MODULE 4 INTERNATIONAL PARITY CONDITIONS

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LEARNING OBJECTIVES

01 02 03 04
Examine how price Show how interest rates Explain how forward Analyze how, in
levels and price level reflect inflationary markets for currencies equilibrium, the spot
changes (inflation) in forces within each reflect expectations held and forward currency
countries determine the country and drive by market participants markets are aligned with
exchange rates at which currency exchange rates about the future spot interest differentials and
their currencies are exchange rate differentials in expected
traded inflation

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INTERNATIONAL PARITY CONDITIONS (1

OF 2)

 Some fundamental questions managers of MNEs, international

portfolio investors, importers, exporters and government
officials must deal with every day are:
 What are the determinants of exchange rates?
 Are changes in exchange rates predictable?

 The economic theories that link exchange rates, price levels, and
interest rates together are called international parity conditions.

 These international parity conditions form the core of the

financial theory that is unique to international finance.
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INTERNATIONAL PARITY CONDITIONS (2

OF 2)

 These theories do not always work out to be “true” when

compared to what students and practitioners observe in the real
world, but they are central to any understanding of how
multinational business is conducted and funded in the world
today.

 The mistake is often not with the theory itself, but with the
interpretation and application of said theories.
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PRICES AND EXCHANGE RATES (1 OF 2)

 If the identical product or service can be:

 sold in two different markets; and
 no restrictions exist on the sale; and
 transportation costs of moving the product between markets are
equal, then
 the product’s price should be the same in both markets.

 This is called the law of one price.

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PRICES AND EXCHANGE RATES (2 OF 2)

 A primary principle of competitive markets is that prices will equalize across markets if
frictions (transportation costs) do not exist.

 Comparing prices then, would require only a conversion from one currency to the other:

P $  S ¥ = $1.00 = P ¥
Where:
The product price in U.S. dollars is P $
( )
The spot exchange rate is S
¥$
( )
The price in Yen is (P ).
¥
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PURCHASING POWER PARITY AND THE

LAW OF ONE PRICE

 If the law of one price were true for all goods and services, the
purchasing power parity (PPP) exchange rate could be found
from any individual set of prices.

 By comparing the prices of identical products denominated in

different currencies, we could determine the “real” or PPP
exchange rate that should exist if markets were efficient.

 This is the absolute version of the PPP theory.

 A fun example is the Big Mac Index published annually by the

Economist. Exhibit 6.1 illustrates.
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EXHIBIT 6.1 (1 OF 2)
Selected Rates from the Big Mac Index
Country Currency (1) (2) (3) (4) (5)
Big Mac Actual Dollar Big Mac Implied Under/
Price in Local Exchange Rate Price in PPP of the overvaluation
Currency July 2017 Dollars Dollar against Dollar
United
States $ Dollar sign

5.66 Blank

5.66 Blank Blank

Britain £ Pound

3.29 1.3489* 4.44 1.7204* −21.6%

Minus 21.6 percentage.

C$ −6.6%
Canadian dollar

Canada 6.77 1.2803 5.29 1.1961 Minus 6.6 percentage.

China Yuan 22.4 6.4751* 3.46 3.9576* −38.9%

Minus 38.9 percentage.

Denmark DK 30.0 6.1207 4.90 5.3004 −13.4%

Minus 13.4 percentage.

Euro area € Euro

4.25 1.2151 5.16 1.3318 −8.8%

Minus 8.8 percentage.

India Rupee 190.0 73.390 2.59 33.569 −54.3%

Minus 54.3 percentage.

−33.9%
Minus 33.9 percentage.

Japan ¥ Yen

390 104.295 3.74 68.905

Mexico Peso 54.0 20.1148 2.68 9.5406 −52.6%
Minus 52.6 percentage.

Norway kr 52.0 8.5439 6.09 9.1873 7.5% 7.5 percentage.

−41.9%
Minus 41.9 percentage.

Peru Sol 11.9 3.6207 3.29 2.1025

Russia Ruble 135.0 74.63 1.81 23.852 −68.0%
Minus 68.0 percentage.
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EXHIBIT 6.1 (2 OF 2)
Country Currency (1) (2) (3) (4) (5)
Big Mac Actual Dollar Big Mac Implied Under/
Price in Local Exchange Rate Price in PPP of the overvaluation
Currency July 2017 Dollars Dollar against Dollar

Singapore S$
S Dollar sign

5.90 1.3308 4.43 1.0424 −21.7%

minus 21.7 percentage.

