International Parity Relationships and Forecasting Foreign Exchange Rates

Thota Nagaraju
Dept of Econ & Fin
BITS-Pilani Hyd Campus
Derivatives and Risk Management
International Parity Relationships and Forecasting Foreign Exchange Rates
(Reference: International Financial Management by Cheol Eun, and Bruce G. Resnick, 6th edition, McGraw-Hill. Chapter- 6)

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Why should we discuss about the International Parity Relationships
and Forecasting Foreign Exchange Rates?
For companies and investors alike, it is important to have a firm understanding of the forces driving
exchange rate changes as these changes would affect investment and financing opportunities. To that
end, in this chapter, we examine several key international parity relationships, such as interest rate parity
and purchasing power parity, that have profound implications for international financial management. An
understanding of these parity relationships provides insights into (1) how foreign exchange rates are
determined, and (2) how to forecast foreign exchange rates.
Learning Outcomes of this Chapter
Basics of the forex market
 Direct and Indirect, American, European, Base/Variable quotes
 Cross rates
Interest Rate Parity
 Covered Interest Arbitrage
 Uncovered Interest Arbitrage
Purchasing Power Parity
Fisher Effects
International Fisher Effects
Forecasting Exchange Rates
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Importance of the Forex Markets
Foreign Exchange Market:-The foreign exchange market provides the physical and institutional
structure through which the money of one country is exchanged for that of another country, the rate
of exchange between currencies is determined, and foreign exchange transactions are physically
completed.
FX Market Participants:- international banks, bank customers, nonbank dealers, FX brokers, and
central banks.
Trading Hours: The market for foreign exchange is the largest financial market in the world by
virtually any standard. It is open somewhere in the world 365 days a year, 24 hours a day.
Market Size:-
Trading in foreign exchange markets averaged $5.1 trillion per day in April 2016. This is equivalent
to over $681 in transactions for every person on earth.
The US dollar remained the dominant vehicle currency, being on one side of 88% of all trades in
April 2016. The euro, yen and Australian dollar all lost market share. In contrast, many emerging
market currencies increased their share.
In April 2016, sales desks in five countries – the United Kingdom, the United States, Singapore,
Hong Kong and Japan – intermediated 77% of foreign exchange trading, up from 75% in April 2013
and 71% in April 2010.

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Foreign Exchange - Spot Market
The Spot Market:- The spot market involves almost the immediate purchase or sale of foreign
exchange.
Spot foreign exchange quotations can be given in variety of ways i.e, direct/indirect
American/European, base/variable quotations.
Direct and Indirect quotes:-
A direct quote is the home currency price of one unit of foreign currency.
An indirect quote is foreign currency price of one unit of domestic currency.
A forex quotation becomes direct/indirect quotations depending on who is using this quote.
For example, INR 68.17/USD is a direct quotation for resident Indian while it is indirect
quotation for American.
Similarly, USD 0.015/ INR is a direct quotation for American person while it is an indirect
quotation for Indian.

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Foreign Exchange - Spot Market
American/European quotes:-
Foreign currency price per one USD, known as “European Terms” b) USD price per unit of foreign currency known as
“American Terms”.
For example, INR 68.17 /USD is in “European Terms” while USD 0.015/INR is in “American Terms”.
Base/Variable quotes:-
Each forex quotation has a “base” currency and a “variable/quote/term” currency. Any exchange rate quotation
shows how many units of variable/quote/term currency for unit of base currency.
For example a forex exchange dealer is quoting USD/INR as 68.17. In his case, USD is the base currency while INR
68.17 variable/quote/term currency.

