International Finance

Parity Conditions in International Finance

Parity Conditions
Parity conditions in international finance

provides a framework to understand the

inter-relationships between and among
exchange rates, interest rates and
inflation rates.

Parity Conditions
Terms utilized:

spot exchange rate ( )

forward exchange rate ( )
interest rates ( )
inflation rate ( )
home/domestic country (H or D)
foreign country (F)

Law of One Price

This theory states that the price of a good or

financial asset (using a common currency) will
be the same in different real or financial
markets.

The Law of One Price serves as the

foundation for all the parity conditions to be
considered.

Law of One Price

The Law of One Price exists due to arbitrage

opportunities. Arbitrage will cause prices to
converge across markets, the difference will
only be as a result of transaction and
transportation costs

Five Parity Conditions

1) Purchasing Power Parity (PPP)

Relationship between spot rates and inflation

rates

2) Fisher Effect (FE)

Relationship between interest rates and

expected inflation rates

Five Parity Conditions

3) International Fisher Effect (IFE)

Relationship between domestic and foreign

interest rates and exchange rates

4) Interest Rate Parity (IRP)

Relationship between spot and forward

exchange rates and interest rates

Five Parity Conditions

5) Forward Rates as Unbiased Predictor of

Future Spot Rates (UFR)

Relationship between forward exchange and

expected spot exchange rates

Purchasing Power Parity

Absolute PPP

States that price levels should equalize

worldwide when expressed in a common
currency

Such relationship is more applicable to traded

goods with no trade restrictions

Purchasing Power Parity

Sample Problem:
The US and UK both produce the same
type of wheat. Price of wheat in the US
is $3.25 per bushel and the price of
wheat for the same unit in the UK is
1.35. The exchange rate should be
e = $3.25/ 1.35 = $2.4074/

Purchasing Power Parity

Relative PPP

States that exchange rate movements are

offset by inflation differentials between two
countries

Relative PPP

Accurate version
=

Approximate version
=

Relative PPP
Insights from approximate version of relative PPP

The exchange rate change would equal the

inflation rate differential
Currencies affected by high rates of inflation
should devalue or depreciate relative to
currencies enjoying lower rates of inflation

Relative PPP
Exchange rate movements should just
cancel out the difference in the foreign price
level relative to the domestic price level
Offsetting movements in price levels and
exchange rates should have no effect on
the relative competitiveness of domestic
firms products vis--vis foreign products

Relative PPP
Sample Problem 1

If the US and EU are running annual inflation

rates of 5% and 3%, respectively, and the
current spot rate is 1 = $1.07. What would
be the spot rate in a years time? (US = home)

Relative PPP
Sample Problem 2

From the base level of 100 in the year 2000,

Japanese and US price levels in 2003 stood at
102 and 106, respectively. If the 2000 $/
exchange rate is $0.007692, what should the
exchange rate be in 2003? (US = home)

Relative PPP
Sample Problem 3

Suppose the EU is the domestic country and

the US is the foreign country. The spot
exchange rate quote is $1.25 per euro.
Suppose further that the expected annual US
inflation rate is 8.91% and the expected EU
annual inflation rate is 12.87%. Calculate the
expected spot rate one year away.

Relative PPP
Relative PPP generally does not hold for the

following reasons:

Goods prices are sticky

Differently constructed price indices
Inclusion of non-traded goods and services in
the basket of goods used for determining the
CPI

Real Exchange Rate

The Real Exchange Rate

Offsetting movements in currencies and

inflation rates should not affect the relative
competitive positions of countries. Currency
changes that affect relative competitiveness is
best reflected in the real exchange rate

Fisher Effect

The Fisher Effect states that the nominal rate

of return is comprised of

The real required rate of return ( )

An inflation premium ( ) or the inflation rate

Fisher Effect

The relationship approximately being

The exact version of the relationship is

Fisher Effect

The exact version of the Fisher Effect can

further be reduced to

This would mean that financial assets in high

inflation countries would bear higher rates of
nominal returns than those in countries with lower
rates of inflation.

Fisher Effect
Sample Problem 1

If the expected inflation is 100% and the

real required return is 5%, what should the
nominal interest rate be according to the
Fisher Effect?

Fisher Effect
Sample Problem 2

In early 1996, the short term interest rate in

France was 3.7% and forecast inflation was
1.8%. At the same time, short-term German
interest rate was 2.6% and forecast German
inflation was 1.6%. What were the real
interest rates in France and Germany?
What accounts for the difference in real
rates between France and Germany?

International Fisher Effect

IFE states a relationship that links relative

interest rates to changes in the exchange rate

Exact version:

Approximate version:

International Fisher Effect

The approximate version states that

financial assets with low rates of nominal
returns are expected to experience an
appreciation in its currency value relative
to those countries whose financial
assets have higher nominal rates of
returns.

International Fisher Effect

Sample Problem 1

The one year interest rate is 12% on British

pound and 9% on the US dollar

If the current exchange rate is $1.63/, what is

the expected future exchange rate in one year?
Suppose a change in expectations regarding
future US inflation (rates) causes the expected
future spot rate to decline to $1.52/, what should
happen to the US interest rate?

International Fisher Effect

Sample Problem 2

Suppose the three-year deposit rates on

Eurodollars and Eurofrancs (Swiss francs) are
12% and 7%, respectively. If the current spot
rate for the Swiss franc is $0.3985/SF, what is
the spot rate implied by these interest rates for
the Swiss franc three years from now?

International Parity Theory

Interest Parity Theory (IRP)

In countries where there are forward markets,

expectations about the forward rate ( ) at
period t is that

IRP establishes a relationship between the

forward discount or premium and the interest
differential between two countries.

International Parity Theory

Exact Version:

Approximate Version:

Financial assets with high nominal rates of

returns are offset by forward discounts and vice
versa.

International Parity Theory

Sample Problem

Assume interest rate is 16% on pound sterling

and 7% on euros. At the same time, inflation
is running at an annual rate of 3% in Germany
and 9% in England.

If the euro is selling at a one-year forward

premium of 10% against the pound, is there an
arbitrage opportunity?
What is the real interest rate in Germany? In
England?

Forward Rate
The Forward Rate as an Unbiased Predictor

of the Future Spot Rate

If markets are efficient and all prices reflect all

forms of information (past, present and future),
the forward rate should equal the future spot
rate, such that
and that

Forward Rate
Additional Problems:

Suppose that in Japan the interest rate is 8%

and inflation is expected to be 3%. Meanwhile
the expected inflation rate in France is 12%
and the English interest rate is 14%. To the
nearest whole number, what is the best
estimate of the one-year forward exchange
premium (discount) at which the pound will be
selling relative to the euro?

Forward Rate
Additional Problems:

Chase Econometrics has just published projected inflation

rates for the US and Germany for the next five years. US
inflation is expected to be 10% per year and German
inflation is expected to be 4% per year.
If the current exchange rate is $0.95/, forecast the
exchange rate for the next five years.
Suppose US inflation, over the next five years, turns out
to average 3.2%, German inflation averages 1.5%, and
the exchange rate in five years is $0.99/. What has
happened to the real value of the euro over this five-year
period?