AJAFIN 6605-03

Parity Conditions In International Finance

* * * *

Outline: International Arbitrage and the Law of One Price Excess Money Supply Growth and Inflation The Neutrality of Money Inflation and Domestic Currency Depreciation Nominal Interest Rates and Real Interest Rates International Arbitrage: The Covered Interest Arbitrage Parity Conditions: IRP, FRP, PPP, FE & GFE, and IFE.

Parity Conditions in International Finance

These are economic theories linking exchange rates, price levels, and interest rates. International Arbitrage and the Law of One Price
In a competitive market characterized by: i. Many buyers ii. Many sellers iii. Cost-less access to information iv. Lack of government controls v. Free transportation

The price of an identical tradable good and financial asset must be equalized. This is the law of one price All goods and financial assets obey the law of one price or, equivalently, free trade will equalize the price of an identical product in all countries.

This law is enforced by the international arbitragers who follow the dictum of buy low" and "sell high" to generate profits for themselves.
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Certain key theoretical economic relationships result from arbitrage activities, namely: Interest Rate Parity (IRP) Forward Rate Parity (FRP) Purchasing Power Parity (PPP) Fisher Equation (FE) & GFE International Fisher Equation (IFE)

These relationships explain the links between prices, spot exchange rates, interest rates, and forward exchange rates. Underlying these parity conditions is the adjustment of various rates and prices to inflation.

Modern monetary theory posits that an expansion of the money supply in excess of real output results in a logical outcome of inflation. While this view is not universally subscribed to, it has a solid microeconomic foundation.

The basic precept of price theory is that as the supply of product A increases relative to others, the price of product A must decrease relative to others.
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Extraordinary verifications of this theory abound.

The German hyperinflation (1920-23) and the lessons thereof. Inflation peaked at 200 billion percent in 1923. In 1922, Germanys highest currency denomination was 50,000 mark.

By 1923, the highest denomination was 100,000,000,000,000 mark.

In December of 1923 one US dollar was equal to 4,000,000,000,000 marks!.

The Bolivian hyperinflation (1985).

In the spring 1985 Bolivian hyperinflation was running at over 100,000% per year. The government revenue covered only 15% of spending while the rest was paid for by printing peso currency notes. The government fell. Spending cuts were introduced. Excessive Peso printing stopped. Inflation returned to 0% that same year.

Greece, in the mid 1940s with 8.55 billion

percent per month.
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Yugoslavia, 1993 (500 billion dinar for a gallon of milk!)

Yugoslavias Central Bank introduced a 500 billion dinar bank note around Christmas 1993. It marked another milestone in the countrys descent into economic chaos.

In November 1993, inflation topped 600,000 %.

In 1992, the U.S dollar was worth 1,000 dinar. By Christmas 1993, it took 180 trillion of the same 1,000 dinar notes to equal one dollar!
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Hungary about the 1940s at 4.19 quintillion (1 plus 18 zeros) percent per month. Zimbabwe (Aug. 2008). Facing inflation of about 50
million percent per year, Zimbabwe's Reserve Bank knocked 10 zeros off its hyper-inflated currency. 10 billion old Z$ note becomes one new Z$1 note. 100 billion new Z$ note introduced (still not enough to buy a loaf of bread!). Gasoline coupon used for currency. In Jan 09, Zimbabwe rolled out Z$100tr note $33

The widespread use of fiat money created the possibility of hyperinflation as governments often print large amounts of money, without actual market demand, to finance spending. 9

Inflation causes a transfer of wealth: It benefits: -- the asset-rich at the expense of the asset-poor -- debtors at the expense of creditors -- non-savers at the expense of savers It results in less total wealth within the economy than would have been in its absence. Deflation is a decrease in the general price level over a period of time. It is the opposite of inflation. With deflation, the demand for liquidity goes up, in preference to goods or interest. The purchasing power of money increases.
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For consumers, deflation is a delight because the purchasing power of money increases with time. Consumers are encouraged to delay their purchases until the future when the goods they wish to buy will be cheaper. Deflation depresses consumption, leading to lower national income which further decreases consumption the vicious cycle continues. Depressed profits for firms translates to less income for households and this in turn means less income to spend on goods and services and decline in investment by firms. Deflation is bad for borrowers. The debt continues to grow the real value of money owed increases. Nominal interest rate may be zero, but real rate may be several percentage points higher since inflation is negative.
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Economic values measured in current dollars are termed nominal while those measured in constant (adjusted) dollars are termed real.

