Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

6-0
INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICK
Fourth Edition
Chapter Objective:

This chapter examines several key international
parity relationships, such as interest rate parity and
purchasing power parity.


6
Chapter Six
International Parity
Relationships & Forecasting
Foreign Exchange Rates
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-1
Chapter Outline
Interest Rate Parity
Purchasing Power Parity
The Fisher Effects
Forecasting Exchange Rates
Interest Rate Parity
Covered Interest Arbitrage
IRP and Exchange Rate Determination
Reasons for Deviations from IRP
Purchasing Power Parity
The Fisher Effects
Forecasting Exchange Rates
Interest Rate Parity
Purchasing Power Parity
PPP Deviations and the Real Exchange Rate
Evidence on Purchasing Power Parity
The Fisher Effects
Forecasting Exchange Rates
Interest Rate Parity
Purchasing Power Parity
The Fisher Effects
Forecasting Exchange Rates
Interest Rate Parity
Purchasing Power Parity
The Fisher Effects
Forecasting Exchange Rates
Efficient Market Approach
Fundamental Approach
Technical Approach
Performance of the Forecasters
Interest Rate Parity
Purchasing Power Parity
The Fisher Effects
Forecasting Exchange Rates
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-2
Important concepts
Arbitrage: actions that seek to take advantage of price discrepancies
between different markets for the purpose of making guaranteed
profits.
Law of One Price (LOP): similar goods cost the same in different
countries of the world

LOP requires that there be no transportation costs, tariffs, monopolies,
price restrictions
In an absence of these costs, arbitragers will ensure that similar goods
cost the same across countries by buying where the goods are cheap
and selling where the goods are expensive.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-3
Interest Rate Parity (IRP)
Uncovered Interest Rate Parity (UIRP) Condition:



Covered Interest Rate Parity (CIRP) Condition:

*
(1 ) 1
E
i i
S
+ = +
*
(1 ) 1
F
i i
S
+ = +
E = expected spot
rate on the future date
F = forward rate
i = domestic interest rate
i* = foreign interest rate
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-4
Covered Interest Rate Parity (CIRP)
Consider alternatives one year investments for $1,000:
Option 1: Invest in the U.S. at i
$
. Future value
1
= $1,000 (1 + i
$
)
Option 2: Trade your $ for at the spot rate, invest $1,000/S
$/
in
Britain at i

while eliminating any exchange rate risk by selling
the future value of the British investment forward.

S
$/
F
$/
Future value
2
= $1,000(1 + i

)
S
$/
F
$/
1,000(1 + i

) = $1,000(1 + i
$
)
Since these investments have the same risk, they must have
the same future value (otherwise an arbitrage would exist)
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-5
IRP
Invest those
pounds at i

$1,000
S
$/
$1,000
Future Value =
Step 3: repatriate
future value to the
U.S.A.
Since both of these investments have the same risk, they must
have the same future valueotherwise an arbitrage would exist
Alternative 1:
invest $1,000 at i
$

$1,000(1 + i
$
)
Alternative 2:
Send your $ on
a round trip to
Britain
Step 2:
$1,000
S
$/
(1+ i

) F
$/

$1,000
S
$/
(1+ i

)
=
I
R
P

Step 1:
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-6
Covered arbitrage and
Equilibrium exchange rate
If the CIRP does not hold. Suppose

Arbitrage strategy:
1. Borrow $x, pay back principal + interest = x(1+i
$
) dollars

Exchange $X for x/S
($/ )
pounds, and sell forward contract.

Invest x/S
($/ )
pounds. Receive x/S
($/ )
(1+i

) pounds.
Convert back to $: x/S
($/ )
(1+i

) F
($/ )
dollars

Net profit = x/S
($/ )
(1+i

) F
($/ )
- x(1+i
$
) > 0

(1 + i
$
)
F
$/

S
$/
(1+ i

)
<
2
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-7
Interest Rate Parity (IRP)
(1 + i
$
)
F
$/

S
$/
(1+ i

)
=
Formally,

IRP is sometimes approximated as
i
$
i

S

F S

1 + i
$
1 + i

S
$/
F
$/
=
From above example,
Interest rate
differential
Forward
premium/discount
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-8
Forward Premium
Its just the interest rate differential implied by
forward premium or discount.
For example, suppose the is depreciating from
S(/$) = 33.30 to F
180
(/$) = 34.50
The forward premium is given by:
F
180
(/$) S (/$)
S (/$)

360
180
f
180
= =
$34.5 $33.3
$33.3
2 = 0.036
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-9
Interest Rate Parity Carefully Defined
Depending upon how you quote the exchange rate
($ per or per $) we have:
1 + i
$
1 + i

S
/$

F
/$

=
1 + i
$
1 + i

S
$/
F
$/
= or
so be a bit careful about that
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-10
IRP and Covered Interest Arbitrage
If IRP failed to hold, an arbitrage would exist. However,
Reasons for Deviations from IRP:
Transactions Costs
The interest rate available to an arbitrageur for borrowing, i
b
,may
exceed the rate he can lend at, i
l
.
There may be bid-ask spreads to overcome, F
b
/S
a
< F/S
Thus (F
b
/S
a
)(1 + i
$
l
) (1 + i

b
) s 0
Capital Controls
Governments sometimes restrict import and export of money
through taxes or outright bans.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-11
Transactions Costs Example
Will an arbitrageur facing the following prices be
able to make money?
Borrowing Lending
$ 5% 4.50%
6% 5.50%
Bid Ask
Spot $1.00=1.00 $1.01=1,00
Forward $0.99=1.00 $1.00=1.00
1 + i
$
1 + i