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Foreign Exchange - Spot Market notations
Most currencies in the interbank market are quoted in either American or
European terms.
In general, S(j/k) will refer to the price of one unit of currency k in terms of
currency j and “s” denotes the spot rate.
S($/₹) = 0.015, which indicates that $0.015 per rupee.
S(₹/$)= 68.17, which indicates that ₹ 68.17 per dollar.
It should be intuitive that the American and European term quotes are reciprocals
of one another. That is,
1 1
S($/₹) = ₹  0.015=( ) and
68.17
𝑆( ) $
1 1
S(₹/$)=  68.17 =( )
$
𝑆( )
0.015
₹
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Cross-Exchange Rate Quotations
A cross-exchange rate is an exchange rate between a currency pair where neither currency is the U.S.
dollar.
The cross-exchange rate can be calculated from the U.S. dollar exchange rates for the two currencies,
using either European or American term quotations. For example, the €/£ cross-rate can be calculated
from American term quotations as follows:
Lets assume that S($/£) = 1.9077, S($/€) = 1.3112, S(€/$) = 0.7627 and S(£/$)= 0.5242
S($/£) 1.9077
Then S(€/£)=  1.3112 = 1.4549
S($/€)
That is, if £1.00 cost $1.9077 and €1.00 cost $1.3112, the cost of £1.00 in euros is €1.4549.
In European terms, the calculation is
S(€/$) 0.7627
S(€/£)=  = 1.4549
S(£/$) 0.5242
S($/€) 1.3112
Analogously, S(£/€)=   0.6873 and
S($/£) 1.9077
S(£/$) 0.5242
S(£/€)=   0.6873
S(€/$) 0.7627
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Alternative Expressions for the Cross-Exchange Rate
For some purposes, it is easier to think of cross-exchange rates calculated as the
product of an American term and a European term exchange rate rather than as
the quotient of two American term or two European term exchange rates.
For example,
1
S(€/$) for can be rewritten as:
S($/€)
S(€/£) = S($/£) X S(€/$)  1.9077 X .7627 = 1.4549
In general terms,
S(j/k) = S($/k) X S(j/$)
and taking reciprocals of both sides of the above equation yields
S(k/j) = S(k/$) = S($/j)
Note the $ signs cancel one another out in both the above equations.

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Basic Concepts
Law of One Price “a good must sell for the same price in all locations”. This law is
derived from the assumption of the inevitable elimination of all arbitrage.
Arbitrage is the process of buying and selling in more than one market to make a
riskless profit.
Spot exchange rate is the rate for immediate delivery.
Forward exchange rate is an exchange rate agreed upon today but which calls for
delivery or payment at a future date.
Forward exchange rate > Spot exchange rate = Premium
Forward exchange rate < Spot exchange rate = Discount
So the premium or discount is known as the forward-spot differential.

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Interest Rate Parity (IRP)
Interest rate parity (IRP) is an arbitrage condition that must hold when international
financial markets are in equilibrium.
If IRP did not hold, then it would be possible for an astute trader to make unlimited
amounts of money exploiting the arbitrage opportunity.
Since we don’t typically observe persistent arbitrage conditions, we can safely assume
that IRP holds.

Assumptions of IRPT
1) No Transaction Costs
2) No Capital Controls
3) Unlimited borrowing is allowed

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Interest Rate Parity Defined
Consider alternative one-year investments for $1:
1. Invest in the U.S. at 𝑖$ . Future value = $1 × (1 + 𝑖$ )
2. Alternatively you can invest in U.K. exchange $1 for a pound amount that is £ (1/S) at the prevailing spot rate(S).
3. Invest the amount at the U.K. interest rate 𝑖£ with maturity value £ (1/S)(1 + 𝑖£)
4. Sell the maturity value of the U.K. investment forward in the exchange for a predetermined dollar amount that is
$[(1/S)(1 + 𝑖£)F, where F denotes the forward exchange rate.
𝐹
The effective dollar interest rate from the U.K. investment alternatives is given by 𝑆 (1 +i£) -1
Arbitrage equilibrium then would dictate that the future dollar proceeds from investing in the two equivalent investments must
be the same, implying that
𝐹 1+𝑖$
1 + 𝑖$ = 𝑆 (1 + 𝑖£) alternatively, F=S 1+𝑖
£
Market equilibrium requires that the net cash flow on the maturity date be zero for this portfolio:
1 + 𝑖£ 𝐹 − 1 + 𝑖$ 𝑆 = 0
The IRP relationship is sometimes approximated as follows:
𝐹−𝑆 𝐹−𝑆
𝑖$ − 𝑖£ = 1 + 𝑖£ ≈
𝑆 𝑆

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Interest Rate Parity Defined Contd………
When IRP holds, you will be indifferent between investing your money in the United States and investing in the U.K.
with forward hedging. However, if IRP is violated, you will prefer one to another. You will be better off by investing in
the United States (U.K.) if (1 + 𝑖$ ) is greater (less) than (F/S)(1 + 𝑖£). When you need to borrow, on the other hand,
you will choose to borrow where the dollar interest is lower. When IRP doesn’t hold, the situation also gives rise to
covered interest arbitrage opportunities.

