9.

4 Parity Theorems
This Section includes :
 Theory of Purchasing Power Parity (PPP)
 Theory of Interest Rate Parity (IRP)
 International Fisher Effect (IFE)

INTRODUCTION :
Foreign exchange includes Foreign Currency, Drafts, Bills, Letters of credit and travellers
cheques that are denominated and eventually payable in foreign currency. Exchange rate is
the price of foreign currency expressed in terms of local currency. The factors influencing
rates are the purchasing power parity (inflation). The differences between two countries,
vis-a-vis inflation and interest are addressed and suggested means are expressed to bring an
equilibrium.

THEORY OF PURCHASING POWER PARITY (PPP) :

This theory was enunciated by Gustav Cassel. Purchasing power of a currency is deter-
mined by the amount of goods and services that can be purchased with one unit of that
currency. If there is more than one currency, it is fair and equitable that the exchange rate
between these currencies provides the same purchasing power for each currency. This is
referred to as purchasing power parity.
It is ideal if the existing exchange rate is in tune with this cardinal principle of purchasing
power parity. On the contrary, if the existing exchange rate is such that purchasing power
parity does not exist in economic terms, it is a situation of disequilibrium. It is expected that
the exchange rate between the two currencies conform eventually to purchasing power parity.
Likewise, if the rate of inflation is different in two countries, the floating exchange rate should
accordingly vary to reflect that difference. Let us consider two countries, A and B. The rate
of inflation in the country A is higher than that in the country B. As a result, imports of the
country A increases since the price of foreign goods tend to be lower. Similarly exports from
the country A decreases since the prices of its goods appear to be higher to foreigners (resi-
dents of country B included). This situation cannot persist for long. In consequence, the
currency of country A will depreciate with respect to that of the country B.
If ih and if are the inflation rates in the home country and the foreign country; and ERo is the
value in terms of home currency for one unit of foreign currency at the beginning of the
given period and ERt is the value in terms of home currency at the end of the period,

ERt (1 + in ) t
then =
ER0 (1 + i f )t
(1 + in )
Change in the exchange rate =
(1 + i f )

Financial Management & International Finance 697

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

Criticism of the PPP Theory

Conceptually, this theory is sound. However, there are a number of recognized factors that
prevent this theory from determining exchanges rates, in practice. Some of the major factors
in this regard are:
1. Government intervention, directly in the exchange markets or indirectly through trade
restrictions;
2. Speculation in the exchange market;
3. Structural changes in the economy of the countries;
4. Continuation of long-term flows in spite of the disequilibrium between purchasing
power parity and exchange rates.
Another criticism leveled against this theory is that the rate of inflation or the relevant price
level indices are not well defined. Questions pertaining to what constitutes an appropriate
sample and weight assigned to each commodity are not satisfactorily answered. For example,
should the sample represent all the goods and services, or only those that are traded interna-
tionally?
The theory takes into account only the movement of goods and services and not that of capital.
In operational terms, it is concerned only with the current account segment of the balance of
payment and not with the total BOP.
Above all, this theory ignores the fact that a currency may be an instrument of payment by
other countries (e.g. US dollar). In this situation the exchange rate may evolve in a manner that
has nothing to do with the price levels of the country (i.e. the USA).
The PPP theory can be considered as an ideal theory to determine exchange rates in specific
situations, such as high inflation or monetary disturbances. In such situations, the response to
individuals to changes in value of real and monetary assets can be expected to be strong and
the exchange rate prediction by PPP theory may turn out to be realistic.
Absolute Purchasing Power Parity : A theory which states that the exchanqe rate between one
currency and another is in equilibrium when their domestic purchasing powers at that rate’of
exchange are equivalent. In short, what this means is that bundle of goods should cost the
same in India and the United States once you take the exchange rate into account. To see why,
we’ll use an example.
First suppose that one Australian Dollar (AUD) is currently selling for 25 Indian Rupees (INR)
on the exchange rate market. In Australia cricket bats sell for AUD 40 while in India they sell
for only Rs.800. Since 1 AUD = Rs.25, then while the bat costs AUD 40 if we buy it in Australia,
it costs only AUD 32 if we buy it in India. Clearly there’s an advantage to buying the bat in
India, so consumers are much better off going to India to buy their bats. If consumers decide to
do this, we should expect to see three things happen :
1. Australian consumers would buy Indian Rupees in order to buy cricket bats in India. So
they go to an exchange rate office and sell their Australian Dollars and buy Indian Rupees.
This will cause the Indian Rupee to become more valuable relative to the Australian Dollar.

