7-1

International Parity Conditions

International parity conditions are the economic theories that
link exchange rates, price levels, and interest rates
together.

International Parity Conditions are only theories and do not
always work out to be true when compared to what is
observed in the real world,

BUT they are central to any understanding of how
multinational businesses are conducted in terms of the
exchange rates.

The mistake is often not with the theory itself, but with the
interpretation and application of such theories.
7-2
Prices and Exchange Rates: THE
LAW OF ONE PRICE
If two identical products are:
sold in two different markets; and
no restrictions exist on the sale; and
transportation costs of moving the product between
markets are equal, then
the products price should be the same in both markets.
If not, ARBITRAGE will make them the same.
This is called the LAW OF ONE PRICE, and
arbitrage adjust any discrepancy in prices.
7-3
Prices and Exchange Rates: THE
LAW OF ONE PRICE
Because of the law of one price, prices for the same
products will be the same across countries if frictions
(transportation costs, barriers) do not exist.

Lets say two identical products are traded in two countries
at prices P
d
and P
f
. Because of law of one price, after
conversion from one currency to the other, the value of
these products should be the same:
P
d
= S x P
f
As the prices are given, the exchange rate could be deduced
as:
S = P
d
/ P
f




PURCHASING POWER PARITY
Purchasing Power Parity (PPP) is the law of one price
applied to international trade.

If instead of prices of two identical products traded in two
countries, we used the price levels for a basket of
similar products in those countries (P
d
,P
f
), we obtain
that:
S = P
d
/P
f

PPP states that, as a result of the law of one price the
exchange rate between currencies of two countries should
equal the ratio of the countriesprice levels.

Note that what is valid for a single product should be also
valid for a basket of similar products. This the law of one
pice applied to international trade.
7-4
7-5
PURCHASING POWER PARITY
In summary, the purchasing power parity (PPP) says that
the exchange rate between currencies of two countries is
determined by prices levels of those two countries, as
follows:





But, in practice PPP has proved not to be helpful in
determining what the spot rate should be.



f
d
P
P
S =
7-6
ABSOLUTE PURCHASING POWER
PARITY

Absolute purchasing power parity says that the purchasing
power parity exchange rate could be found by
comparing the prices of any pair of identical products.


Ex. Big Mags in China and USA.




) 1 (
) 1 (
) 1 (
) 1 (
) 1 ( 1
) 1 (
) 1 (
) 1 (
1 2
1
2
f
d
f
d
f
d
S S
S
S
e
t
t
t
t
t
t
+
+
=
+
+
= +
+
+
= +
) 1 (
) 1 (
) 1 (
) 1 (
) 1 (
) 1 (
) (
) (
) (
f
d
f
f
f
d
d
d
f f
d d
S
S
P
P
P
P
P
P
S
S
S
P P
P P
S S
t
t
+
+
=
A
+
A
+
A
+
=
A
+
A +
A +
= A +
RPPP holds that the relative change in prices between two
countries over a period of time determines the change in the
exchange rate over that period. RPPP focus on explaining the
change is S, rather than the true value of S.



The change in S due to an change in P
d
and P
f
is given by
RELATIVE PURCHASING POWER
PARITY (RPPP)
f
d
P
P
S =
7-8
RELATIVE PURCHASING POWER
PARITY (RPPP)
RPPP: A change in the differential rate of inflation between
two countries tend to be offset over the long run by an equal
but opposite change in the spot exchange rate.





If a country experiences inflation rate higher than other
countries (trading partners), and its exchange rate does not
change, its products become more expensive or less
competitive with comparable overseas products. A
depreciation will make domestic products more
competitive.