Thailand Baht 128.0 30.1300 4.25 22.6148 −24.9%

minus 24.9 percentage.

Note:* These exchange rates are stated in US$ per unit of local currency,
$ = £1.00 and $ = €1.00
** Percentage under/overvaluation against the dollar is calculated as (Implied –
Actual)/(Actual), except for the Britain and Euro area calculations, which are (Actual –
Implied)/(Implied).
Source: Data for columns (1) and (2) drawn from “The Big Mac Index Tells You about
Currency Wars,” The Economist, July 12, 2021.
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RELATIVE PURCHASING POWER PARITY (1 OF 2)

 If the assumptions of the absolute version of the PPP theory

are relaxed a bit more, we observe what is termed relative
purchasing power parity (relative PPP).
 Relative P PP holds that PPP is not particularly helpful in
determining what the spot rate is today, but that the relative
change in prices between two countries over a period of time
determines the change in the exchange rate over that period.
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RELATIVE PURCHASING POWER PARITY (2 OF 2)

 More specifically, with regard to relative PPP:

“If the spot exchange rate between two countries starts in

equilibrium, any change in the differential rate of inflation between
them tends to be offset over the long run by an equal but opposite
change in the spot exchange rate.”
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EMPIRICAL TESTS OF PURCHASING POWER PARITY

 Empirical testing of P PP and the law of one price has been done, but
has not proved PPP to be accurate in predicting future exchange
rates.
 Two general conclusions can be made from these tests:
 PPP holds up well over the very long run but poorly for shorter
time periods
 The theory holds better for countries with relatively high rates of
inflation and underdeveloped capital markets.
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EXCHANGE RATE INDICES: REAL AND NOMINAL

 Individual national currencies often need to be evaluated against other currency

values to determine relative purchasing power to discover whether a nation’s
exchange rate is “overvalued” or “undervalued” in terms of PPP.

 This problem is often dealt with through the calculation of exchange rate indices,
such as the nominal effective exchange rate index.

C$
$
ER = E N$

C FC

 Exhibit 6.2 illustrates real effectives exchange rate indexes for Japan, the
euro area, and the United States.
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EXHIBIT 6.2
Real Effective Exchange Rate Indexes (Base Year 2010 = 100)

For long description, see slide 40: Appendix 1

Source: Bank for International Settlements, www.bis.org/statistics/eer/. BIS effective

exchange rate (EER), Real (CPI-based), narrow indices, monthly averages, January 1980–
March 2021.
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EXCHANGE RATE PASS-THROUGH (1 OF 3)

 Exchange rate pass-through is a measure of the response of

imported and exported product prices to changes in exchange
rates.
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EXCHANGE RATE PASS-THROUGH (2 OF 3)

 Price elasticity of demand is an important factor when

determining pass-through levels.

 The own-price elasticity of demand for any good is the

percentage change in quantity of the good demanded as a result
of the percentage change in the good’s price.

%Qd
Price elasticity of demand = ε p =
%P
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EXCHANGE RATE PASS-THROUGH (3 OF 3)

 A number of emerging market countries have chosen in recent

years to change their objectives and choices.

 These countries have shifted from choosing a pegged exchange

rate and independent monetary policy over the free flow of
capital (point A in Exhibit 6.3) to policies allowing more capital
flows at the expense of a pegged or fixed exchange rate (toward
point C in Exhibit 6.3).
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EXHIBIT 6.3
Pass-Through, the Impossible Trinity, and Emerging Markets

Many emerging market countries have chosen to move from Point A to Point C,
exchanging fixed exchange rates for the chance of attracting capital inflows. The result
is that these countries are now the subject to varying levels of exchange rate pass-
through.
For long description, see slide 41: Appendix 2
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Interest Rates and Exchange Rates (1 of 3)

 The Fisher effect states that nominal interest rates in each
country are equal to the required real rate of return plus
compensation for expected inflation.
 This equation reduces to (in approximate form):

i=r +
Where i = nominal interest rate, r = real interest rate and
 = expected inflation.
 Empirical tests (using ex-post) national inflation rates have shown the
Fisher effect usually exists for short-maturity government securities
(treasury bills and notes).
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INTEREST RATES AND EXCHANGE RATES

(2 OF 3)

 The relationship between the percentage change in the spot

exchange rate over time and the differential between
comparable interest rates in different national capital markets is
known as the international Fisher effect.

