Chapter 6

International Parity Relationships and

Forecasting Exchange Rates
• Interest Rate Parity
– Covered Interest Arbitrage
– IRP and Exchange Rate Determination
– Currency Carry Trade
– Reasons for Deviations from IRP
• Purchasing Power Parity
– PPP Deviations and the Real Exchange Rate
– Evidence on Purchasing Power Parity
• The Fisher Effects
• Forecasting Exchange Rates
– Efficient Market Approach
– Fundamental Approach
– Technical Approach
– Performance of the Forecasters 6-2
 Interest Rate Parity Defined

• IRP is a “no arbitrage” condition.

• 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.
– Most of the time…

6-3
 Interest Rate Parity Example
• Consider an investor with €10,000 who faces an interest rate in the euro
zone of i€ = 5%
• He could invest in Europe and have €10,500 in one year.
• Or he could trade his euro for pounds sterling at the spot exchange rate
and invest in the United Kingdom at i£ = 15½%
• The spot exchange rates are
£1.00 = $1.50 and €1.00 = $1.20 $1.50 × €1.0 = €1.25
£1.0 $1.20 £1.00 = S0(€/£)
• If he invests in Britain, he prudently hedges his exchange rate risk with a
short position in a forward contract on the £9,240 his investment will grow
£1.00
to £9,240 = €10,000 × €1.25 × 1.155

• £9,240
IRP says that the forward exchange rate must be £0.8800/€
F1(£/€) = = £0.8800/€
€10,500 6-4
 Interest Rate Parity Example
€10,000 invest at i€ = 5% €10,000 × (1.05) = €10,500

i€ = 5%; i£ =0 15½% 1
Alternatively £1.00 $1.20 £0.80
× =
$1.50 €1.00 €1.00

£9,240 = €10,500
S0(£/€) =
Buy £8,000 at spot
£0.80 × 1.155 £0.88
F1(£/€) = =
€1.00 × 1.05 €1.00

$1.20 £1.00
€10,000 × × = £8,000invest at i£ = 15½% £9,240
€1.00 $1.50
£9,240
IRP says that the 1-year forward rate must be £0.88/€ =
€10,500
6-5
 Why IRP Holds: Part 1
• Suppose that the one-year forward rate was a tiny bit too low
at £0.8799/€
• An astute trader would move quickly to
1. Borrow €1,000,000 at i€ = 5%
2. Trade €1,000,000 for £800,000 at the spot rates
3. Invest £800,000 at i£ = 15½%
4. Enter into a short position in a one-year forward contract on
£924,000 at £0.8799/€
• In one year he has a cash inflow of €1,050,119.33 from the
forward contract and owes €1,050,000
• Risk-free arbitrage profit of €119.33

6-6
 Why IRP Holds: Part 1
At T = 0 borrow at i€ = 5% & sell At T = 1, owe €1.05m:
€1,000,000 £924,000 forward €1m×(1.05) = €1,050,000

Buy 0 1
£800,000 at The easy profit of €119.33 will attract trades that will force

Sell £924,000 per forward

spot prices back into line.

Repay loan with €1,050,000

You are short in a forward contract
Sell £924,000 for €1,050,119.33

contract
€1.00
£924,000 × = €1,050,119.33
£0.8799
$1.20 £1.00 invest at i£ = 15½% £924,000
€1m × × = £800,000
€1.00 $1.50
6-7
 Why IRP Holds: Part 2
• Suppose that the one-year forward rate was a tiny bit too high
at £0.8801/€
• An astute trader would move quickly to
– Borrow £800,000 at i£ = 15½%.
– Trade £800,000 for €1,000,000 at spot rates
– Invest €1,000,000 at i€ = 5%
– Enter into a long position in a one-year forward contract on £924,000
at £0.8801/€
• In one year he has a cash outflow of €1,050,000 from the
forward contract and owes £924,000
• Risk-free arbitrage profit of €119.31

6-8
 Why IRP Holds: Part 2
receive
Invest at i€ = 5% €10,000 ×(1.05) = €1,050,000
€1,000,000

0 You are long in a forward contract 1

Buy £924,000 at £0.8801/€

Buy £924,000 forward

this will only cost €1,049,880.70
Repay loan with £924,000

Risk-free arbitrage profit of €119.31

At T = 0 Sell £800,000 for €1m at
spot; go long in forward contract on The easy money will attract traders who will force prices
£924,000 at £0.8801/€ back into line.