The relationship between real and nominal is given by: Real = nominal/deflator.
The deflator adjusts for inflation. Common deflators are:
CPI = Consumer price index based on market basket of consumer goods. PPI = Producer price index based on prices of inputs (labor and capital) GDP deflator: takes into account all components of GDP.
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Another link in the money supply growth, inflation, interest rates, and exchange rates, is the notion of the neutrality of money" i.e., money should have no impact on real variables, such as output, employment and interest rates. For example, if money supply (Ms) should increase by 10% relative to money demand (Md), then prices should increase by 10%.

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The neutrality of money has strong policy implications.

If money were neutral, there would be an easy way to reduce inflation if we ever wanted to. All we would have to do would be to reduce the rate of growth of money stock. In practice, however, it is very difficult to change inflation rate without producing a recession, e.g., in 1979-83, the experiment with lower growth rate of money in the US first resulted in unemployment, and only later in lower inflation.
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Inflation and Currency Depreciation

The international analogue to inflation is the depreciation of domestic currency.

Inflation results in a change in the exchange rate between domestic currency and domestic goods.
Whereas domestic currency depreciation results in a change in the exchange rate between domestic currency and foreign goods.

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If international arbitrage enforces the law of one price, then the change in the exchange rate between domestic currency and domestic goods (inflation) must equal the change in the exchange rate between domestic currency and foreign goods.

Therefore if $1.00 buys a loaf of bread in the U.S., it should buy the same loaf in Japan, the U.K., or elsewhere. For this to happen, foreign exchange rate must change by the difference between domestic and foreign rates of inflation. The theory of Purchasing Power Parity (PPP) espouses this notion.

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Nominal and Real Interest Rates:

The nominal interest rate is the price quoted on lending and borrowing transactions. It determines the exchange rate between current and future dollars.
But the Fisher Equation and International Fisher Equation emphasize what really matters, i.e., the exchange rate between current and future purchasing power as measured by the real interest rate.

Lenders are concerned about how many more goods can be obtained in the future by foregoing consumption today and borrowers are concerned about how much of future consumption must be given up, or sacrificed, for today's consumption to be paid for with future earnings. 17

Consequently, if exchange rate between current and future goods (the real interest rate) varies from one country to another, arbitrage activities (in the form of capital flows) will tend to equalize the real interest rate across countries. Arbitrage can be defined as "The process of buying or selling a good or an asset in order to exploit a price differential so as to make a riskless profit."

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Covered Interest Arbitrage (CIA):

CIA is a profit seeking activity that takes advantage of differences in domestic and foreign interest rates in the presence of forward exchange markets. Suppose a U.S. investor decides to capitalize on a relatively higher British interest rates. The spot exchange rate is known and there exists a forward market.
The only uncertainty is the future spot exchange rate. A forward sale can be used to lock-in the rate at which pounds could be exchanged for dollars.
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Hence, the CIA strategy proceeds as follows: A US investor:

Converts dollars to pounds Deposits pounds in the U.K. Sells pound proceeds forward for term to maturity At maturity converts pounds proceeds to dollars at the agreed upon forward rate.

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Algebraically, Let A = Amount to be invested, e.g. $1 S = Spot exchange rate (direct) ius = U.S. interest rate F = Forward exchange rate iuk = U.K. interest rate

Comparing what can be earned at home with what is possible through CIA we have:
1(1+ius) vs 1/S(1+iuk)F Then arbitrage profit (AP) is given by: AP = 1/S(1+iuk)F (1+ius)
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CIA will be profitable if AP > 0. However, market forces resulting from CIA will cause a price realignments so that excess profits from arbitrage are no longer possible.

For example, as $s are used to purchase s in the spot market, S increases, netting fewer s. The forward sale of s puts a downward pressure on the forward rate F, netting fewer $s.
In addition, as U.S. investors transfer funds to the U.K., there will be a decrease in iuk and an increase in ius

As a result of market forces from CIA a relationship exists between the forward rate premium(discount) and the interest rate differentials. 22 This is the subject matter of Interest Rate Parity Theory .