 “Fisher-open,” as it is termed, states that the spot exchange rate

should change in an equal amount but in the opposite direction
to the difference in interest rates between two countries.
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INTEREST RATES AND EXCHANGE RATES (3 OF 3)

More formally:

S1 − S2
 100 = i − i
$ ¥

S2
 Where
i $ and i ¥ are the respective national interest rates

and S is the spot exchange rate using indirect quotes ( ¥/$ ) .

 Justification for the international Fisher effect is that investors must be

rewarded or penalized to offset the expected change in exchange rates.
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THE FORWARD RATE (1 OF 4)

 A forward rate is an exchange rate quoted for settlement at some future

date.
 A forward exchange agreement between currencies states the rate of
exchange at which a foreign currency will be bought forward or sold
forward at a specific date in the future.
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THE FORWARD RATE (2 OF 4)

 The forward rate is calculated for any specific maturity by adjusting the current spot
exchange rate by the ratio of eurocurrency interest rates of the same maturity for the two
subject currencies.
SF
 For example, the 90-day forward rate for the Swiss franc/U.S. dollar exchange rate ( F / $90)
SF
is found by multiplying the current spot rate (S / $) by the ratio of the 90-day euro-Swiss
franc deposit rate ( iSF ) over the 90-day eurodollar deposit rate ( i$ ) .
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THE FORWARD RATE (3 OF 4)

 Formulaic representation of the forward rate:

  SF 90  
1 +  i  360  
  
F SF/$
=S SF/$

  $ 90  
90

1 +  i  360  
  

For long description, see slide 42: Appendix 3

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THE FORWARD RATE (4 OF 4)

 The forward premium or forward discount is the percentage
difference between the spot and forward exchange rate, stated in
annual percentage terms.

Spot − Forward 360

f SF =   100
Forward days

 This is the case when the foreign currency price of the

home currency is used (SF/$).
 See Exhibit 6.4
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EXHIBIT 6.4
Currency Yield Curves and the Forward Premium

For long description, see slide 43: Appendix 4

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INTEREST RATE PARITY (IRP)

 The theory of Interest Rate Parity (IRP) provides the linkage

between the foreign exchange markets and the international
money markets.
 The theory states, “The difference in the national interest rates for
securities of similar risk and maturity should be equal to, but
opposite in sign to, the forward rate discount or premium for the
foreign currency, except for transaction costs.”
 See Exhibit 6.5
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EXHIBIT 6.5
Interest Rate Parity (IRP)

For long description, see slide 44: Appendix 5

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COVERED INTEREST ARBITRAGE (CIA)

 The spot and forward exchange rates are not constantly in the state of
equilibrium described by interest rate parity.
 When the market is not in equilibrium, the potential for “risk-less” or
arbitrage profit exists.
 The arbitrager will exploit the imbalance by investing in whichever
currency offers the higher return on a covered basis.
 See Exhibit 6.6
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EXHIBIT 6.6
Covered Interest Arbitrage (CIA)

For long description, see slide 45: Appendix 6

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UNCOVERED INTEREST ARBITRAGE (UIA)

 In the case of uncovered interest arbitrage (UIA), investors borrow in

countries and currencies exhibiting relatively low interest rates and convert
the proceed into currencies that offer much higher interest rates.
 The transaction is “uncovered” because the investor does not sell the
higher yielding currency proceeds forward, choosing to remain uncovered
and accept the currency risk of exchanging the higher yield currency into
the lower yielding currency at the end of the period.
 See Exhibit 6.7
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EXHIBIT 6.7 Uncovered Interest Arbitrage (UIA): The Yen Carry Trade

For long description, see slide 46: Appendix 7

EQUILIBRIUM  Exhibit 6.8 illustrates the conditions necessary for equilibrium
between interest rates and exchange rates.
BETWEEN  The disequilibrium situation, denoted by point U, is located off the
INTEREST RATES interest rate parity line.
AND EXCHANGE  However, the situation represented by point U is unstable because all
RATES investors have an incentive to execute the same covered interest
arbitrage, which is virtually risk-free.