Reasons for Deviations from IRP

1) Transactions Costs
2) Capital Controls

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How long will this arbitrage opportunity last?
As soon as deviations from IRP are detected, informed traders will immediately carry out CIA transactions.
As a result of these arbitrage activities, IRP will be restored quite quickly.
To see this, let’s get back to our numerical example, which induced covered interest arbitrage activities. Since every
trader will (1) borrow in the United States as much as possible, (2) lend in the U.K., (3) buy the pound spot, and, at
the same time, (4) sell the pound forward, the following adjustments will occur to the initial market condition
1. The interest rate will rise in the United States (𝑖$ ↑).
2. The interest rate will fall in the U.K. (𝑖£↓).
3. The pound will appreciate in the spot market (S↑).
4. The pound will depreciate in the forward market (F↓).

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Interest Rate Parity and Exchange Rate Determination
Being an arbitrage equilibrium condition involving the (spot) exchange rate, IRP has an immediate implication for
exchange rate determination. To see why, let us reformulate the IRP relationship in terms of the spot exchange rate:
1+𝑖$
S= 𝐹
1+𝑖
£
The above indicates that given the forward exchange rate, the spot exchange rate depends on relative interest rates.
All else equal, an increase in the U.S. interest rate will lead to a higher foreign exchange value of the dollar.
This is so because a higher U.S. interest rate will attract capital to the United States, increasing the demand for
dollars. In contrast, a decrease in the U.S. interest rate will lower the foreign exchange value of the dollar.
Under certain conditions the forward exchange rate can be viewed as the expected futures spot exchange rate
conditional on all relevant information being available now. i.e.
𝐹 = 𝐸(𝑆𝑡+1 |𝐼𝑡 ) where 𝑆𝑡+1 is the future spot rate when the forward contract matures, and 𝐼𝑡 denotes the set of
information currently available. When we combine both the above equations we get
1+𝑖$
S= 𝐸(𝑆𝑡+1 |𝐼𝑡 )
1+𝑖
£
When the forward exchange rate F is replaced by the expected future spot exchange rate, 𝐸(𝑆𝑡+1 ) we get
𝐸(𝑆 −𝑆 )
(𝑖$ − 𝑖£ )≈E(e) where E(e) is the expected rate of change in the exchange rate. i.e. 𝑡+1 𝑡
𝑆𝑡
This relationship is known as uncovered interest rate parity.

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Purchasing Power Parity (PPP) - Absolute PPP
The exchange rate between currencies of two countries should be equal to the ratio of the countries’ price levels.
There are two different types of PPPs
1) Absolute PPP
2) Relative PPP
Absolute PPP
Let 𝑃$ be the dollar price of the standard commodity basket in the United States and 𝑃£ the pound price of the same
basket in the United Kingdom. Formally, PPP states that the exchange rate between the dollar and the pound should be
𝑃
S= $ 𝑃
£
where S is the dollar price of one pound. PPP implies that if the standard commodity basket costs $225 in the United
States and £150 in the U.K., then the exchange rate should be $1.50 per pound:
$1.50/£ = $225/£150
If the price of the commodity basket is higher in the United States, say, $300, then PPP dictates that the exchange rate
should be higher, that is, $2.00/£.
To give an alternative interpretation to PPP, let us rewrite above equation, as follows:
𝑃$ = S X 𝑃£
The above equation states that the dollar price of the commodity basket in the United States, 𝑃$ , must be the same as the
dollar price of the basket in the U.K., that is, 𝑃£ multiplied by S. In other words, PPP requires that the price of the standard
commodity basket be the same across countries when measured in a common currency.