The Interest Rate Parity:

Let: ius = Interest rate in U.S. iuk = Interest in U.K. S = Spot exchange rate (Dollar/ Pound) F = Forward exchange rate ( Dollar/Pound) A U.S. investor can earn (1 + iUS) in the U.S., or (1/S)(1 + iUK) in the U.K. Since investment proceeds will ultimately be converted to dollars, but future spot exchange rates are not known with certainty, the investor can eliminate the uncertainty regarding the dollar value of the proceeds by covering with a forward contract. The covered return is given by: (1/S)(1 + iUK)F.
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Arbitrage between the two investments (the domestic and the foreign) results in parity so that, or

(1+ iUK )F 1 + iUS = S 1 + iUS F = 1 + iUK S

(1)

(2)

Subtracting 1 from both LHS and RHS gives:

ius - iuk
UK

F-S S

(3)
UK

where (1 + i ) = 1 (approximately.), assuming small values of i . Equation 3 indicates that the interest rate differential between a comparable U.S. and U.K. investment is equal to the forward premium (discount) on the pound.
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Examples:
(1) Spot $/C$ = .80 90 day fwd $/C$ = .79 90 day iCan = 4% 90 day iUS = 2.5% . (2) Spot $/ = 1.50 90- day fwd rate = 1.4550 90- day ius = 3% 90- day iuk = 4%.

Show whether or not IRP holds Find the yield to a U.S. investor who executes a CIA. Explain the direction of flow and compute arbitrage profits 25 Find the 90-day fwd rate on C$ () if IRP holds.

Solution (1)

Yield

1 CIA = (1.04)(.79) - 1 = 1.027 - 1 = .027 .80

For parity, forward rate on C$ rate is given by:

1 (1.04)F = 1.025 .80

from which F = .78846

The currency of the country with a lower interest rate should be at a forward premium with respect to the currency of the higher interest rate country. The interest rate differential should be approximately equal to the forward rate differential (premium or discount) when parity exists.
(SEE APPENDIX I)
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Interpret points A,B,X,Y.

In reality the IRP line is a band because transaction costs arising from the spread on spot and forward contracts and brokerage fees on security purchases and sales cause effective yields to be lower than nominal yields.
Note that if IRP exists, it does not mean that domestic and foreign investors earn the same return. Rather existence of IRP means that investors cannot use covered interest arbitrage to achieve higher returns than those possible at home.
Effective returns are equalized for domestic investors if IRP holds regardless of where they invest - domestic or 27 foreign market.

Empirical Evidence
It is difficult to get quotations that reflect the same point in time for interest rates and the forward rates.

Nevertheless IRP theory is well supported empirically in international finance literature. In the Euro-Currency markets the forward rate is frequently calculated from interest rate differencial between two countries using the no arbitrage condition.

The Eurocurrency markets are relatively unregulated. Deviations from IRP occur due to capital controls, taxes, transaction costs, political risks etc.
Note that "default risks" could exit on loan contracts for which IRP is supposed to apply. 28 This would create deviation from parity.

Forward Rate Parity (FRP)

(The forward rate is an unbiased predictor of future spot rate)

The forward exchange rate must be equal to the expected future spot exchange rate at maturity otherwise risk-less arbitrage will take place. One may argue whether the forward rate should be equal the expected future spot rate or whether there is a premium incorporated in the forward rate that serves as reward for bearing risk in which case the forward would differ from the expected future spot by this premium. Empirical work typically focuses on whether the fwd rate is an unbiased predicator of future spot rate. An unbiased predictor is one that is correct on average: it is equally likely to guess too high or guess too low . 29

Pressure from the forward market is transmitted into the spot market and vice-versa. Equilibrium is achieved only when the forward differential equals the expected change in the future exchange rate (Append II)

At I, parity prevails as an expected 2% depreciation of the Pound is matched by a 2% discount on the Pound. Point J is a position of dis-equilibrium because a 3% forward discount on the Pound is more than offset by a 4% expected depreciation of the Pound.
Speculators are expected to sell pound forward and replenish or cover their commitments with 4% fewer units of domestic currency (short sale). Points L, X, K are also in disequilibrium.