T = 1 owe
€1.00 $1.50 At T= 0, Borrow £800,000 at i£ =
€1m = × × £800,000
$1.20 15½% £924,000
£1.00

6-9
 Multi-Year Interest Rate Parity
• So far we’ve computed the no-arbitrage 1-year.forward rate
• To calculate the two-year forward rate compound the interest for 2 years:
£924,000

£1,067,220
F1(£/€) =

£924,000
£800,000

€1,050,000
spot
i£ = 15½%. i£ = 15½%.
F1(£/€) =£0.8800/€
€1.25
£1.00

£1,067,220
0 1 2
=

F2(£/€) =
€1,102,500
€1.00
$1.20

i€ = 5% i€ = 5%
F2(£/€) =£0.9680/€
×

€1,000,000

€1,102,500
€1,050,000
£1.00
$1.50

£1.00×(1+ i£)2
F2(£/€) =
€1.25×(1+ i€)2
6-10
 IRP Even More Carefully Defined
• Interest Rate Parity is a “no arbitrage” condition that suggests
that forward exchange rates are defined by today’s spot
exchange rates grossed up and down by the future value
interest factors:
• In our example with a spot rate of €1.25/£, interest rate parity
says that the N-year future exchange rate that prevails today
must be:

£1.00×(1+ i£)N
FN(£/€) =
€1.25×(1+ i€)N
Notice that we increase the pounds in the spot rate at i£ and the
euro in the spot rate by i€ to find the forward rate.
6-11
 Currency Carry Trade
• Currency carry trade involves buying a currency that
has a high rate of interest and funding the purchase
by borrowing in a currency with low rates of interest,
without any hedging.
• The carry trade is profitable as long as the interest
rate differential is greater than the appreciation of
the funding currency against the investment
currency.

6-12
 Currency Carry Trade Example
• Suppose the 1-year borrowing rate in dollars is 1%.
• The 1-year lending rate in pounds is 2½%.
• The direct spot ask exchange rate is $1.60/£.
• A trader who borrows $1m will owe $1,010,000 in one year.
• Trading $1m for pounds today at the spot generates £625,000.
• £625,000 invested for one year at 2½% yields £640,625.
• The currency carry trade will be profitable if the spot bid rate prevailing in
one year is high enough that his £640,625 will sell for at least $1,010,000
(enough to repay his debt).
• No less expensive than:

b $1,010,000 $1.5766
S ($/£) =
360
=
£640,625 £1.00
6-13
Interest Rate Spreads and Exchange Rate Changes Australian
Dollar vs. Japanese Yen

Carry
trade
loses
money Carry trade makes money
when interest rate spread >
exchange rate change

6-14
 Reasons for Deviations from IRP
• Transactions Costs
– The interest rate available to an arbitrageur for borrowing,
ib, may exceed the rate he can lend at, il.
– There may be bid-ask spreads to overcome, Fb/Sa < F/S.
– Thus, (Fb/Sa)(1 + i¥l)  (1 + i¥ b)  0.
• Capital Controls
– Governments sometimes restrict import and
export of money through taxes or outright bans.

6-15
 IRP with Transactions Costs

e
F1($/€) –S0($/€)

lin
P
IR
S0($/€)

←Unprofitable “arbitrage”
opportunity

exploitable arbitrage i$ − i¥
opportunity →

Unprofitable
arbitrage 6-16
 Transactions Costs Example
• Will an arbitrageur facing the following prices be able to make
money?
Borrowing Lending (1 + i$)
F($/ €) = S($/ €) ×
$ 5.0% 4.50% (1 + i€)
€ 5.5% 5.0%
Bid Ask
Spot $1.42 = €1.00 $1.45 = €1,00
Forward $1.415 = €1.00 $1.445 = €1.00
S0a($/€)(1+i$b) S0b($/€)(1+i$l )
F1b($/€) = F1a($/€) =
(1+i€l ) (1+i€b)
6-17
 Step 1
b
$1m Borrow $1m at i$ $1m×(1+i$) b