698 Financial Management & International Finance

 2. The demand for cricket bats sold in Australia decreases, so the price Australian retailers
charge goes down.
3. The demand for cricket bats sold in India increases, so the price Indian retailers charge
goes up.
Eventually these three factors should cause the exchange rates and the prices in the two countries
to change such that we have purchasing power parity. If AUD declines in value to 1 AUD =
Rs.23, the price of cricket bats in the AUD goes down to AUD 38 each and the price of cricket
bats in India goes up to Rs. 874 each, we will have purchasing power parity. This is because a
consumer can spend AUD 38 in Australia for a cricket bat, or he can take his AUD 38, exchange
it for Rs. 874 (since 1 AUD = Rs.23) and buy a cricket bat in India and be no better off.
Purchasing-power parity theory tells us that price differentials between countries are not
sustainable in the long run as market forces will equalize prices between countries and change
exchange rates in doing so. The example of consumers going overseas to buy cricket bats may
seem unrealistic as the expense of the longer trip would wipe out any savings you get from
buying the bat for a lower price. However it is not unrealistic to imagine an individual or
company buying hundreds or thousands of the bats in India then shipping them to Australia
for sale. In the long run having different prices in Australia and India is not sustainable because
an individual or company will be able to gain an arbitraae profit by buying the good cheaply in
one market and selling it for a higher price in the other market.
Thus Absolute PPP says that,
PIndia = Spot (Rs.lAUD) × PAustralia implies
Spot Exchange rate (Rs./AUD) = PIndia/PAustralia
Thus it is the price levels in countries that determine the exchange rate.
Since the price for any one good should be equal across markets, the price for any combination
or basket of goods should be equalized.
So, why Purchasing Power Parity theory doesn’t always work in practice?
Anything which limits the free trade of goods will limit the opportunities people have in taking
advantage of these arbitrage opportunities. A few of the larger limits are :
1. Import and Export Restrictions : Restrictions such as quotas, tariffs and laws will make it
difficult to buy goods in one market and sell them in another. If there is a 300% tax on
imported cricket bats, then in our first example it is no longer profitable to buy the bat in
India instead of the Australia. Australia could also just pass a law make it illegal to import
cricket bats.
2. Travel Costs : If it is very expensive to transport goods from one market to another, we
would expect to see a difference in prices in the two markets.
3. Perishable Goods : It may be simply physically impossible to transfer goods from one
market to another. There may be a place which sells cheap sandwiches in Indore, but that
doesn’t help me if I’m living in Delhi. Of course, this effect is mitigated by the fact that
many of the ingredients used in making the sandwiches are transportable, so we’d expect
that sandwich makers in Delhi and Indore should have similar material costs.

Financial Management & International Finance 699

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

4. Location : You can’t buy a piece of property in Indore and move it to New Delhi. Because
of that realestate prices in markets can vary wildly. Since the price of land is not the
same every where, we would expect this to have an impact on prices, as retailers in New
Delhi have higher expenses than retailers in Indore.
So while purchasing power parity theory helps us understand exchange rate differentials,
exchange rates do not always converge in the long run the way PPP theory predicts.
Absolute PPP works as a theoretical construct to understand an imaginary world of perfect
competition. It does not serve well as a practical model to forecast exchange rates.
As a practical matter, a relative version of PPP has evolved, which states that the change in
the exchange rate over time is determined by the difference in the inflation rates of the two
countries.

