International Parity

Relationships & Forecasting

Foreign Exchange Rates Chapter Six
6
INTERNATIONAL INTERNATIONAL
FINANCIAL Chapter Objective: FINANCIAL
MANAGEMENT MANAGEMENT
This chapter examines several key international
parity relationships, such as interest rate parity and
Seventh Edition Fourth Edition
purchasing power parity.
EUN / RESNICK EUN / RESNICK

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Chapter Outline Chapter Outline

l  Interest Rate Parity l  Interest Rate Parity
l  Purchasing Power Parity n  Covered Interest Arbitrage
l  The Fisher Effects
n  IRP and Exchange Rate Determination
n  Reasons for Deviations from IRP
l  Forecasting Exchange Rates
l  Purchasing Power Parity
l  The Fisher Effects
l  Forecasting Exchange Rates

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Chapter Outline Chapter Outline

l  Interest Rate Parity l  Interest Rate Parity
l  Purchasing Power Parity l  Purchasing Power Parity
n  PPP Deviations and the Real Exchange Rate l  The Fisher Effects
n  Evidence on Purchasing Power Parity
l  Forecasting Exchange Rates
l  The Fisher Effects
l  Forecasting Exchange Rates

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 Chapter Outline Interest Rate Parity
l  Interest Rate Parity
l  Purchasing Power Parity

l  The Fisher Effects

l  Forecasting Exchange Rates

n  Efficient Market Approach
n  Fundamental Approach
n  Technical Approach

n  Performance of the Forecasters

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Interest Rate Parity Interest Rate Parity Defined

l  Interest Rate Parity Defined l  (Covered) IRP is an arbitrage condition.
l  Covered Interest Arbitrage l  If IRP did not hold, then it would be possible for
l  Interest Rate Parity & Exchange Rate an astute trader to make unlimited amounts of
Determination money exploiting the arbitrage opportunity.
l  Reasons for Deviations from Interest Rate Parity l  Since we don’t typically observe persistent
arbitrage conditions, we can safely assume that
IRP holds.
n  Exception in periods of financial market stress? Why?

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Alternative 2: $1,000 IRP

Send your $ on a
Interest Rate Parity Carefully Defined round trip to S$/£
Step 2:
Britain
Invest those
Consider alternative one year investments for $100,000: pounds at i£
1.  Invest in the U.S. at i$. Future value = $100,000 × (1 + i$) $1,000 Future Value =
Trade your $ for £ at the spot rate, invest $100,000/S$/£ in $1,000
2.  × (1+ i£)
Britain at i£ and get rid of any exchange rate risk by selling S$/£
Step 3: repatriate
the future value of the British investment forward. future value to the
F$/£ Alternative 1:
Future value = $100,000(1 + i£)× invest $1,000 at i$ U.S.A.
S$/£ $1,000×(1 + i$) =
$1,000
× (1+ i£) × F$/£
Since these investments have the same risk, they must have S$/£
the same future value (otherwise an arbitrage would exist)
IRP

F$/£
(1 + i£) × = (1 + i$) Since both of these investments have the same risk, they must
S$/£
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the same future value—otherwise an arbitrage
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2
 Interest Rate Parity Interest Rate Parity Defined
l  The scale of the project is unimportant
$1,000 × (1+ i ) × F
$100,000 $100,000(1 + i$) $1,000×(1 + i$) = £ $/£
S$/£

1.  Trade $100,000 for £ at S $100,000(F/S)(1 + i£)

F$/£
(1 + i$) = × (1+ i£)
3.  One year later,
S$/£
trade £ for $ at F
2.  Invest £100,000 at i£
S
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Interest Rate Parity Defined Interest Rate Parity Carefully Defined