0 IRP 1
Step 2 1
$1m × ×(1+i€)×l Fb 1($/€) = $1m×(1+i$) b
Buy € at spot Sa0($/€)
ask
No arbitrage forward bid price (for customer):

(1+i$) b Sa0($/€)(1+i$) b
Step 4
Fb 1($/€) = =
1 Sell € at
×(1+i€) l (1+i€) l
Sa0($/€) forward bid

= $1.4431/€

1 1
$1m × Step 3 invest € at i€ l $1m × ×(1+i€) l
Sa0($/€) Sa0($/€)
(All transactions at retail prices.) 6-18
€1m × S0($/€)
b €1m × S0($/€)
b × (1+i$) l
Step 3: lend at i l
$

0 IRP 1
€1m × S0($/€)
b × (1+i$) ÷ F1($/€)
l = a €1m×(1+i€) b

No arbitrage forward ask price:

Sb0($/€)(1+i$) l
Step 4
Step 2: Fa 1($/€) =
buy € at
(1+i€) b
forward ask
sell €1m at
= $1.4065/€
spot bid

€1m Step 1: borrow €1m at i€ b €1m×(1+i€) b

(All transactions at retail prices.)

6-19
 Why This May Seem Confusing
• On the last two slides we found “no arbitrage.”
– Forward bid prices of $1.4431/€.
– Forward ask prices of $1.4065/€.
• Normally the dealer sets the ask price above the bid
—recall that this difference is his expected profit.
• But the prices on the last two slides are the prices of
indifference for the customer, NOT the dealer.
– At these forward bid and ask prices the customer is
indifferent between a forward market hedge and a money
market hedge.

6-20
 Setting Dealer Forward Bid and Ask
• Dealer stands ready to be on the opposite side of every trade.
– Dealer buys foreign currency at the bid price.
– Dealer sells foreign currency at the ask price.
– Dealer borrows (from customer) at the lending rates.
– Dealer lends to his customer at the posted borrowing rates.

Borrowing Lending il$ = 4.5% and i€l = 5.0%

$ 5.0% 4.50% i$b = 5.0%, i€b = 5.5%.
€ 5.5% 5.0% Bid Ask
Spot $1.42 = €1.00 $1.45 = €1.00
Forward $1.415 = €1.00 $1.445 = €1.00

6-21
 Setting Dealer Forward Bid Price
Our dealer is indifferent between buying euros today at the spot bid price and
buying euros in 1 year at the forward bid price.

$1m Invest at i$ b $1m×(1+i$) b

He is willing to spend $1m today He is also willing to buy at

forward bid
and receive
spot bid

Sb0($/€)(1+i$) b
1 Fb1($/€) =
$1m ×
Sb0($/€) (1+i€) b

1
$1m × Invest at i€ b 1
Sb0($/€) $1m × ×(1+ib €)
Sb0($/€)

6-22
 Setting Dealer Forward Ask Price
Our dealer is indifferent between selling euros today at the spot ask price and
selling euros in 1 year at the forward ask price.

€1m × S0($/€)
b
Invest at i$ b €1m × S0($/€)
b ×(1+ib $)

He is also willing to buy at

He is willing to spend €1m today and

forward ask
receive
spot ask

Sa0($/€)(1+i$) b

€1m × S0($/€)
b Fa 1($/€) =
(1+i€) b

€1m Invest at i€ b €1m×(1+i€)b

6-23
 PPP and Exchange Rate Determination
• The exchange rate between two currencies should equal the
ratio of the countries’ price levels:
P$
S($/£) =
P£
For example, if an ounce of gold costs $300 in the U.S. and £150 in the
U.K., then the price of one pound in terms of dollars should be:
P$
S($/£) = = $300 = $2/£
P£ £150
Suppose the spot exchange rate is $1.25 = €1.00. If the inflation rate in the U.S. is
expected to be 3% in the next year and 5% in the euro zone, then the expected
exchange rate in one year should be $1.25×(1.03) = €1.00×(1.05).

6-24
 PPP and Exchange Rate Determination

• The euro will trade at a 1.90% discount in the forward market:

$1.25×(1.03)
F($/€) €1.00×(1.05) 1.03 1 + $
= = =
S($/€) $1.25 1.05 1 + €
€1.00
Relative PPP states that the rate of change in the exchange rate is
equal to differences in the rates of inflation—roughly 2%.

