International Parity Conditions
and Currency Forecasting
International Financial
Management
Dr. A. DeMaskey
1
Learning Objectives
What is the “law of one price?”
 How does arbitrage link goods prices
and asset returns internationally?
 What are parity conditions and why
should we study them?
 What currency forecasting techniques
can be used under a fixed versus a
floating rate system?

2
What are Parity Conditions?

Parity Conditions
 Pricing relationships based on the law of one price
 Hold if no arbitrage opportunities exist

Law of One Price
 Identical products should sell for the same price
everywhere
 Otherwise, arbitrage opportunities will exist

Arbitrage
 Profit-guaranteeing strategy of “Buy low, sell high”
 No investment and no risk
3
Why Study Parity Conditions?
They provide the foundation of
international finance.
 They are useful in:

 Explaining the determinants of foreign
exchange rates.
 Forecasting the long-run trend in an
exchange rate.
4
International Parity Conditions

Purchasing Power Parity (PPP)
 Absolute PPP
 Relative PPP

Fisher Effect (FE)
 Generalized Fisher Effect (GFE)
International Fisher Effect (IFE)
 Interest Rate Parity (IRP)
 Unbiased Forward Rate (UFR)

5
Purchasing Power Parity

Absolute PPP
 Asks what should be the current exchange
rate
 Is based on price levels

Relative PPP
 Asks how the exchange rate should
change
 Is based on price changes
6
Absolute PPP
Application of the “law of one price” to
national price levels
 The foreign exchange rate is given as:


The law of one price is stated as:
7
The Big Mac Hamburger
Standard

The Economist developed the Big Mac Standard to
track PPP:
 Assuming that the Big Mac is identical in all countries, it
serves as a comparison point as to whether or not
currencies are trading at market prices
 Big Mac in Switzerland costs Sfr6.30 while the same Big
Mac in the US costs $2.54
 The implied PPP of this exchange rate is

However, on the date of the survey, the actual
exchange rate was Sfr1.73/$
8
How Well Does the Absolute PPP
Work?


Based on the assumption of free trade
It has limited usefulness due to:
 Differentiated goods
 Costly information
 Transportation costs
 Differential tariffs, quotas, and other restrictions on
free trade

Thus, the Relative PPP is more commonly
used today because is has more reasonable
assumptions
9
Relative PPP

The exchange rate change is equal to:

Parity in the new foreign and domestic
price index is stated as:

Relative PPP states that:
10
Simplified PPP

PPP can be approximated as:

PPP states that currencies with high
rates of inflation devalue relative to
currencies with low rates of inflation.
11
Nominal versus Real Exchange
Rates

Nominal exchange rate
 Price of one currency in terms of another

Real exchange rate
 Real purchasing power of one currency relative to
another

PPP and real exchange rates
 If an exchange rate adjusts fully to the inflation
differential according with PPP, the real exchange
rate remains constant.
 PPP holds if real exchange rates are stable over
time.
12
Real Exchange Rate

Quoted exchange rate adjusted for the
country’s inflation rate.

The real exchange rate is equal to:
13
How Well Does Relative PPP
Work?

PPP does not hold over the short-run
 Sticky goods prices (lagged changes)
 Changes in exchange rates precede changes in
prices.

PPP holds over the long-run
 Clear relationship between relative inflation rates
and changes in nominal exchange rates


PPP holds more closely when price indices
cover tradable goods.
PPP holds better in high-inflation cases.
14
Fisher Effect
Describes the relationship between the
nominal interest rate, real interest rate,
and the inflation rate.
 Fisher equation:

15
Simplified FE

The Fisher Effect can be approximated
as:

The nominal rate equals the real rate
plus inflation.
16
Generalized Fisher Effect

GFE says that real rates are equal among
countries.