Formally we can state that the forward rate is an unbiased predictor of future spot or that the forward differential 30 equals the expected change in exchange rates as follows :

S0 Sn |------------------------------------| t=0 t=n Fn Speculative efficiency hypothesis: Ft = E[St]

OR

Sn Fn Sn - So F n - So So So

(4)

(Expected Change (Forward Differenti al) in Exchange Rate) [Premium(Discount)]

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Empirical Evidence

There are pros and cons for the notion that the forward rate is an unbiased predictor of the future spot. It is probably unrealistic to expect a perfect correlation between forward rates and the realized future spot rates since future spot rates are influenced by events that cannot be perfectly forecast.
The rationale for the hypothesis that the fwd rate is unbiased is that the foreign exchange market is reasonably efficient (semistrong form). The forward market can be said to be efficient if the forward rate ruling at anytime is equal to the rational expectation of the future spot when the contract matures, plus the risk premium that speculators require to in order to compensate them for the additional risk that they bear in the forward market. 32

Questions for Discussion.

Under what conditions would the forward rate be a biased predictor of future spot?
What should be expected to happen? Currencies trading at a forward premium are expected to appreciate while currencies trading at a forward discount are expected to depreciate.

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Empirical Verifications (A method)

Consider, Ft,n = forward rate at n+t St+n = spot rate at time n+t

Then, St+n = a0 + b0Ft,n + Ut The null hypothesis: a0 = 0 ; b0 = 1

(5)

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If the null hypothesis cannot be rejected, the forward rate is an unbiased predictor of the future spot rate. However, movements in the spot are expected to be dominated by a trend. Therefore the above equation may produce high R2, or low DW statistic. There is also the danger of spurious regression if the series are not stationary. The level of forward rate will explain a high percentage of the variations in the level of future spot. This relationship may be spurious if the series are not stationary. But changes in the spot rate about its trend are likely to be nearly random so that, (6) S t+n F t,n

St

= a1 + b1

St

+ t

is likely to produce a low R2 - i.e., the forward premium (or discount) will explain a low percentage of the variation of the changes in the spot rates. If the null hypotheses a1 = 0, b1 = 1 cannot be rejected, we can conclude that the forward premium or discount is an unbiased 35 predictor of changes in the exchange rates.

The Purchasing Power Parity (PPP)

The PPP was first stated by Gustav Cassel (1918). He used it as a basis for a new set of official exchange rates at the end of World War I so that normal trade relations might resume among nations.
The Absolute Form: The PPP states that equilibrium exchange rate between the domestic and the foreign currencies equals the ratio between the domestic and foreign price levels. The absolute PPP postulates that perfect commodity arbitrage [in the absence of transaction or information cost of other restrictions] ensures that PPP relationship holds at each point in time. 36

Algebraically, given: St = et = exchange rate at time t Pd, Pf = aggregate price level for domestic and foreign, then:

et
OR

P f P
f

d
7(a)

= et P

7(b)

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This means that:

The general level of prices, when converted to a common currency will be the same in every country. In other words, a unit of domestic currency should
command the same purchasing power around the world.

This theory rests on the law of one price which states that free trade will equalize the price of any good (or asset) in all countries.

The theory however assumes away transportation cost, tariffs, quotas, product differentiation, and other restrictions. 38

The Relative Version: more meaningful and practical. It moves from levels to changes in exchange rates given relative price innovations. It states that: In comparison to a period when equilibrium rates prevailed, changes in the ratio of domestic and foreign prices will indicate the necessary adjustment between domestic and the foreign currencies.
Given that: S0 = e0 and St = et
= domestic currency units per unit of a foreign currency at 0,t. Pod, Pof = initial aggregate price levels respectively for domestic and foreign. Ptd, Ptf = aggregate price levels at time t respectively for domestic and foreign. 39

Formally:

/P et P / P P = = eo P / P P /P
where P0d, P0f, Ptd, Ptf are price indices. Letting,

d t f t

d 0 f 0

d t d 0

f t f 0

(8)

Ptd / Pod = 1 + d ; d = Domestic inflation rate

Ptf / Pof = 1 + f ; f = Foreign inflation rate

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then,

et e0

1+ d = 1+ f

So that, and

d 1 + et -1 = -1 f 1+ e0

d f et e0 d f = - f 1+ e0

(9)

assuming that 1 + f 1, for low values of f .