) 1 (
) 1 (
) 1 (
) 1 (
) 1 (
1 2
f
d
f
d
e or S S
t
t
t
t
+
+
= +
+
+
=
7-9
RPPP and Real Exchange Rate
When RPPP holds, the differential inflation rate between
two countries should be exactly offset by the exchange rate
change, and:



When RPPP is violated,








The expression is called real exchange
rate



1
) 1 (
) 1 ( ) 1 (
=
+
+ +
e
f d
t t
1
) 1 (
) 1 ( ) 1 (
) >
+
+ +
e
a
f d
t t
1
) 1 (
) 1 ( ) 1 (
) <
+
+ +
e
b
f d
t t
) 1 (
) 1 ( ) 1 (
e
f d
+
+ + t t
7-10
RPPP and Real Exchange Rate
Problem 1: Inflation rate is 6% per year in USA and
4% in UK. If RPPP holds, how much should the
exchange rate change?
7-11
RPPP and Real Exchange Rate
Problem 1: Inflation rate is 6% per year in USA and
4% in UK. If RPPP holds, how much should the
exchange rate change?


Sol: If RPPP holds, then:




% 92 . 1 1 %) 4 1 ( %) 6 1 ( = + +
7-12
RPPP and Real Exchange Rate
Problem 2: USA annual inflation rate is 5%, and 1% in
UK. USD is depreciated 0.5% against the UK. Calculate
the real exchange rate and its probable consequences.


7-13
RPPP and Real Exchange Rate
Problem 2: USA annual inflation rate is 5%, and 1% in
UK. USD is depreciate 0.5% against the GBP. Calculate
the real exchange rate and its probable consequences.


Sol:



The real effective exchange rate rises if domestic
inflation exceed inflation abroad and the exchange
rate fails to depreciate to compensate for the higher
domestic inflation rate.

Note that if the real exchange rate rises (falls) the
domestic country competitiveness declines (improves)

1 03 . 1
%) 5 . 0 1 (
%) 1 1 ( %) 5 1 (
> =
+
+ +
7-14
Exchange Rates Pass-Through
Exchange rate fluctuations affect the prices of imported and
exported goods, and then impact on domestic inflation.

PPP implies that all exchange rate changes are passed through by
equivalent changes in prices to trading partners. But, empirical
research in the 80s questioned this long-held assumption.

Exchange rate pass-through is defined as the effect of exchange
rate changes on domestic inflation.

Incomplete exchange rate pass-through is one reason that a
countrys real effective exchange rate index can deviate

For example, a car manufacturer may or may not adjust pricing
of its cars sold in a foreign country if exchange rates alter the
manufacturers cost structure.

7-15
Exchange Rates Pass-Through
Pass-through can also be partial as there are many
mechanisms by which companies can absorb the impact of
exchange rate changes.

Price elasticity of demand is an important factor when
determining pass-through levels.

Price elasticity of demand for any good is the percentage
change in quantity of the good demanded as a result of the
percentage change in the goods own price.

INTEREST RATE AND
EXCHANGE RATES
Fisher Effect (interest rate and inflation)

International Fisher Effect (exchange rate an interest rate)

Interest Rate Parity (interest rate, spot exchange rate, forward
exchange rate)
7-17
INTEREST RATES AND EXCHANGES RATES
Fisher Effect
Irving Fisher: nominal interest rates in each country
must be equal to the required real rate of return plus
compensation for expectated inflation


i = nominal interest rate
r = real interest rate
= inflation rate


Fisher Effect applied to USA and Japan should be as follows:





7-18
) 1 )( 1 ( ) 1 ( t + + = + r i
t t t + + = + + = r r r i ) 1 )( 1 (
t + = r i
JY JY JY
r i Japan
r i USA
t
t
+ =
+ =
:
:
$ $ $
INTEREST RATES AND EXCHANGES RATES
International Fisher Effect
If a USA investor buys a 10-year japanese yen bond earning
4% interest, instead of a 10-year dollar bond earning 6%
interest, the USA investor must be expecting the japanese
yen to appreciate against the dollar by at least 2% during
10 years.

If not, the USA investor would be better off remaining in
dollars, and if the japanese yen appreciates more than 2%
during the 10-year period, the USA investor would earn a
higher return.

International Fisher effect predicts that an investor
should be indiffirent to whether his bond is in dollars or yen,
because if there are opportunities to earn other investors
would see the same opportunity and compete among them
(LAW OF ONE PRICE)

7-19
INTEREST RATES AND EXCHANGES RATES
International Fisher Effect
The relationshipbetween the percentage change in the spot
exchange rate over time and the differential between
interest rates in different countries is known as the
International Fisher effect.

