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Chapter 4

International Parity Conditions

Prepared by Shafiq Jadallah

To Accompany
Fundamentals of Multinational Finance
Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman
Copyright 2003 Pearson Education, Inc. Slide 4-1
Interest Rate Parity (IRP)
i $ = 8.00 % per annum
(2.00 % per 90 days)
Start End
$1,000,000 1.02 $1,020,000

Dollar money market $1,019,993*

S = SF 1.4800/$ 90 days F90 = SF 1.4655/$

Swiss franc money market

SF 1,480,000 1.01 SF 1,494,800

i SF = 4.00 % per annum


(1.00 % per 90 days)

Note that the Swiss franc investment yields $1,019,993, $7 less on a $1 million investment.

Copyright 2003 Pearson Education, Inc. Slide 4-2


Covered Interest Arbitrage (CIA)
Eurodollar rate = 8.00 % per annum
Start End
$1,000,000 1.04 $1,040,000 Arbitrage
$1,044,638 Potential
Dollar money market

S = 106.00/$ 180 days F180 = 103.50/$

Yen money market

106,000,000 1.02 108,120,000

Euroyen rate = 4.00 % per annum

Copyright 2003 Pearson Education, Inc. Slide 4-3


Uncovered Interest Arbitrage (UIA):
The Yen Carry Trade
Investors borrow yen at 0.40% per annum
Start End
10,000,000 1.004 10,040,000 Repay
10,500,000 Earn
Then exchanges Japanese yen money market 460,000 Profit
the yen proceeds
for US dollars,
S = 120.00/$ 360 days S360 = 120.00/$
investing in US
dollar money
markets for US dollar money market
one year
$ 83,333,333 1.05 $ 87,500,000

Invest dollars at 5.00% per annum

Copyright 2003 Pearson Education, Inc. Slide 4-4


Forward Rates as an Unbiased Predictor
Exchange rate

S2 F2

Error Error
S1 F3

F1 S3 Error

S4

Time
t1 t2 t3 t4
The forward rate available today (Ft,t+1), time t, for delivery at future time t+1, is used as a predictor of the
spot rate that will exist at that day in the future. Therefore, the forecast spot rate for time St2 is F1; the actual
spot rate turns out to be S2. The vertical distance between the prediction and the actual spot rate is the forecast
error. When the forward rate is termed an unbiased predictor, it means that the forward rate over or
underestimates the future spot rate with relatively equal frequency and amount, therefore it misses the mark in
a regular and orderly manner. The sum of the errors equals zero.

Copyright 2003 Pearson Education, Inc. Slide 4-5


Prices, Interest Rates and
Exchange Rates in Equilibrium
(A) Purchasing power parity
forecasts the change in the spot rate on the basis of differences in expected
rates of inflation
(B) Fisher effect
nominal interest rates in each country are equal to the required real rate of
return (r) plus compensation for expected inflation ()
(C) International Fisher effect
the spot exchange rate should change in an amount equal to but in the opposite
direction of the difference in interest rates between countries
(D) Interest rate parity
the difference in the national interest rates should be equal to, but opposite in
sign to, the forward rate discount or premium for the foreign currency, except
for transaction costs
(E) Forward rate as an unbiased predictor
the forward rate is an efficient predictor of the future spot rate, assuming that
the foreign exchange market is reasonably efficient
Copyright 2003 Pearson Education, Inc. Slide 4-6
Summary of Learning Objectives
Parity conditions have traditionally been used by economists to
help explain the long run trend in an exchange rate
Under conditions of free floating rates, the expected rate of
change in the spot rate, differential interest and inflation rates,
and the forward rate are all directional and proportional to each
other
If two products are identical across borders and there are no
transaction costs, the products price should be the same in both
countries. This is the law of one price
The absolute theory of PPP states that the spot rate is determined
by the relative prices of similar goods
The relative theory of PPP states that if the spot rate starts in
equilibrium, any change in the differential inflation rates should
be offset over the long run by an opposite change in the spot rate

Copyright 2003 Pearson Education, Inc. Slide 4-7


Summary of Learning Objectives
The Fisher Effect states that nominal interest rates in each
country are equal to the required real rate of return plus
compensation for expected inflation The international Fisher
Effect states that the spot rate should change in an equal
amount but in the opposite direction to the difference in
interest rates between two countries
The IRP theory states that the difference between national
interest rates for similar securities should be equal to, but
opposite sign to, the forward discount or premium rate
excluding transaction costs
When the forward and spot market rates are not in equilibrium,
the opportunity for risk free arbitrage exists. This is termed
covered interest arbitrage
If markets are believed to be efficient, then the forward rate is
considered an unbiased predictor of the future spot rate
Copyright 2003 Pearson Education, Inc. Slide 4-8