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Equation (9) states that the relative (expected) exchange rate change for two currencies between t1 and t2 should equal the relative change in price indices of the two countries between t1 and t2. For parity in the purchasing power of two currencies to obtain over a period of time, the rate of change of the exchange rate must equal the rate of change of relative prices. (See Appendix III)

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At A or inflation differentials are offset by corresponding foreign currency appreciation or depreciation. At A, there exists a 3% more domestic inflation. This is matched by a 3% increase in exchange rate (a 3% depreciation of domestic currency).

At B, 1% more f is matched by 1% reduction in ex (d/f). At D, f > d by 3%, but exchange rate (d/f) has reduced by only 1%. This means that domestic residents have a reduced purchasing power on the foreign goods. They therefore reduce their purchase of foreign goods but foreigners continue to purchase domestic goods. Foreign currency depreciates in value so that D approaches the PPP line.
Similarly at C, d > f by 2% but ex (d/f) has risen by only 1%. There is a higher PP on foreign goods for domestic 43 residents.

Note that if changes in nominal exchange rates are fully offset by relative price level changes between two countries, then the real exchange rates remains unchanged. Alternatively, a change in the real exchange rate is equivalent to a deviation from PPP.
Algebraically: Let Real Exchange Rate = RERt then,
$ $ ( ) d us $ 1 + uk 1+ 1+ = RERt = us BP BP BP 1 + ( ) t uk 1+ 1+

= BP,

f (1 + ) et RER t = (1+ d )
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But by PPP,

et

d (1 + ) e0 (1 + f )

d f (1 + ) (1 + ) e0 RERt = = e0 f d (1 + ) (1 + )

(10)

This means that there are no real changes in e from t = 0 to t = t, if PPP holds. If PPP holds then real return on an identical asset is equalized for investors worldwide.
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Empirical Evidence
Relative PPP holds fairly in the long-run especially in high inflation countries. The PPP does not hold consistently for many reasons: 01. Other factors maybe at work 02. No substitute for traded goods 03. Existence of internationally non-traded goods in the national price indexes. 04. Changes in Taste 05. Technological Progress 06. Differently constructed price indexes 07. Different "Market Baskets" 08. Different weighing formula for Market Basket 09. Relative price changes (vs. changes in general price level) 10. The "best" index cannot be a basis for a perfect representation of theoretical parity. 46

Empirical Verifications
Recent empirical tests focus on the L-R behavior of the RER (regarded as a measure of deviations from PPP)
Examples:

Joseph Whilt [RWK (1991) article #24] reports that inflation adjusted exchange rates (= RER) do not follow a random, but instead returns, over time, to some L-R equilibrium level posited by PPP.
Richard Roll (1979), Jacob Frenkel (1981), Michael Adler & Bruce Lehmann (1983), and others are unable to reject the hypothesis that the RER follows a RW. If RER follows a RW, no L-R equilibrium exists to which the rate tends to return, so that PPP can no longer serve as a gauge of L-R exchange equilibrium. So PPP does not hold. 47

Other studies - Cumby & Obstfeld (1984), Jeffrey Frankel (1985), John Huizinga (1987) have been able to reject the RW hypothesis for RER in some instances. (equil. Level exists) However, Hakkio (1984, 1986) is also unable to reject the RW hypothesis. He demonstrates that, if in fact, the RER differs modestly from a RW, standard tests are very likely to favor the RW even if it is false! So tests may be the problem.