Formally, l  Depending upon how you quote the exchange rate
(F/S)(1 + i¥) = (1 + i$) ($ per ¥ or ¥ per $) we have:
or if you prefer,
1 + i¥ F¥/$ 1 + i$ F$/¥
1 + i$ F = or =
= 1 + i$ S¥/$ 1 + i¥ S$/¥
1 + i¥ S
IRP is sometimes approximated as
i$ – i¥ = F – S
S
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IRP and Covered Interest Arbitrage IRP and Covered Interest Arbitrage
If IRP failed to hold, an arbitrage would exist. It’s A trader with $1,000 to invest could invest in the
easiest to see this in the form of an example. U.S., in one year his investment will be worth
Consider the following set of foreign and domestic $1,071 = $1,000×(1+ i$) = $1,000×(1.071)
interest rates and spot and forward exchange rates. Alternatively, this trader could exchange $1,000 for
£800 at the prevailing spot rate, (note that £800 =
Spot exchange rate S($/£) = $1.25/£ $1,000÷$1.25/£) invest £800 at i£ = 11.56% for
360-day forward rate F360($/£) = $1.20/£
one year to achieve £892.48. Translate £892.48
U.S. discount rate i$ = 7.10%
British discount rate i£ = 11.56%
back into dollars at F360($/£) = $1.20/£, the
£892.48 will be exactly $1,071.
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 Interest Rate Parity
Interest Rate Parity & Exchange Rate Determination

According to IRP only one 360-day forward rate,

$1,000 $1,071 F360($/£), can exist. It must be the case that
F360($/£) = $1.20/£
1.  Trade $100,000 for £800 $1,071 Why?

3.  One year later, trade If, say, F360($/£) ≠ $1.20/£, an astute trader could
£892.48 for $ at make money with one of the following strategies:
2.  Invest £800 at 11.56% = i£ F360($/£) = $1.20/£
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Arbitrage Strategy I Arbitrage Strategy II

If F360($/£) > $1.20/£ If F360($/£) < $1.20/£
i. Borrow $1,000 at t = 0 at i$ = 7.1%. i. Borrow £800 at t = 0 at i£= 11.56% .
ii. Exchange $1,000 for £800 at the prevailing spot
rate, (note that £800 = $1,000÷$1.25/£) invest ii. Exchange £800 for $1,000 at the prevailing spot
£800 at 11.56% (i£) for one year to achieve rate, invest $1,000 at 7.1% for one year to
£892.48 achieve $1,071.
iii. Translate £892.48 back into dollars, if iii. Translate $1,071 back into pounds, if
F360($/£) > $1.20/£ , £892.48 will be more than F360($/£) < $1.20/£ , $1,071 will be more than
enough to repay your dollar obligation of $1,071. enough to repay your £ obligation of £892.48.
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Reasons for Deviations from IRP “Problems” with Covered IRP

l  Transactions Costs l  It is an arbitrage relation
n  The interest rate available to an arbitrageur for n  What if we want to forecast future FX rates, or to
borrowing, ib, may exceed the rate he can lend at, il. explain past FX rate changes
n  There may be bid-ask spreads to overcome, Fb/Sa < F/S l  Where is inflation?
n  Thus
n  Shouldn’t inflation affect exchange rates?
(Fb/Sa)(1 + i$a) - (1 + i¥ b) ≤ 0
n  If so, what is the connection with IRP?
l  Capital Controls u For example, why did the dollar depreciate in March 2008
n  Governments sometimes restrict the import/export against the € despite news of an unexpected drop in US
of currency by means of taxes or outright bans. inflation and Eurozone inflation at a 14-year high?

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 Purchasing Power Parity Purchasing Power Parity
l  Purchasing Power Parity and Exchange Rate
Determination
n  Law of One Price
n  Absolute version of PPP
n  Relative version of PPP
u The latter is the most frequently used (“default”)version