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EXHIBIT 6.8 Interest Rate Parity and Equilibrium

If market interest rates were at point U, covered interest arbitrage profits

are available and would be undertaken until the market drove interest rate
differences back to point X, Y, or Z.
For long description, see slide 47: Appendix 8
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FORWARD RATE AS AN UNBIASED PREDICTOR OF THE

FUTURE SPOT RATE

 Some forecasters believe that forward exchange rates are unbiased predictors of future spot
exchange rates.

 Intuitively this means that the distribution of possible actual spot rates in the future is centered
on the forward rate.

 Unbiased prediction simply means that the forward rate will, on average, overestimate and
underestimate the actual future spot rate in equal frequency and degree.

 Exhibit 6.9 illustrates this theory.

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EXHIBIT 6.9 Forward Rate as an Unbiased Predictor of Future Spot

(F )
The forward rate available “today” t , for delivery at a future time (Ft ) is used as a forecast or predictor
of the spot rate at time ( t + 1) . The difference between the spot rate which and the forward rate is the
forecast error. When the forward rate is termed an “unbiased predictor of the future spot rate,” it means
that the errors are normally distributed around the mean future spot rate (the sum of the errors equals
zero).

For long description, see slide 48: Appendix 9

PRICES, INTEREST RATES, AND
EXCHANGE RATES IN EQUILIBRIUM

 Exhibit 6.10 illustrates all of the fundamental parity relations

simultaneously, in equilibrium, using the U.S. dollar and the
Japanese yen.

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EXHIBIT 6.10
International Parity Conditions in Equilibrium (in approximate form)

For long description, see slide 49: Appendix 10

Appendix

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APPENDIX 1
Long description for Exhibit 6.2

The graph has three curves representing the exchange rate indexes for U.S. dollar, Japanese yen, and Euro
Area euro. The following list outlines the trends demonstrated by the graph. All rates are based on base
year 2010 = 100. All values are estimated. The index for the U.S. dollar started at 106 in January 1980,
before rising to a peak at 145 around August 1984. The index then fell to a low at 95 in December 1991,
before fluctuating between 95 and 130 during the period from 1991 and 2021. The index for the dollar
reached notable peaks at 125 in 2001, at 112 in 2008, at 129 in 2016, and at 130 in 2020. The index reached
notable valleys at 95 in 1991, 2007, and 2010. By 2021, the index for the U.S. dollar was at 120. The index
for the Japanese yen started at 73 in January 1980. Despite fluctuations of up to 30 points over 2 years, the
index generally rose between the years 1982 and 1995, with notable peaks at 115 in 1998 and at 142 in
1995. From 1995 to 2021, the index for the yen then generally declined. During this period, the index had
notable peaks at 123 in 2001 and at 108 in 2011. The index had notable valleys at 93 in 1997, at 75 in 2006,
and at 72 in 2014. By 2021, the index for the Japanese yen was at 75. The index for the Euro Area euro
started at 98 in 1980, before falling to near 80 by 1981. From 1981 to 1984, the index for the euro fluctuated
between 78 and 88, before rising to near 98 in 1986. From 1986 to 1998, the index fluctuated between 85
and 100, ending at 95. The index then fell to near 74 in 2000, before once again climbing to near 110 by
2007. From 2007 to 2021, the index for the euro generally fell, ending at 95
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APPENDIX 2
Long Description for Exhibit 6.3

A triangle has vertices that represent the pegged exchange rate, the free flow of capital, and
independent monetary policy. Points A, B, and C on the sides of the triangle represent the
changing approach of emerging market nations to their exchange rates. The following list outlines
this changing approach. Emerging market nations generally start at point A on the side of the
triangle between the pegged exchange rate and independent monetary policy. These nations
traditionally value exchange rate stability and monetary independence. Emerging market nations
want to attract capital inflows. So, they have shifted toward point C on the side of the triangle
between independent monetary policy and free flow of capital. Exchange rate pass through has
also led emerging market nations to shift toward point B on the side of the triangle between
pegged exchange rate and free flow of capital. Now that these countries are experiencing
changing exchange rates, exchange rate pass through is a growing source of inflationary pressure
and price instability.