Sims (1988) proposes a new statistical test that is especially sensitive in determining whether a variable is a true RW or whether the variable returns to its equilibrium level after a long-lag.
More recent developments: Cointegration and error correction models.
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 A Test of PPP
The exchange rate can be expressed as: et = ao + a1 (Pt - Pt*) + Ut
where et , Pt , Pt* are in logs. and a0, a1 can be estimated in a regression equation with monthly, quarterly, or annual data on et , Pt , Pt*. However problems exist here! Direction of causality? Estimated residuals, Ut, always exhibit severe positive autocorrelation. If residuals are autocorrelated, the estimated std. errors of coefficient will be biased downwards! The usual fix is to difference the data. 49

That means: Construct Zt = Xt - Xt-1, thus shifting the focus to changes in the (natural log of) original series Xt rather than (natural log of) the levels. Thus: et - et -1 = a1 [(Pt - Pt-1) - (Pt* - Pt -1*)] + Ut - Ut-1 or et = a1 ( Pt - Pt *) + Zt , where Zt is iid (inde. and identically distr.)

Another problem: PPP is an "equality" relationship not "causal".

Empirical evidence shows as much impact of exchange rates on prices as of prices on exchange rates. The usefulness of PPP, however, depends on existence of a lag between price level changes and exchange rates changes. 50

Demand-pull Vs Cost Push Inflation

The cost-push view of inflation relates inflation rate to factors such as changes in wage rate, and productivity gains (compared to Demand-pull which views inflation as a monetary phenomenon).
A synthesis is possible so that, ex = f( in wage rates, in productivity gains, in price levels)

Economies with relatively stable wage rates and higher productivity gains more than the US, for example, will experience currency appreciation against the US dollar.
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Other Issues About PPP

Is the PPP expected to hold in the S-R and L-R? Too many market imperfections exist in the S-R that allow S-R deviations from parity. In certain circumstances, the PPP might serve as an indicator of L-R equilibrium relationship among currencies. New econometric designs may improve tests of PPP e.g. Cointegration & error correction models. The selection of the reference currency (country) may be critical. Differential speed of adjustment between financial prices (very fast) and goods prices (relatively slow).52

In general, a validity for PPP (the necessary condition) can be established by showing that the series et, Ptd, Ptf, share a common LR equilibrium relationship - i.e. they are bound in a LR equal relationship. (that means that the series are cointergrated) PPP is important because it is the centerpiece of many exchange rate models and also because of its policy implications.

It provides a benchmark exchange rate for policy makers and exchange rate arbitragers. Check significance of coefficients, explanatory power, and residuals.

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The U.S. Dollar Price of a Big Mac around the world in May 2004

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The Fisher Equation:

There is a distinction between the real and nominal interest rates.

The nominal interest rate is the rate quoted or observed in the market. The real rate measures the return after adjusting for inflation.

The real rate is the rate at which current goods are being converted into future goods.
It is the net increase in wealth that people expect to achieve when they save and invest their current income. It is the added future consumption promised by a borrower to a lender.
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Since virtually all financial contracts are stated in nominal terms, nominal interest rates will tend to incorporate inflation expectation in order to provide lenders with a real return. The Fisher Equation (named after Irving Fisher) states that the nominal interest rate, i, is made up of a real required rate of return, r and inflation premium (the expected rate of inflation), This equation is given by (Approx)

i r +

(11)

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The exact relationship is given by:

1 + i = (1 + r) ( 1 + ) = 1 + + r + r and, i r + , if r 0 Thus an increase in will tend to increase i.
Example: If r = 3% and = 5%, find the: exact nominal rate: i = r + +r = .03+.05+ (.03)(.05) = .08+.0015 = 8.15%

approximate nominal rate i r + =.03+.05 = 8%

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In the U.S. for example, we have the following experiences:

In the 1950's and the 60's low inflation rates were accompanied by low nominal rates. In the 1970's and 80's high inflation rates were accompanied by high nominal rates. In the 90's the experience was low inflation rates with low interest rates! So far in the 20s, the experience has been historically low inflation with low interest rates!
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The Generalized Fisher Equation (GFE)

This theory asserts that real returns are equalized across countries through arbitrage. If rd > rf capital inflows will ensue and continue until rd = rf. Hence if we express the FE for both domestic (d) and foreign (f) countries, we have: id rd + d if rf + f And if rd = rf then,

id - i f d - f

(12)