THEORY OF INTEREST RATE PARITY :

There is a relationship between the foreign exchange market and the money market. This
relationship affects the rate of exchange as well as the difference between spot rate and
forward rate. The IRP says that the spread between the forward rate and the spot rate
should be equal but opposite in sign to the difference in interest rates between two countries.
So, as per IRP, a change in interest rate in any country will affect the exchange rates of its
currency with other currencies and vice-a-versa. The basic principle is that there is an
interconnection between the interest rates and the exchange rates. As per IRP, the forward
exchange rates between two currencies will be equal to the spot rate adjusted for the interest
rates differential between the currencies. According to IRP, the currency of one country
with a lower interest rate should be at a forward premium in terms of the currency of the
country with the higher interest rates. So, in an efficient market, the interest rate differential
should be equal to the forward rate differential. When this condition is met, the forward rate
is said to be at interest parity and the quilibrium prevails in the exchange market.
When the nominal interest rates differ from one country to another, the spot rate and the
forward rate will also be different. The relationship can be expressed as follows:

Forward Rate 1 + rh
=
Spot Rate 1 + rf
Where rh is the home interest rate and rf is the foreign country rate.

Criticism of the Theory of Interest Rate Parity

The theory of interest rate parity is a very useful reference for explaining the differential
between the spot and future, exchange rate, and international movement of capital. Accept-
ing this theory implies that international finance markets are perfectly competitive and func-
tion freely without any constraints. However, reality is much more complex. Some of the
major factors that inhibit the theory from being put into practice are as follows:
Availability of funds that can be unused for arbitrage is not infinite. Further, the importance
of capital movements, when they are available, depends on the credit conditions practiced

700 Financial Management & International Finance

between the financial places and on the freedom of actions of different operators as per the
rules of the country in vogue.
Exchange controls certainly place obstacles in the way of theory of interest rate parity. The
same is true about the indirect restrictions that can be placed on capital movement in the
short run.
Interest rate is only one factor affecting the attitude and the behaviour of arbitrageurs. In the
other words, capital movements do not depend only on interest rates. Other important
factors are concerned with liquidity and the case of placement.
Speculation is an equally important element. This becomes very significant during the crisis
of confidence in the future of currency. The crisis manifests in terms of abnormally high
premium or discount – much higher that what the interest rate parity can explain.

Fisher Effects
All interest rates in a country are nominal interest rates consisting of two elements:
a) The real interest rate, and
b) The expected rate of inflation
The real interest rate is also known as the real required rate of return. The expected rate of
inflation embodies an inflation premium sufficient to compensate lenders or investors for
expected loss of purchasing power. So, the nominal interest rate depends on the rate of
inflation and is defined as:
Nominal Interest Rate = (1+ Real Rate) (1+ Inflation Rate) – 1
The real interest rate is relatively stable over time and is identical every where, but the nomi-
nal interest rate will vary by the differences in expected rates of inflation. The Fisher Effect
says that the real interest rates are equalized across the countries, otherwise arbitrage will
take place. So, in the equilibrium stage, the nominal rate differential will approximately
equal the anticipated inflation rate differential. This can be stated follows:
(1 + rh ) (1 + ih )
=
(1 + rf ) (1 + i f )
Where rh and rf are nominal interest rates for home currency and foreign currency and ih and
if are inflation rates.
So, the Fisher Effect analyses the relationship between the interest rates and the expected
inflation. The countries with higher rate of inflation will have higher nominal interest rates.

Implications of IRP
 If domestic interest rates are less than foreign interest rates, foreign currency must
trade at a forward discount to offset any benefit of higher interest rates in foreign country
to prevent arbitrage. IRP states that if foreign currency does not trade at a forward
discount or if the forward discount is not large enough to offset the interest rate advantage
of foreign country, then arbitrage opportunity exists for domestic investors. In such case,
domestic investors can benefit by investing in the foreign market.