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APPENDIX 3
Long Description for the Forward Rate

F to the power of S, F divided by $90 equals start expression S to the power of S, F

divided by dollar sign end expression times start fraction 1 plus left parenthesis i to the
power of S, F times 90 divided by 360 right parenthesis over 1 plus left parenthesis i to
the power of dollar sign times 90 divided by 360 right parenthesis end fraction.

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APPENDIX 4
Long Description for Exhibit 6.4

The graph has two yield curves for the euro dollar and euro Swiss franc. Each curve rises with
decreasing steepness from a point on the positive vertical axis. The euro dollar yield curve rises
from (0, 3.5) through (90, 8.0) to (180, 8.6). At 80 days forward, the interest yield for the euro dollar is
8.0 percent. The euro Swiss franc yield curve rises from (0, 1.6) through (90, 4.0) to (180, 4.6). At 80
days forward, the interest yield for the euro Swiss franc is 4.0 percent. The forward pendulum is the
percentage difference between interest yields. The percentage difference is equal to the vertical
distance between the curves at 80 days forward. The percentage difference is 3.96 percent. All
values estimated.

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APPENDIX 5
Long Description for Exhibit 6.5

A diagram demonstrates how the same US dollar amount can generate very similar final amounts when it passes
through the US dollar money market and the Swiss franc money market over a 90-day period. The following list
outlines the conversion process in each market and compares the final amounts. With a start of 1,000,000 dollars
enters the U. S. dollar money market and the Swiss franc money market. The U.S. dollar money market uses the
euro dollar interest rate of 8.00 percent, which is equivalent to 2 percent for 90 days. 1,000,000 dollar times 1.02
equals 1,020,000 dollars. Before entering the Swiss franc money market, the starting amount is converted using
the spot exchange rate of SF 1.4800 equals 1.00 dollar. 1,000,000 dollar times 1.4800 equals SF 1,480,000. The
Swiss franc money market uses the Swiss franc interest rate of 4.00 percent per annum, which is equivalent to 1
percent for 90 days. SF 1,480,000 times 1.01 equals SF 1,494,800. This Swiss franc amount is then converted using
the 90-day forward rate, or F 90, of SF 1.4655 equals 1.00 dollar. SF 1,494,800 divided by 1.4655 equals 1,019,993
dollar. At the end, the final amount from the US dollar money market is 1,020,000 dollars. The final amount from
the Swiss franc money market is 1,019,993 dollars. The amounts only differ by a transaction cost of 7.00 dollars.

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APPENDIX 6
Long Description for Exhibit 6.6

A diagram demonstrates how the same U.S. dollar amount can generate different final amounts when it
passes through the U.S. dollar money market and the Japanese money market over a 180-day period. The
following list outlines the conversion process in each market and compares the final amounts. With a start
of 1,000,000-dollar entry the U.S. dollar money market and the Japanese yen money market. The U.S. dollar
money market uses the euro dollar interest rate of 8.00 percent, which is equivalent to 4 percent for 180
days. 1,000,000 dollar times 1.04 equals 1,040,000 dollars. Before entering the Japanese yen money market,
the starting amount is converted using the spot exchange rate 106.00 yen equals 1.00 dollar. 1,000,000
dollar times 106 equals S F 106,000,000 yen. For the Japanese yen money market, the investor uses a euro
yen account with an interest rate of 4.00 percent per annum, which is equivalent to 2 percent for 180 days.
106,000,000 yen times 1.02 equals 108,120,000 yen. This yen amount is then converted using the 180-day
forward rate, or F 180, of 103.50 yen equals 1.00 dollar. S F 108,120,000 yen divided by 103.50 equals
1,044,638 dollars.

End. The final amount from the US dollar money market is $1,040,000. The final amount from the Japanese
yen money market is $1,044,638. The amounts only differ by an arbitrage potential of $44,638.