6-25
 PPP and IRP
• Notice that our two big equations equal each
other:

PPP IRP
F($/€) 1 + $ 1 + i$ F($/€)
= = =
S($/€) 1 + € 1 + i€ S($/€)

6-26
 Expected Rate of Change in Exchange Rate
as Inflation Differential

• We could also reformulate our equations as inflation or

interest rate differentials: F($/€) 1 + $
=
S($/€) 1 + €

F($/€) – S($/€) 1 + $ 1 + $ 1 + €
= –1= –
S($/€) 1 + € 1 + € 1 + €

F($/€) – S($/€) $ – €
E(e) = = ≈ $ – €
S($/€) 1 + €
6-27
 Expected Rate of Change in Exchange Rate
as Interest Rate Differential

F($/€) – S($/€) i$ – i€
E(e) = = ≈ i$ – i€
S($/€) 1 + i€
 Given the difficulty in measuring expected inflation,
managers often use a “quick and dirty” shortcut:

 $ –  € ≈ i$ – i€

6-28
PPP Deviations and the Real Exchange Rate

6-29
 Evidence on PPP
• PPP probably doesn’t hold precisely in the real world
for a variety of reasons.
– 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.
– Shipping costs, as well as tariffs and quotas, can lead to
deviations from PPP.
• PPP-determined exchange rates still provide a
valuable benchmark.

6-30
 Evidence on PPP
Big Mac prices Implied Actual dollar Under or over
In local PPPa of exchange rate valuation against
currency In dollars the dollara 7/13/2009 the dollar, %
United States $4.33 4.33 − 1.00 −
Argentina Peso 19 4.16 4.39 4.57 -4
Australia A$ 4.56 4.68 1.05 0.97 8
Brazil Real 10.08 4.94 2.33 2.04 14
Britain £ 2.69 4.16 1.61c 1.55c -4
Canada C$ 3.89 3.82 0.90 1.02 -12
China Yuan 15.65 2.45 3.62 6.39 -43
Egypt Pound 16 2.64 3.70 6.07 -39
Euro area € 3.58 4.34 1.21e 1.21e 0
Japan Yen 320 4.09 73.95 78.22 -5
Mexico Peso 37 2.70 8.55 13.69 -38
Russia Ruble 75 2.29 17.33 32.77 -47
Sweden SKr 48.4 6.94 11.18 6.98 60
Switzerland SFr 6.5 6.56 1.52 0.99 52

6-31
 A Guide to World Prices: March 2013
Hamburger Aspirin Man’s Haircut Movie Ticket
Location (1 unit) (20 units) (1 unit) (1 unit)
Athens $3.81 $2.09 $58.72 $13.24
Copenhagen $7.00 $4.86 $55.50 $13.82
Hong Kong $2.82 $2.39 $80.13 $9.62
London $5.71 $1.39 $56.60 $20.49
Los Angeles $3.57 $2.72 $27.33 $11.90
Madrid $5.40 $5.76 $20.43 $9.87
Mexico City $4.02 $0.91 $21.72 $4.72
Munich $4.71 $5.01 $17.25 $10.70
Paris $5.97 $3.70 $68.49 $12.63
Rio de Janeiro $5.56 $5.63 $44.70 $10.64
Rome $5.14 $7.99 $42.19 $9.64
Sydney $5.38 $4.34 $53.77 $16.29
Tokyo $3.29 $8.24 $77.00 $18.91
Toronto $5.32 $2.20 $40.28 $12.20
Average $4.82 $4.15 $46.89 $12.48
6-32
Approximate Equilibrium Exchange Rate Relationships

E(e)
≈ IFE ≈ FEP
≈ PPP F–S
(i$ – i¥) ≈ IRP
S
≈ FE ≈ FRPPP
E($ – £)

6-33
 The Exact Fisher Effects
• An increase (decrease) in the expected rate of inflation will
cause a proportionate increase (decrease) in the interest rate
in the country.
• For the U.S., the Fisher effect is written as:
1 + i$ = (1 + $ ) × E(1 + $)
Where:
$ is the equilibrium expected “real” U.S. interest rate.
E($) is the expected rate of U.S. inflation.
i$ is the equilibrium expected nominal U.S. interest rate.