S
$/
F
$/
=
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-12
Purchasing Power Parity (PPP)
The exchange rate between two currencies should
equal the ratio of the countries price levels:


S($/) =

P


P
$
S($/) =

P


P
$
150


$300

= = $2/
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:
Law of One Price
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-13
Absolute and Relative PPP
Absolute PPP:
Relative PPP:

Real ER:

Absolute PPP states that the real exchange rate is always equal to 1.
But, this will only hold under the most stringent conditions (no tariffs,
transport costs or other distortions).
Relative PPP states that the real exchange rate is constant but not
necessarily equal to 1.
PPP is a way of defining exchange rate in the long run.
*
P P S =
*
% % % P P S A = A A
*
S P
R
P

=
* = foreign
S = DC/FC
Price of foreign goods in DC
Price of domestic goods in DC
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-14
Relative PPP
According to relative PPP,





t - t* = Depreciation of domestic currency
*
% % % P P S A = A A
Domestic inflation Foreign inflation
Depreciation of
domestic currency
An economy that has relatively high inflation rate, its
currency tends to depreciate in value.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-15
Purchasing Power Parity (PPP)
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 $1.25(1.03) / 1.00(1.05)
F($/) =
$1.25(1.03)
1.00(1.05)
$1.23
1.00
=
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-16
Purchasing Power Parity (PPP) and
Exchange Rate Determination
The euro will trade at a 1.90% discount in the forward
market:
$1.25
1.00
=
F($/)
S($/)
$1.25(1.03)
1.00(1.05) 1.03
1.05
1 + t
$
1 + t

= =
Relative PPP states that the rate of change in the exchange rate
is equal to differences in the rates of inflationroughly 2%
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-17
PPP & IRP
Notice that our two big equations today equal each
other:
=
=
F($/)
S($/)
1 + t
$
1 + t

1 + i

1 + i
$
=
F($/)
S($/)
PPP IRP
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-18
Expected Rate of Change in Exchange
Rate as Inflation Differential
We could also reformulate
our equations as inflation or
interest rate differentials:
=
F($/) S($/)
S($/)
1 + t
$
1 + t

1
=
1 + t
$
1 + t


1 + t

1 + t

=
F($/)
S($/)
1 + t
$
1 + t

=
F($/) S($/)
S($/)
t
$
t

1 + t

E(e) = t
$
t

Expected ER
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-19
Expected Rate of Change in Exchange
Rate as Interest Rate Differential
=
F($/) S($/)
S($/)
i
$
i

1 + i

E(e) =
i
$
i

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-20
Quick and Dirty Short Cut
Given the difficulty in measuring expected
inflation, managers often use
i
$
i

t
$
t

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-21
Evidence on PPP
PPP probably doesnt hold precisely in the real world for a
variety of reasons.
Services are non-tradable: eg. Haircuts cost 10 times as much in the
developed world as in the developing world. (Services are unlikely to be
arbitraged across countries.)
Different quality: eg. Tradable goods produced in China may be of
lower quality than those produced in Europe. (Also, the basket of goods
and services consumed can differ across countries.)
Shipping costs, as well as tariffs and quotas can lead to deviations
from PPP.
PPP-determined exchange rates still provide a valuable
benchmark.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-22
The 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 + t
$
)
Where

$
is the equilibrium expected real U.S. interest rate
E(t
$
) is the expected rate of U.S. inflation
i
$
is the equilibrium expected nominal U.S. interest rate
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-23
International Fisher Effect
If the Fisher effect holds in the U.S.
1 + i
$
= (1 +
$
) E(1 + t
$
)
and the Fisher effect holds in Japan,
1 + i

= (1 +

) E(1 + t

)
and if the real rates are the same in each country

$
=

then we get the
International Fisher Effect:
E(1 + t

)
E(1 + t
$
) 1 + i
$
1 + i

=
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-24
International Fisher Effect
If the International Fisher Effect holds,




then forward rate PPP holds:
E(1 + t

)
E(1 + t
$
) 1 + i
$
1 + i

=
and if IRP also holds
1 + i
$
1 + i

S
/$

F
/$

=
E(1 + t

)
E(1 + t
$
)
=
S
/$

F
/$

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-25
PPP
FRPPP FE
FEP
IFE
Equilibrium Exchange Rate
Relationships
$ /
$ /
) (

S
S E
$ /
$ /

S
F
IRP
E(1 + t

)
E(1 + t
$
)
1 + i
$
1 + i

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-26
Forecasting Exchange Rates
Efficient Markets Approach
Fundamental Approach
Technical Approach
Performance of the Forecasters
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-27
Efficient Markets Approach
Financial Markets are efficient if prices reflect all
available and relevant information.
If this is so, exchange rates will only change when
new information arrives, thus:
S
t
= E[S
t+1
]
and
F
t
= E[S
t+1
| I
t
]
Predicting exchange rates using the efficient
markets approach is affordable and is hard to beat.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-28
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.
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-29
Technical Approach
Technical analysis looks for patterns in the past
behavior of exchange rates.
Clearly it is based upon the premise that history
repeats itself.
Thus it is at odds with the EMH
Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-30
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 forward
rate.
The founder of Forbes Magazine once said:
You can make more money selling financial
advice than following it.

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6-31
Homework/Make-up class
Homework: on page 156-158 (Chapter 6):

Problems # 3, 4, 6, 7, 9 to be handed in next class

Make-up class:
Option 1: Friday 2-5pm
Option 2: Sunday 9am-12pm