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APPENDIX 7
Long Description for Exhibit 6.7

A diagram demonstrates how the same Japanese yen amount can generate different final amounts when it passes through
the Japanese yen money market and the U S dollar money market over a 360-day period. The following list outlines the
conversion process in each market and compares the final amounts. With a start of 10,000,000-yen entry the Japanese yen
money market and the U. S. dollar money market. For the Japanese yen money market, the investor borrows yen for 360
days at 0.40 percent per annum. 10,000,000 yen times 1.004 equals 10,040,000. Before entering the U. S. dollar money
market, the starting amount is converted using the spot exchange rate of 120.00 yen equals 1.00 dollar. 10,000,000 yen
divided by 120.00 equals 83,333.33 dollars. The investor deposits this amount in the U. S. dollar money market at 5.00
percent per annum. 83,333.33 dollar times 1.05 equals 87,500.00 dollars. The investor then converts this dollar amount back
to yen, using the expected spot exchange rate of 120.00 yen equals 1.00 dollar. 87,500.00 dollar times 120.00 equals
10,500,000 yen. At the end the final amount from the Japanese yen money market is 10,040,000, which is repaid. The final
amount from the U. S. dollar money market is 10,500,000, which is earned. The amounts differ by a profit of 4460,000 yen.

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 47

APPENDIX 8
Long Description for Exhibit 6.8

The graph falls diagonally through the origin, point X at (4, negative 4), point Y at
approximately (4.41, negative 4.41), and point Z at (4.83, negative 4.83). The line
intersects a rectangular region in quadrant 4. Counterclockwise from the top right, the
rectangular region has vertices at (4.83, 0), (0, 0), (0, negative 4), and point U at (4.83,
negative 4). Point X lies on the bottom side of the region, 0.83 units to the left of point U.
Point Z is 0.83 units below point U. If market interest rates were at point U, covered
interest arbitrage profits are available, and would be undertaken until the market drove
interest rate differences back to point X, Y, or Z.

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APPENDIX 9
Long Description for Exhibit 6.9

The graph includes separate plots for spot rate S and forward rate F, as described in the following list. The plot of
spot rate S rises from (t sub 1, S sub 1) to (t sub 2, S sub 2) and then falls through (t sub 3, S sub 3) to (t sub 4, S
sub 4). Vertical lines rise through the t axis at t sub 1, t sub 2, t sub 3, and t sub 4. The vertical lines intersect the
graph of S at S sub 1, S sub 2, S sub 3, and S sub 4, respectively. The plot of forward rate F consists of three line
segments with end points on the vertical lines at t sub 1, t sub 2, t sub 3, and t sub 4. The first line segment falls
from (t sub 1, S sub 1) to (t sub 2, F sub 1), where F sub 1 is less than S sub 2. The second line segment rises from (t
sub 2, S sub 2) to (t sub 3, F sub 2), where F sub 2 is greater than S sub 3. The third line segment rises from (t sub 3,
S sub 3) to (t sub 4, F sub 3), where F sub 3 is greater than S sub 4. On each vertical line, the distance between the S
and F values represents the error in the forward rate.

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 49

APPENDIX 10
Long Description for Exhibit 6.10

The approximate model of equilibrium involves five relations identified by the letters A, B, C, D, and E. The
following list describes each relation based on changes to exchange rates, interest rates, and inflation for the
Japanese yen. Relation A: purchasing power parity. The forecast change in the spot exchange rate is plus 4
percent, meaning the yen strengthens. The forecast difference in rates of inflation is minus 4 percent, meaning less
in Japan. Relation B: Fisher effect. The forecast difference in rates on inflation is minus 4 percent, meaning less in
Japan. The difference in nominal interest rates is minus 4 percent, meaning less in Japan. Relation C: International
Fisher effect. The forecast change in the spot exchange rate is plus 4 percent, meaning the yen strengthens. The
difference in nominal interest rates is minus 4 percent, meaning less in Japan. Relation D: Interest rate. The
difference in nominal interest rates is minus 4 percent, meaning less in Japan. The forward premium on foreign
currency is plus 4 percent, meaning the yen strengthens. Relation E: forward rate as an unbiased predictor. The
forward premium on foreign currency is plus 4 percent, meaning the yen strengthens. The forecast change in the
spot exchange rate is plus 4 percent, meaning the yen strengthens.

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End of Module
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