International Fisher effect: the spot exchange rate should
change in an equal amount but in the opposite direction
to the difference in interest rate between countries.


7-20
) 1 (
) (
2
1 2
d
d f
i
i i
S
S S
+

Forward Rate and Forward Change

Agreement
A forward rate is an exchange rate quoted today for
settlement at some future date.

A forward exchange agreement between currencies
states the rate of exchange at which a foreign currency will
be bought forward or sold forward at a specific date in the
future (after 30,60,90,180,270, or 360 days)
7-21
INTEREST RATES AND EXCHANGES RATES
International Rate Parity
7-22

The theory of Interest Rate Parity (IRP) provides the linkage
between the foreign exchange rates and the interest rates of
two countries.

IRP: the difference in the interest rates for two financial
assets of similar risk and maturity should be equal to,
but opposite in sign to, the forward rate for the foreign
currency.
IRP is an arbitrage condition that must be hold when
international financial markets are in equilibrium, otherwise
arbitrage and the LAW OF ONE PRICE will make the
equilibrium possible.
INTEREST RATES AND EXCHANGES RATES
International Rate Parity
7-23
Assume that an investor has $1 million. If the investor
chooses to invest dollar money market instrument, the
investor would earn the dollar rate of interest. This results in
(1+ i
$
) at the end of the period.
But the investor may choose to invest in a Swiss Francs
money market instrument of identical risk and maturity for
the same period.
The investor will exchange the US$ for SF at the spot rate
S, and immediately sell the SF in a forward exchange
agreement to avoid the exchange rate risk by locking the
forward rate at F and convert the resulting proceed back
to US$.
The comparison of returns would be as follows:
$ /
$ / $
1
) 1 ( ) 1 (
SF
SF SF
F
i S i + = +
INTEREST RATES AND EXCHANGES RATES
International Rate Parity
7-24


IRP:


The left hand side of the equation is the gross return the
investor would earn by investing in USD.

The right hand side is the gross return the investor would
earn by exchanging USD for SF at the spot rate S,
investing the SF in the SF money market instrument and
simultaneously selling the principal plus interest in SF for
USD at the current forward rate.

$ /
$ / $
1
) 1 ( ) 1 (
SF
SF SF
F
i S i + = +
INTEREST RATES AND EXCHANGES RATES
International Rate Parity
7-25
IRP:


If the returns are the same for the two alternative
investments, the spot (S) and the forward rate (F) are
considered to be at IRP.

Arbitrage states the that the future dollars proceeds from
investing in two equivalent investments must be the same
(no one should be able to make profits as other
investors will do the same until profits become zero)

$ /
$ / $
1
) 1 ( ) 1 (
SF
SF SF
F
i S i + = +
) 1 (
) 1 (
$ $ /
$ /
i
i
S
F
SF
SF
SF
+
+
=
0 ) 1 ( ) 1 (
$ / $ $ /
= + +
SF SF SF
i S i F
Or
INTEREST RATES AND EXCHANGES RATES
International Rate Parity
7-26
When IRP holds, you will be indifferent between investing
your money in USD and investing in SF with forward
exchange agreements.

However, if IRP is violated, you will prefer one to
another.

When IRP doesnt hold the situation gives rise to
COVERED INTEREST ARBITRAGE opportunities.

INTEREST RATES AND EXCHANGES RATES
International Rate Parity
7-27
INTEREST RATES AND EXCHANGES RATES
International Rate Parity
7-28
INTEREST RATES AND EXCHANGES RATES
International Rate Parity
7-29
The following adjustment will occur to the initial market conditions
This adjustments will rise the left -hand side and, at the same time lower
the right-hand side until both side are equlized, restoring IRP
7-30
Interest Rates
and Exchange Rates
A deviation from covered interest arbitrage is uncovered
interest arbitrage (UIA).
In this case, investors borrow in countries and currencies
exhibiting relatively low interest rates and convert the
proceed into currencies that offer much higher interest
rates.
The transaction is uncovered because the investor
does no sell the higher yielding currency proceeds
forward, choosing to remain uncovered and accept the
currency risk of exchanging the higher yield currency
into the lower yielding currency at the end of the period.