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Relative Purchasing Power Parity
 Even if the dollar does not buy the same basket of goods in other countries, the purchasing power of dollar in
these countries could remain stable 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
𝜋$ −𝜋ℒ
i.e. e= ≈ 𝜋$ − 𝜋ℒ
1+𝜋ℒ
Where “e” is the rate of change in the exchange rate and 𝜋$ and 𝜋ℒ are the inflation rates in the USA and UK.
Eg. If the inflation rate is 6% in USA and 4% in UK then the pound should appreciate against the dollar by about 2%.
It is noted that even if absolute PPP does not hold, relative PPP may hold.
The real exchange rate, q measures deviations from PPP, can be defined as
1+𝜋$
𝑞=
(1+𝑒)(1+𝜋ℒ )
1+𝜋$
First note that if PPP holds, that is (1+e) = , the real exchange rate will be unity, q=1.
1+𝜋ℒ
when PPP is violated, however, the real exchange rate will deviate from unity.

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Relative Purchasing Power Parity
Suppose, for example, the annual inflation rate is 5% in USA and 3.5% in the UK., and the pound appreciated
against the dollar by 4.5%. The real exchange rate is 0.97
1.05
q= = 0.97
1.045 (1.035)
In the above example, the dollar depreciated by more than is warranted by PPP, strengthening the competitiveness
of U.S. industries in the world market.
If the dollar depreciates by less than the inflation rate differential, the real exchange rate will be greater than unity,
weakening the competitiveness of U.S. industries.
To summarize,
q=1: competitiveness of the domestic country unaltered.
q<1: competitiveness of the domestic country improves.
q>1: competitiveness of the domestic country deteriorates.

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Does PPP Hold? Examples
.

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Evidence on PPP
Empirical Research:
 Richardson (1978); Kravis and Lipsey (1978); Adler and Lehman (1983); and Frenkel (1981) found
deviations from PPP.
 Generally unfavorable evidence about PPP suggests that substantial barriers to international
commodity arbitrage exists.
 Obviously, commodity prices can diverge between countries up to the transaction costs without
triggering arbitrage.
 Likewise, deviations from PPP can result from tariffs and quotas imposed on international trade.
 Tradable and non-tradable factors of production
 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.
 Relative PPP-determined exchange rates can provide a more valuable benchmark

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Fisher Effect
 An increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in
the interest rate in the country is know as “Fisher effect”.
 For a single economy, the nominal interest rate equals the real interest rate plus the expected rate of inflation.
 The Fisher effect represents arbitrage between real assets and nominal (or financial) assets within a single
economy.
 At the end of one period, a $1 commodity holding can be liquidated for $1[1+E(𝜋)], where E(𝜋) is the expected
rate of inflation.
 To be indifferent, an interest-bearing security will need an end-of-period value of $1(1+r)[1+E(𝜋)], or $1(1+i).
So, (1+𝑖$ ) = (1+𝑖$ )[1+E(𝜋$ )]
 𝑖$ = 𝑟$ +E(𝜋$ )+rE(𝜋$ )
Where “r” is the real inflation rate and E(𝜋) expected inflation.
Where inflation and the real interest rate are low, the Fisher effect is usually approximated as:
𝑖$ = 𝑟$ +E(𝜋$ )
% nominal interest rate = % real interest rate + % expected inflation.
The fisher effect holds as long as bond market is efficient.

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International Fisher Effect
The fisher effect implies that the expected inflation rate is the difference between the nominal and real interest
rates in each country, that is
𝑖$ = 𝑟$ +E(𝜋$ )+rE(𝜋$ )
E(𝜋$ )=(𝑖$ − 𝑟$ )/(1+𝑟$ ) ≈𝑖$ − 𝑟$
E(𝜋£ )=(𝑖£ − 𝑟£ )/(1+𝑟£ ) ≈𝑖£ − 𝑟£
Now let us assume that the real interest rate is the same between countries, that is 𝑟$ = 𝑟£ because of unrestricted
capital flows.
In the relative PPP case we have seen that the PPP is
𝜋$ −𝜋£
e= ≈ 𝜋$ − 𝜋£
1+𝜋£
When we substitute the international fisher results into PPP, we get
E(e) = (𝑟$ − 𝑟£ )/(1+𝑟£ ) ≈ 𝜋$ − 𝜋£
Which is known as the international Fisher effect (IFE). It suggests that the nominal interest rate differential reflects
the expected change in exchange rate.
Alternatively,
For two economies, the U.S. interest rate minus the U.K. (foreign) interest rate equals the expected percentage
change in the exchange rate.

