Interest Rate Parity

• Interest rate parity is a theory that can be

used to relate differences in the interest
rates in two countries to the ratios of spot
and forward exchange rates of the two
countries’ currencies.

• Specifically,
Differences in interest rates = Ratio of the
forward and spot rates

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Interest Rate Parity (cont.)

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 Interest Rate Parity (cont.)
• Interest rate parity means that you get the
same total return for the following two
options:

– Invest directly in the US; or

– Convert dollars to Japanese Yens,

– Invest Yens in the risk-free rate in Japan, and
– Convert Yens back to U.S. dollars.

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Interest Rate Parity (cont.)

• Example 19.1 You have $1,000,000

to invest and you observe the following
quotes in the market:
1$ = ¥ 106
180-day forward rate = 103.50
U.S. 180-day risk-free interest rate = 4.4%
Japan 180-day risk-free interest rate = 2%

• Determine whether interest rate

parity holds.
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 Interest Rate Parity (cont.)
Option I: Invest directly in USA and earn 4.4%
1,000,000 * 1.044 = $1,044,000

Option II:
(a) Convert to Yen at spot rate = ¥ 106,000,000
(b) Invest at 2% = ¥106,000(1.02) = ¥ 108,120,000
(c) Convert to $ at the forward rate = 108,120,000 ÷103.5 =
$1,044,638

==> Difference of $638 ==> Interest Rate Parity does not hold

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Purchasing Power Parity and the

Law of One Price

• According to the theory of purchasing

power parity (PPP), exchange rates
adjust so that identical goods cost the
same amount regardless of where in the
world they are purchased.

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 Purchasing Power Parity and the
Law of One Price (cont.)

• Underling PPP theory is the law of one

price, which states that the same good
should sell for the same price in different
countries after making adjustments for the
exchange rate between the two currencies.

• Figure 19-2 illustrates one example of

exception to the PPP theory.

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 Copyright © 2011 Pearson Prentice Hall. All rights reserved.
19-9
Sources: The Economist. Big Mac Index, fin24.com. https://www.fin24.com/Economy/infographic-how-sa-stacks-up-on-the-big-mac-index-20180722

Purchasing Power Parity and the

Law of One Price (cont.)

• The differences in prices around the world

could be explained by:
– Tax differences among countries
– Differences in labor costs
– Differences in raw material costs
– Differences in rental costs

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 Purchasing Power Parity and the
Law of One Price (cont.)
• In general, we expect PPP to hold for goods that
can be cheaply shipped between countries (for
example, expensive gold jewelry).

• PPP does not seem to hold for non-traded goods

like restaurant meals and haircuts.

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The International Fisher Effect

• The International Fisher Effect (IFE) assumes
that real rates of return are the same across the
world, so that the differences in nominal returns
around the world arise because of differences in
inflation rates.

• Like purchasing power parity, IFE is just an

approximation that may not hold exactly.

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 The International Fisher Effect
(cont.)

• Example 19.2 Assume that the real rate of

interest is equal to 2% in all countries.
What will be the nominal interest rate in
UK and USA, if UK is expecting an inflation
rate of 6% and USA is expecting an
inflation rate of 3%.

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The International Fisher Effect

(cont.)

• Interest rate (USA) = .03 + .02 +

[.03×.02]
= .0506 or 5.06%

• Interest rate (UK) = .06 + .02 + [.06×.02]

= .0812 or 8.12%

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 The International Fisher Effect
(cont.)

• IFE cautions us that we should not invest

in a country just because it offers the
highest interest rates.

• IFE notes that such high interest rate is an

indication of high inflation. Accordingly,
any gain in interest rates will be offset by
losses due to foreign currency
depreciation.

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