This is the Generalized Fisher Equation. It asserts that "the nominal interest rates, id and if , differ solely by expected inflation differential. (SEE APPENDIX IV)
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At C, there is equilibrium. A 2% increase in f is offset by a 2% increase in if . At D, there is a 5% increase in if but only 3% increase in f which implies that real return is higher in foreign country. Funds should flow from domestic to foreign country to take advantage of this real difference until expected real returns are equalized. Empirical evidence tends to support this hypothesis if we ignore the effects of tax differences, government controls, political risks, and risk premia.
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We can summarize the link between interest, inflation, and exchange rates by combining the Interest Rate Parity and the Generalized Fisher Equation, so that,

F-S id - i f - S
d f

(13)

i.e., real interest rates are equalized across countries when the Fisher Equation and Interest Rate Parity hold and nominal interest rates differ by expected inflation differential between domestic and foreign. In the real world, the above inter-relationship are determined simultaneously because interest rates, inflation expectation, and exchange rates are jointly affected by the arrival of new information (events).

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The International Fisher Equation (IFE)

The IFE expresses the relationship between interest rate differential and the expected change in exchange rates. This relationship can be derived by combining the PPP with the GFE. The IFE is based on nominal interest differentials which are influenced by expected inflation. Algebraically, the IFE states that:

et e0
or

1 + id 1 + if

(14)

id - i f et - e0 = id - i f 1 + if e0
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Alternatively, we can combine PPP and GFE as follows: (15) et - e0

PPP :

e0

d -

GFE :

id - i f d - f

(16)

Combining (15) and (16) we have:

id - i f

et - e0 e0

(17)

(17) states that the spot exchange rates will change in accordance with the difference in interest rates (on comparable securities) between countries. Hence the return on foreign uncovered money market securities will, on an average, be no higher than return on domestic money market securities from the point of view of a domestic resident (and vice versa). 63

This notion can be expressed as:

1 + id
or

et e0

e0 1 + id 1 + if

(1 + i f ) et

which reduces to (17). That is UIRP holds. IFE states that arbitrage between financial markets in the form of capital flows should ensure that id - if is an unbiased predictor of the expected change in spot exchange rates between domestic and foreign currencies; or that spot exchange rate should change to adjust for differences in nominal interest rates between two countries. (SEE APPENDIX V)

NOTE: A carry trade (in which the investor borrows in low interest currency and invests in high interest currency) is profitable on average. (e.g. Japanese carry trade) Most often, the estimated slope coefficient is negative, meaning that the currency with the higher interest rate tends to appreciate. 64 This is a classic case of empirical rejection of UIRP.

At E, if > id by 3%, foreign currency depreciates by 3% to offset the interest difference so that parity holds. At F parity also obtains as a 2% higher domestic interest is offset by a 2% increase in exchange rates. Points along IFE reflect exchange rates adjusting to offset interest rate differentials.

Points below the IFE line implies an increase in return on foreign assets owned by domestic investors.
Points above the IFE line implies a reduction in return on foreign assets owned by domestic investors.
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Empirical Evidence:

Evidence exists that currencies with high interest rates like the Peso, Real, etc tend to depreciate, while those with low interest rates like the Yen, Swiss Franc, tend to appreciate. High nominal rates reflect high inflation. In the long-run interest rate differentials tend to offset exchange rate changes.
Problems with IFE: Determining the effects of the change in i on exchange rates is complicated by the Fisher Equation which says: i r + . However, a change in i can be due to a change in r or a change in . These two possibilities have opposite effects.
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When a parity condition fails to hold, the structure of international financial markets may influence investors strategy of borrowing, investing, hedging, speculating, or making investment location decisions. If absolute PPP does not hold, sellers have the power to price discriminate across countries and buyers have incentives to overcome barriers to access lower cost goods. If IRP does not hold, the cost of borrowing or return on investment (with forward cover) differs depending on which currency is used therefore it is possible to find superior investment or lower cost funds without incurring foreign exchange risk.
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If IFE does not hold, investments with higher expected returns and funds with lower expected costs are possible but these contain exposure to currency risk.

Rational for the IFE is that a country with a higher interest rate will tend to have a higher inflation rate. This increased level of inflation should cause the currency in the country with the high interest rate to depreciate against that of a country with lower interest rate.

Internet Resources: www.oecd.org/std/nadata/html www.ft.com/cgi-bin/pft/intcrates.p1/report

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