l  PPP Deviations and the Real Exchange Rate

l  Evidence on PPP
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PPP and Exchange Rate Determination PPP and Exchange Rate Determination
(“Law of One Price” Version of PPP) (“Absolute” Version of PPP)
l Absent transactions costs, goods should cost the l  The exchange rate between two currencies should
same in any pair of countries: P$ = P£ . S($/£), i.e., equal the ratio of the countries’ price levels:
P$ P$
S($/£) = S($/£) =
P£ P£
l  Example: if an ounce of gold costs $600 in the l  For
example, if the price of a “reference basket”
U.S. and £300 in the U.K., then the price of one is $300 in the U.S. and £150 in the U.K., then the
pound in terms of dollars should be: price of 1£ in terms of the dollar should be:
P$ $600 P$ $300
S($/£) = = = $2/£ S($/£) = = = $2/£
P£ £300 P£ £150
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PPP and Exchange Rate Determination PPP Deviations and the

(“Relative” Version of PPP) Real Exchange Rate (RER Index)
l  Idea: “Relative PPP” states that the rate of change (1 + π$)
Define the U.S. RER index = q =
in the exchange rate, denoted e, should be equal (1 + e)(1+ π£)
to the differences between inflation rates (why?): (1 + π$ )
(st+T – st) (π$ – π£) If PPP holds, then (1 + e) = so q = 1.
e= = ≈ π$ – π£ (1 + π£ )
st (1 + π£ )
If q < 1 competitiveness of domestic country (U.S.)
l  If U.S. inflation is π$ = 5% and U.K. inflation is improves; (Example: The Economist_07a)
π£ = 8%, then the pound should depreciate by If q > 1 competitiveness of domestic country (U.S.)
2.78%, i.e., lose about 3% of its value in dollars worsens.
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 PPP Deviations and the PPP Deviations and the
Real Exchange Rate (RER Level) Real Exchange Rate (RER Index)
s’t+T
The RER at time t is, by definition, s’t = st Foreign country’s RER index q* =
s’t
The RER at time t+T = s’t+T = st+T [(1+ π*)/(1+ π)] =
If PPP holds, then s’t+T = s’t so q* = 1
If PPP holds, then st+T = st [(1+ π)/(1+ π*)], so
s’t+T = st [(1+ π)/(1+ π*)][(1+ π*)/(1+ π )]= st = s’t q* < 1 à foreign country’s competitiveness
improves (and U.S. competitive position worsens);
If s’t+T < s’t : U.S. competitiveness worsens. q* > 1 à foreign country’s competitiveness worsens
If s’t+T > s’t : U.S. competitiveness improves. (and U.S. competitiveness improves).
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PPP Deviations and the PPP Deviations and the

Real Exchange Rate (Example) Real Exchange Rate (Example)
Question 2, PS#4. Question 2, PS#4: Intuitive Answer.
Intuitively, notice that 1$ buys in 3-95 about 14.3% (15/105)
The ¥/$ exchange rate moved from ¥105/1$ in March 1994 to ¥90/1$ in fewer ¥ than it did 1 year earlier, yet the inflation differential between
March 1995; the US and Japan was only 2.2% (133.6/130 - 110.7/110). Hence, the
During the same period, the U.S. consumer price index (CPI) rose from real depreciation of the $ must have been about 12% (14.3%-2.2%).
130 to 133.6, and the corresponding Japanese index moved
from 110 to 110.7; We can look at the same situation from the alternative point of
view of the real appreciation of the Japanese ¥. In nominal terms, the ¥
What was the real appreciation of the ¥ during the relevant year (3-94 appreciated against the $ by 16.7% (from 0.009524$/1¥ to 0.011111$/
to 3-95)? Explain, intuitively and formally. 1¥), yet the inflation differential was only 2.2%. Hence, the real
appreciation of the ¥ must have been about 14.5% (16.7%-2.2%).
.
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PPP Deviations and the