6-34
 International Fisher Effect

If the Fisher effect holds in the U.S.,

1 + i$ = (1 + $ ) × E(1 + $)
and the Fisher effect holds in Japan,
1 + i¥ = (1 + ¥ ) × E(1 + ¥)
and if the real rates are the same in each country,
$ = ¥
then we get the International Fisher Effect:
1 + i¥ E(1 + ¥)
=
1 + i$ E(1 + $)
6-35
 International Fisher Effect
If the International Fisher Effect holds,
1 + i¥ E(1 + ¥)
=
1 + i$ E(1 + $)
and if IRP also holds,
1 + i¥ F¥/$
=
1 + i$ S¥/$
then forward rate PPP holds:
F¥/$ E(1 + ¥)
=
S¥/$ E(1 + $)
6-36
Exact Equilibrium Exchange Rate Relationships

E (S ¥ / $ )
IFE
S¥ /$ FEP

1 + i¥ PPP F¥ / $
IRP
1 + i$ S¥ /$
FE FRPPP
E(1 + ¥)
E(1 + $)
6-37
How Large is India’s Economy?

6-38
 Forecasting Exchange Rates: Efficient
Markets Approach

• Financial markets are efficient if prices reflect all

available and relevant information.
• If this is true, exchange rates will only change when
new information arrives, thus:
St = E[St+1]
and
Ft = E[St+1| It]
• Predicting exchange rates using the efficient markets
approach is affordable and is hard to beat.

6-39
Forecasting Exchange Rates: Fundamental
Approach

• Involves econometrics to develop models that use a

variety of explanatory variables. This involves three
steps:
– Step 1: Estimate the structural model.
– Step 2: Estimate future parameter values.
– Step 3: Use the model to develop forecasts.
• The downside is that fundamental models do not
work any better than the forward rate model or the
random walk model.

6-40
Forecasting Exchange Rates: Technical
Approach

• Technical analysis looks for patterns in the past

behavior of exchange rates.
• It is based upon the premise that history repeats
itself.
• Thus, it is at odds with the EMH.

6-41
Forecasting Exchange Rates: Technical
Approach

6-42
Forecasting Exchange Rates: Technical
Approach

6-43
 Performance of the Forecasters
• Forecasting is difficult, especially with regard to the
future.
• As a whole, forecasters cannot do a better job of
forecasting future exchange rates than the forecast
implied by the forward rate.
• The founder of Forbes Magazine once said, “You can
make more money selling financial advice than
following it.”

6-44
 Questions
• 1. Discuss the implications of the interest rate parity for the
exchange rate determination.
• Assuming that the forward exchange rate is roughly an
unbiased predictor of the future spot rate, IRP can be written
as:
• S = [(1 + i£)/(1 + i$)]E[St+1It].
• The exchange rate is thus determined by the relative interest
rates, and the expected future spot rate, conditional on all the
available information, It, as of the present time. One thus can
say that expectation is self-fulfilling. Since the information set
will be continuously updated as news hit the market, the
exchange rate will exhibit a highly dynamic, random behavior.
5-45
 Questions
• 2. Discuss the implications of the deviations from the
purchasing power parity for countries’ competitive
positions in the world market.
• If exchange rate changes satisfy PPP, competitive
positions of countries will remain unaffected following
exchange rate changes. Otherwise, exchange rate
changes will affect relative competitiveness of
countries. If a country’s currency appreciates
(depreciates) by more than is warranted by PPP, that
will hurt (strengthen) the country’s competitive
position in the world market.
5-46
 Questions
• 3. Derive and explain the monetary approach to exchange rate
determination.
• It is based on two tenets: purchasing power parity and the
quantity theory of money. Combing these two theories allows
for stating, say, the $/£ spot exchange rate as:
• S($/£) = (M$/M£)(V$/V£)(y£/y$),
• where M denotes the money supply, V the velocity of money,
and y the national aggregate output. The theory holds that what
matters in exchange rate determination are:
• 1. The relative money supply,
• 2. The relative velocities of monies, and
• 3. The relative national outputs.
5-47