E(S1), should be: E(S1) = S [1 + E(e)]

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Uncovered Rate and IFE: Summarized

If iUH > iH or iUF < iF then investors will profit if they:

borrow in the home country (US) convert the \$ loan amount into foreign currency invest in the foreign capital market at the h end d of f the h b borrowing/investment i /i period i d convert the h foreign f i currency back b k into domestic currency (\$) and pay off the domestic (US) loan If this continues then: S, E(S1), iH, iF, until iUH = iH or iUF = iH, or IFE holds

If iUF > iF or iUH < iH then investors will profit if they:

borrow in the foreign country convert the loan amount from foreign currency into domestic currency (\$) invest in the domestic (US) capital market at the end of the borrowing/investment period convert the domestic currency (\$) back into foreign currency and pay off the foreign loan If this continues then: S, E(S1), iH, iF, until iUH = iH or iUF = iH, or IFE holds

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IFE : Example 1

Interest rate in US, iH = 7 % & Euro zone interest rate, iF = 9 % Current spot rate for , S = \$1.40 According to IFE, the percentage change in exchange rate, based on direct quote, quote for should be: E(e) = (1.07) / (1.09) - 1 = - 1.83486% According to IFE, the expected spot rate for at the end of the year should be: E(S1) = \$1.40 ( 1 - 0.0183) = \$ 1.37 / What happens if you believe (predict) that S1 will be \$1.39 ? You could make money by borrowing in \$ and investing in Can you show how? What happens if you believe (predict) that S1 will be \$1.35 ? You could make money by borrowing in and investing in \$ Can you show how?

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IFE : Example 2

Interest rate in US, iH = 7% & Interest rate in Switzerland, iF = 3% Current spot rate for SF (S)= \$0.85 According to IFE, the percentage change in exchange rate, based on direct quote, quote SF should be: E(e) = (1.06) / (1.03) - 1 = 3.8845% According to IFE, the expected spot rate for SF at the end of the year should be: E(S1) = \$0.85 ( 1 + 0.0288) = \$0.883 / SF What happens if you believe (predict) that S1 will be \$0.90 ? You could make money by borrowing in \$ and investing in FF Can C you show h how? h ? What happens if you believe (predict) that S1 will be \$0.87 ? You could make money by borrowing in SF and investing in \$ Can you show how?

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E(e)
IFE FEP PPP IRP

( iH iF)

FS S

E(H F)
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Exact Equilibrium Exchange Rate Relationships

E ( S1 ) S
PPP IRP

IFE

FEP

1 + iH 1 + iF

F S

E(1 + H) E(1 + F)
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Variable Definitions
S= Current spot rate (price of foreign currency) in direct quote S1 = Actual spot rate, 1 year from now F = 1-year forward rate FPH = the forward premium = [(F-S) / S] = [(F/S) - 1] from the home countrys view point FPF = the forward premium = [(S-F) / F] = [(S/F) - 1] from the foreign countrys view point H = Inflation rate in the home country F = Inflation rate in the foreign country = Real rate of interest E(S1) = Expected spot rate, rate 1 year from now now, based on PPP E(e) = [E(S1)/S] 1 = The expected percentage change, or rate of change, in the spot rate, based on PPP e = (S1/S) 1 = The actual percentage change, or rate of change, in the spot rate Sr= real spot rate iH = Nominal interest rate for the home country iF = Nominal interest rate for the foreign country

Exact relationship: E(e) =(1 (1 + H) / (1 + F) - 1 Approximate relationship: E(e) = H - F S1 = S0 * [ 1 + E(e) ] SR = S1 *(1 + F) / (1 + H) Fisher i Equation: i (1 + i) = (1 + ) (1 + )
i = + + Approximately: i = +

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Formula: International Fisher Effect (IFE)

Fisher Equation: (1 + i) = (1 + ) (1 + ) i = + + Approximately: i = + iuh : Uncovered rate of return, home countrys viewpoint iuf : Uncovered rate of return, foreign countrys viewpoint iuh = (1 + if) (1 + % change in DQ ) 1 iuf = (1 + ih) (1 + % change in IQ ) 1 % change h i in DQ (direct (di t quote)= t ) (S1 - S0) / S0 % change in IQ (indirect quote) = [1 /(1+ % change in DQ] - 1

The IFE relationship holds when:

E(e)= (1 + iH) / (1 + iF) 1 Approximately: E(e)= iH iF S1 = S0 * [1 + E(e)]

Formula: Interest Rate Parity (IRP)

Calculating the covered rate of returns (home & foreign countrys view point)
ich= Covered rate of return, home countrys view point icf= Covered rate of return, foreign countrys view point ich = (1 + if) (1 + FPh) 1 icf = (1 + ih) (1 + FPf) 1 FPh = (1 + ih)/(1 + if) 1 S1= S0 * ( 1 + FPh)

The IRP relationship holds when the expected forward premium from the home countrys point of view (FPh ):

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