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Theories/International
Parity Conditions
Mint Parity Theory
P A = S(A/B) *PB
Purchasing Power Parity (PPP)
PP
P
l in
2
e
1
-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1 Percent difference in
expected rates of inflation
-2 (foreign relative to
home country)
-3
-4
Relative PPP
In approximation
Interest
yield Eurodollar
10.0 % yield curve
9.0 %
8.0 %
7.0 %
Forward premium is the
6.0 % percentage difference of 3.96%
5.0 % Euro Swiss franc
yield curve
4.0 %
3.0 %
2.0 %
1.0 %
Days Forward
Interest Rate Parity (IRP)
i $ = 8.00 % per annum
(2.00 % per 90 days)
Start End
$1,000,000 x 1.02 $1,020,000
$1,019,993*
Dollar money market
•Note that the Swiss franc investment yields $1,019,993, $7 less on a $1 million investment.
Covered Interest Arbitrage
(1+r$)=Fn($/£)/($/£) *(1+r£)
Covered Interest Arbitrage (CIA)
2
Percentage premium on
foreign currency (¥)
1
4.83
-6 -5 -4 -3 -2 -1 1 2 3 4 5 6
-1
-2
-3
Interest
Difference in nominal Fisher
rate
interest rates effect
parity
-4% (B)
(D) (less in Japan)
Forward Rate as an Unbiased Predictor for
Future Spot Rate
Exchange rate
t1 t2 t3 t4
S2 F2
S1 Error F3
Error
Error
F1 S3
S4
Time
t1 t2 t3 t4
Illustration 1
The following are the quotes available at the market:
Spot $ / € 0.8775 / 0.8777
3 months Forward 0.0015 / 0.0010
3 months interest rates are: $ 2.25/2.50% per annum; €
3.50/3.75% per annum
Verify whether there is any scope for covered interest
arbitrage. What should be the amount borrowed to
make an arbitrage profit of $ 1000, if there is scope for
arbitrage.
Illustration 2
A FII invested in Indian capital market on December
01, 2000. When the Mumbai stock exchange sensex was
quoting at 3800. The rupee-dollar spot exchange rate at
that time was Rs./$ 46.30 / 33. The FII sold the
investment on November 30, 2001. When Sensex was
quoting at 3250, to take back the amount in dollars.
The spot rate quoted on November 30, 2001 was Rs./$
48.02/05. Inflation rate in India was 6%, and in US was
2.5% during the same period. Compute nominal and
real rate of return to FII. Compute the real return to
an Indian investor who invested Rs.100,000 in the
capital market for the same period.
Illustration 3
Calculate the interest rate on AUD the bank should quote to break-even.
Illustration 4
Illustration 5
Illustration 6
Illustration 7