Evidence on PPP
Real Exchange Rate (Example)
l  PPP probably doesn’t hold precisely in the real world for a
Question 2, PS#4: Formal Answer. variety of reasons.
s’(beginning of last year) = s’(March 94) = s’(t) = 0.009524 $/¥ n  Non-Tradables (NTG, NTGS):
s’(beginning of this year) = s’(March 95) = s’(t+T) u  Haircuts
cost 10 times as much in OECD countries as in the developing
world (Economist alternative? # of minutes to buy a Big Mac, 08-2009).
1+µ* ⎞
s't+T = st+T ⎛⎜ ⎟ = (0.011111 $/ 1¥) 1.006 ( ) = .010873 $/¥ n  vs. Tradables (TGS):
⎝ 1+µ ⎠ 1.028
u  Computer memory, on the other hand, is a standardized commodity that
Hence, the real appreciation of the ¥ is: is actively traded across borders.
u  Even for such tradables, though, there may be deviations from PPP due
 s‘(beginning of this year) s't+T
-1 = -1 = 0.010873 -1 = 14.17 % to shipping costs, tariffs, quotas, etc.
s‘(beginning of last year) s't 0.009524
l  PPP-determined exchange rates still provide a valuable
Note: The difference between the formal (14.17%) and intuitive (14.5%) answers
comes from discounting.
benchmark.
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 Evidence on PPP The Fisher Effects
l  Big Mac index
n  Law of One Price in Practice
u  Examples: Big Mac parities for many countries (Economist site)
n  Empirical evidence
u Country specificities:
n  Is the Big Mac really a commodity in India?
n  Are fast-food restaurants an everyday experience everywhere?
n  How much time does it take to buy a Big Mac?

u How about a latte? Starbuck index, anyone?

l  Trade-weighted real exchange rate (Economist_07d)

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The Fisher Effects The Fisher Effects

l  An increase (decrease) in the expected rate of inflation will
l  Domestic Fisher effect cause a proportionate increase (decrease) in the interest
n  Link between a country’s nominal int. rate and its inflation rate rate in the country.
l  For the U.S., the Fisher effect is written as:
l  International Fisher effect 1 + i$ = (1+ ρ$)(1 + E[π$]) = 1 + ρ$ + E[π$] + ρ$E[π$]
n  If FF is a reality in every country, what does it say about exchnage
rates i$ = ρ$ + E(π$) + ρ$E[π$] ≈ ρ$ + E[π$]
Where
l  Can the Fisher effects tell us anything ρ$ is the equilibrium expected “real” U.S. interest rate
n  about when forward rates can help predict future spot rates?
E[π$] is the expected rate of U.S. inflation
i$ is the equilibrium expected nominal US int. rate
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Expected Inflation International Fisher Effect

l  The Fisher effect If the Fisher effect holds in the U.S.
i$ = ρ$ + (1 + ρ$)E[π$] ≈ ρ$ + E[π$] i$ = (1+ ρ$)(1 + E[π$]) ≈ ρ$ + E[π$]
and if the Fisher effect holds in Japan,
l  implies that the expected inflation rate is
approximated as the difference between the i¥ = (1+ ρ¥ )(1 + E[π¥]) ≈ ρ¥ + E[π¥]
nominal and real interest rates in each country, i.e. and if the real rates are the same in each country
(i$ – ρ$) (i.e. ρ$ = ρ¥ ), then we get the International Fisher
E[π$] = ≈ i$ – ρ$ (i$ – i¥)
(1 + ρ$) Effect: E(e) = ≈ i$ – i¥
(1 + i¥)
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 Approximate Equilibrium Exchange
International Fisher Effect
Rate Relationships
If the International Fisher Effect holds,
(i$ – i¥) E(e)
E(e) =
(1 + i¥) ≈ IFE ≈ FEP
and “if” IRP also holds ≈ PPP F–S
(i$ – i¥) ≈ IRP
F–S (i$ – i¥) S
=
S (1 + i¥) ≈ FE ≈ FRPPP
F–S E(π$ – π£)
then “forward parity” holds: E(e) =
S
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6-42 6-43