GFE states that currencies with high rates of
inflation should bear higher interest rates than
countries with lower rates of inflation.
17
How Well Does the FE (GFE)
Work?
The FE (GFE) generally holds.
 However, real interest rate differentials
exist due to:

 Currency risk
 Inflation risk
 Political risk
» Differing tax policies
» Regulatory barriers to free flow of capital
18
International Fisher Effect



Similar to Relative PPP except it uses interest
rate rather than inflation rate differentials to
explain exchange rate changes.
The effective return on a home bank deposit
is equal to:
The effective return on a foreign bank deposit
is equal to:
19
International Fisher Effect

Equality in effective return on a home
and foreign investment is stated as:

The IFE states that:
20
Simplified IFE

The IFE can be approximated as:

IFE states that currencies with low
interest rates should appreciate relative
to currencies with high interest rates.
21
How Well Does IFE Work?

Lend some support to IFE.
 Nominal interest rate equals real interest rate plus
expected inflation.
 If real interest rate increases, the nation’s currency
appreciates.
 If expected inflation increases, the nation’s
currency depreciates.

Considerable short-run deviations do occur.
 Uncovered interest arbitrage
22
Interest Rate Parity
Spot and forward rates are related by
IRP
 Relative returns on domestic and
foreign investment:


IRP states that:
23
Interest Rate Parity (IRP):
Example

Suppose you have $1 million to invest for 90
days and the following choices:
 Invest in dollar-denominated securities for 90 days
earning 8.00% per annum, or
 Invest in Swiss franc-denominated securities of
similar risk and maturity earning 4.00% per annum

Suppose you have the following quotes:
 Spot rate of SF1.4800/$
 90-day forward rate of SF1.4655/$

Would you invest in the U.S. or Switzerland?
24
Covered Interest Arbitrage
Spot and forward market are not in
equilibrium.
 Relative forward differential does not
equal relative interest differential.

25
Generalization of Covered
Interest Arbitrage


If:
If:
(1 i d ) 
(1 i f )f1
e0
(1 i f )f1
(1 i d ) 
e0
26
How Well Does IRP Work?

Small deviations from IRP do occur.
 Covered interest arbitrage opportunities

Lack of arbitrage profit opportunities due to:
 Transactions costs
 Differential tax rates
 Government controls
 Political risk
 Time lag
27
Unbiased Forward Rate

Interest rate differential
Unbiased nature of the forward rate
f1 = E(e1)
 Market efficiency does not require that
f1 = E(e1)

28
Are Forward Prices Unbiased?

Evidence that forward rates are biased
predictors of future spot rates.
 Risk premium
» Appears to change signs
» Averages near zero
 Market efficiency

It appears that it does pay to use
resources to forecast exchange rates.
29
Currency Forecasting


Successful currency forecasting is difficult.
Currency forecasting can lead to consistent
profits only if forecaster has:
 Superior forecasting model
 Access to information before other investors
 Exploit small, temporary deviations from
equilibrium
 Ability to predict government intervention in
foreign exchange market
30
Forecasting Fixed Exchange
Rates
Forecasters must focus on predicting
government action, since devaluations
and revaluations are political decisions.
 Basic forecasting methodology involves:

 Determine pressure on a currency to
devalue or revalue
 Determine political will of leaders to persist
with current level of disequilibrium
31
Forecasting Floating Exchange
Rates

Market-Based Forecasts
 Forward rate
 Interest rate

Model-Based Forecasts
 Fundamental analysis
 Technical analysis
32
Parity Conditions
Theory
Purchasing power
parity (PPP)
Key Variables of
Theory
Percentage
change in spot
exchange rate
International Fisher
effect (IFE)
Interest rate parity
(IRP)
Summary of Theory
Interest rate
differential
Forward rate
premium (or
discount)
33
International Parity Conditions
FE
Interest Rate
Differential
(1  ih )
(1  i f )
Expected Inflation
Rate Differential
E (1  I h )
E (1  I f )
IFE
IRP
Forward
Differential
f1
e0
PPP
Expected Change
in Spot Rate
e1
e0
UFR
34