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International Fisher Effect and Interest Rate Parity (IRP)
Lastly, when the international Fisher effect is combined with IRP, that is
(F-S)/S= (𝑖$ − 𝑖£ )/(1+𝑖£ ) we can obtain that

(F-S)/S=E(e)
Which is known as forward expectation parity (FEP).
Forward parity states that any forward premium or discount is equal to the expected change in
the exchange rate.
When the investors are risk neutral, forward parity will hold as long as the foreign exchange
market is informationally efficient.

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Forecasting Exchange Rates
Since the advent of the flexible exchange rate system in 1973, exchange rates have become increasingly more
volatile and erratic.
At the same time, the scope of business activities has become highly international.
Consequently, many business decisions are now made based on forecasts, implicit or explicit, of future exchange
rates.

Some corporations generate their own forecasts, while others subscribe to outside services for a fee. While
forecasters use a wide variety of forecasting techniques, most can be classified into three distinct approaches:

1) Efficient market approach

2) Fundamental approach
3) Technical approach

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Forecasting Exchange Rates-Efficient Market Approach
 Financial markets are said to be efficient if the current asset prices fully reflect all the
available and relevant information. The efficient market hypothesis (EMH), which is largely
attributable to Professor Eugene Fama of the University of Chicago, has strong implications
for forecasting.
 Suppose that foreign exchange markets are efficient. This means that the current exchange
rate has already reflected all relevant information, such as money supplies, inflation rates,
trade balances, and output growth. The exchange rate will then change only when the
market receives new information. Since news by definition is unpredictable, the exchange
rate will change randomly over time.
 In a word, incremental changes in the exchange rate will be independent of the past history
of the exchange rate. If the exchange rate indeed follows a random walk, the future exchange
rate is expected to be the same as the current exchange rate, that is,
𝑆𝑡 =E(𝑆𝑡+1 )
In a sense, the random walk hypothesis suggests that today’s exchange rate is the best
predictor of tomorrow’s exchange rate.

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Forecasting Exchange Rates-Fundamental Approach
The fundamental approach to exchange rate forecasting uses various models. For example, the monetary approach
to exchange rate determination suggests that the exchange rate is determined by three independent (explanatory)
variables: (1) relative money supplies, (2) relative velocity of monies, and (3) relative national outputs.

The fundamental approach to exchange rate forecasting has three main difficulties.
First, one has to forecast a set of independent variables to forecast the exchange rates. Forecasting the former will
certainly be subject to errors and may not be necessarily easier than forecasting the latter.
Second, the parameter values, that is, 𝛼 and 𝛽’s, that are estimated using historical data may change over time
because of changes in government policies and/or the underlying structure of the economy.
Third, the model itself can be wrong.

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Forecasting Exchange Rates - Technical Approach
The technical approach first analyzes the past behavior of exchange rates for the purpose of identifying “patterns”
and then projects them into the future to generate forecasts.
Clearly, the technical approach is based on the premise that history repeats itself.
Technical analysts sometimes consider various transaction data like trading volume, outstanding interests, and bid-
ask spreads to aid their analyses.

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Performance of the Forecasters
Because predicting exchange rates is difficult, many firms and investors subscribe to professional forecasting
services for a fee.
Since an alternative to subscribing to professional forecasting services is to use a market-determined price such as
the forward exchange rate, it is relevant to ask:
Can professional forecasters outperform the market?
In evaluating the performance of forecasters, Levich computed the following ratio:
R = MAE(S)/MAE(F)
where: MAE(S) mean absolute forecast error of a forecasting service.
MAE(F) mean absolute forecast error of the forward exchange rate as a predictor.
• If a professional forecasting service provides more accurate forecasts than the forward exchange rate, that
is, MAE(S)<MAE(F), then the ratio R will be less than unity for the service. If the service fails to outperform
the forward exchange rate, the ratio R will be greater than unity.
Levich empirical results provides the R ratios for each service for the U.S. dollar exchange rates of nine major foreign currencies
for a three-month forecasting horizon. The most striking finding presented that only 24 percent of the entries, 25 out of 104, are
less than unity. This, of course, means that the professional services as a whole clearly failed to outperform the forward exchange
rate.

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