Financial Management & International Finance 701

 Sources of International
COST-VOLUME-PROFIT Finance
ANALYSIS

 If domestic interest rates are more than foreign interest rates, foreign currency must
trade at a forward premium to offset any benefit of higher interest rates in domestic
country to prevent arbitrage. If foreign currency does not trade at a forward premium
or if the forward premium is not large enough to offset the interest rate advantage of
domestic country, arbitrage opportunity exists for foreign investors. Foreign investors
can benefit by investing in the domestic market.
Interest rate parity plays a fundamental role in foreign exchange markets, enforcing an essential
link between short-term interest rates, spot exchange rates and forward exchange rates.
Covered Interest Arbitrage
First, let us examine what is an, uncovered interest arbitrage. Uncovered interest arbitrage is
the notion that the forward exchange rate is an unbiased estimate of the future spot rate.
Uncovered interest arbitrage assumes that, on average, an investor who borrows in a low
interest rate country, converts the funds to the currency of a high interest rate country, and
lends in that country will not realize a profit or suffer a loss. It follows from uncovered
interest arbitrage that the expected return of a forward contract equals 0 percent
A covered interest arbitrage exists when an arbitrage profit can be made. The process of
borrowing in one currency and simultaneously investing in another with the exchange risk
hedged in the forward market is referred to Covered Interest Arbitrage.
If domestic interest rates are higher than the foreign interest rates, an arbitrageur would do
the following :
He would borrow in foreign currency, convert receipts to domestic currency at the prevailing
spot rate, invest in domestic currency denominated securities (as domestic securities carry
higher interest). At the same time he would cover his principal and interest from this
investment at the forward rate. At maturity, he would convert the proceeds of the domestic
investment at prefixed domestic forward rate and payoff the foreign liability. The difference
between the receipts and payments serve as profit to customer.
If foreign interest rates are higher than the domestic interest rates, an arbitrageur would do
the following :
He would borrow in domestic currency, convert receipts to foreign currency at the prevailing
spot rate, invest in foreign currency denominated securities (as foreign securities carry higher
interest). At the same time he would cover his principal and interest from this investment at
the forward rate. At maturity, he would convert the proceeds of the foreign investment at
the prefixed forward rate and payoff the domestic liability. The difference between the receipts
and payments serve as profit to customer.
Example :
$ Interest rate = 2% for 90 days in US £ Interest rate = 3% for 90 days in UK
Spot $/£ = 1.50 90 day forward $/£ = 1.50
Arbitrageur does the following :
Step I Borrow $1.50 million in US for 90 days.
Step II Convert to £ at the prevailing spot rate Le. 1.50 to get £1 million

702 Financial Management & International Finance

Step III Buy 90 days Deposit at UK Bank yielding 3% for 90 days.
Step IV Sell £1.03 million forward [£1 million + £0.03 million interest on deposit] at forward
rate of 1.50 per £.
Step V At maturity he gets £ 1.03 million
Step VI Against his forward contract selling which he has booked he would get
1.50 × £ 1.03 = $1.545 million dollars

Compare this with 1.50 × 1.02= $1.530 million dollars he would have got by depositing
directly in US deposits. Thus he made a profit of $1.545 – $1.530 = 0.015 million dollars
i.e. $15000.

INTERNATIONAL FISHER EFFECT (IFE) :

IFE holds that the interest rates differentials should reflect the expected movement in the
spot exchange rates, i.e., the spot exchange rate should move an equal amount but in a
different direction to the difference in interest rates in two countries. The spot rate of a
currency with higher interest rate would depreciate and that of a lower interest rate would
appreciate.
So, the interest rate differentials between two countries are offset by the spot and forward
exchange rates which is as follows:

S1 1 + rh
=
S0 1 + rf

Where S0 = Current Spot Rate

S1 = Future Spot Rate
rh = Home Interest Rate
rf = Foreign Exchange Rate

Advangates of International Fisher Effect

 Uses interest rate differentials to explain changes in exchange rates
 Assumes real interest rates are the same globally
 Believes high nominal rates indicate, potentially higher inflation and probable weakening
of the currency

Financial Management & International Finance 703