Approximate Equilibrium Exchange

The Exact Fisher Effects
Rate Relationships
l  An increase (decrease) in the expected rate of inflation
E(e) will cause a proportionate increase (decrease) in the
≈ UIRP ≈ FP interest rate in the country.
l  For the U.S., the Fisher effect is written as:
≈ PPP F–S
(i$ – i¥) 1 + i$ = (1 + ρ$ ) × E(1 + π$)
≈ IRP
S Where
ρ$ is the equilibrium expected “real” U.S. interest rate
≈ FE ≈ FRPPP
E(π$) is the expected rate of U.S. inflation
E(π$ – π£) i$ is the equilibrium expected nominal U.S. interest rate

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International Fisher Effect International Fisher Effect

If the Fisher effect holds in the U.S. If the International Fisher Effect holds,
1 + i$ = (1 + ρ$ ) × E(1 + π$) 1 + i¥ E(1 + π¥)
=
and the Fisher effect holds in Japan, 1 + i$ E(1 + π$)
1 + i¥ = (1 + ρ¥ ) × E(1 + π¥)
and “if” IRP also holds
and if the real rates are the same in each country
1 + i¥ F¥/$
ρ$ = ρ¥ =
1 + i$ S¥/$
then we get the F¥/$ E(1 + π¥)
1 + i¥ E(1 + π¥) then forward rate PPP holds: =
International Fisher Effect: 1 + i = E(1 + π ) S¥/$ E(1 + π$)
$ $
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 Exact Equilibrium Exchange Rate Exact Equilibrium Exchange Rate
Relationships Relationships
E (S ¥ / $ ) E (S ¥ / $ )
IFE S¥ / $ FEP UIRP S¥ / $ FP

1 + i¥ PPP F¥ / $ 1 + i¥ PPP F¥ / $
IRP IRP
1 + i$ S¥ /$ 1 + i$ S¥ /$
FE FRPPP FE FRPPP
E(1 + π¥) E(1 + π¥)
E(1 + π$) E(1 + π$)

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Forecasting Exchange Rates Forecasting Exchange Rates

l  Efficient Markets Approach
l  Fundamental Approach
l  Technical Approach

l  Performance of the Forecasters

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Efficient Markets Approach Currency  Carry  Trade

l  Financial Markets are efficient if prices reflect all l  If  UIRP  does  not  hold,  then…
available and relevant information. n  Currency  carry  trade  
l  If this is so, exchange rates will only change when n  buy  a  currency  with  a  high  rate  of  interest  and  
new information arrives, thus: fund  the  purchase  by  borrowing  a  currency  with  
St = E[St+1] low  rates  of  interest,  without  any  hedging.
and l  Carry  trade  profitable  if  the  int.  rate  diff.  
Ft = E[St+1| It] exceeds  the  appreciation  of  the  funding  
l  Predicting exchange rates using the efficient currency  against  the  target  currency.
markets approach is affordable – but is it good? l  Risk?
6-­‐‑53
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 Fundamental Approach Technical Approach
l  Uses econometrics to develop models that use a variety of l  Technical analysis looks for patterns in the past
explanatory variables. Involves 3 steps:
behavior of exchange rates.
n  step 1: Estimate the structural model
n  What variables should be included – macro, order flow? l  Clearly it is based upon the premise that history
n  step 2: Estimate future parameter values repeats itself.
n  Why is this any easier than forecasting the FX rate itself?
l  Thus it is at odds with the EMH
n  step 3: Use the model to develop forecasts
n  Why should past relations between variables hold in the future? l  Short-term vs. Long-term differences?
l  Downside n  In the long run, fundamentals do matter
n  In the short run at least, fundamental models seem not to work any n  In the short run, trader prophecies may be self-fulfilling
better than the forward rate model or the random walk model.
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Performance of the Forecasters End Chapter Six

l  Forecasting is difficult, especially with regard to
the future.
n  Still, the evidence suggests that UIRP does pretty well
at horizons of 5 to 10 years (in contrast to short term)
l  As a whole, forecasters appear not to do a much
better job of forecasting future exchange rates
than does the forward rate
l  The founder of Forbes Magazine once said:

“You can make more money selling financial

advice than following it”
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10