CH 6: International Parity Relationships

Interest Rate Parity

IRP holds that the forward premium or discount should be equal to the interest rate differential between two countries. Manifestation of the LOP applied to international money market instruments and represents an arbitrage equilibrium condition.

IRP implies that in the short run, the exchange rate depends on a) the relative interest rates between 2 countries and b) the expected future exchange rate.

An arbitrage portfolio involves 1) no net investment 2) no risk and 3) requires that such a portfolio should not generate any net cash flow in equilibrium.

Covered Interest Arbitrage

When the IRP doesn’t hold, the situation also gives rise to covered interest arbitrage opportunities.

CIA activities will increase the interest rate differential and at the same time, lower the forward premium/discount.

Uncovered interest rate parity

The difference in interest rates between two countries is equal to the expected change in the exchange rate between the countries’ currencies.

Purchasing Power Parity

Purchasing power parity doesn’t hold precisely in the real world for a variety of reasons:

  • Transaction costs

  • Capital controls

States that the exchange rate between 2 countries currencies should be equal to the ratio of their price levels. Manifistation of the law of one price applied internationally to a standard commodity basket.

The relative version of PPP states that the rate of change in the exchange rate should be equal to the inflation rate differential between countries.

PPP-determined exchange rates still provide a valuable benchmark.

Generally unfavourable evidence about PPP suggests that substantial barriers to international commodity arbitrage exist, such as tariffs and quotas.

As long as there are nontradables, PPP will not hold in its absolute version. If PPP holds for tradables and the relative prices between tradables and nontradables are maintained, then PPP can hold in its relative version.

The Fisher effects

An increase (decrease) in the expected rate of inflation will cause a proportionate increase (decrease) in the interest rate in the country.

Implies that the expected inflation is the difference between the nominal and real interest rates in each country.

Forecasting techniques

3 distinct approaches:

  • Efficient market approach

    Efficient if the current asset prices fully reflect all the available and relevant information.

    The random walk hypothesis suggests that today’s exchange rate is the best predictor of tomorrows exchange rate.

2 Key features:

Costless to generate since based on market-determined prices

Difficult to outperform the market-based forecasts given the efficiency of foreign exchange markets.

  • Fundamental approach

    Uses various models.

    Involves 3 steps:

    1) estimation of the structural model using historical data to determine numerical values

    2) Estimation of future values of the independent variables

    3) Substituting the estimated values of the independent variables from Step 2 into the estimated structural model obtain from step 1 to generate the exchange rate forecasts.

  • Technical approach

    Analyzes the past behaviour of exchange rates for the purpose of identifying patterns and then projects them into the future to generate forecasts.

    Compute moving averages as a way of separating short and long term trends from the vicissitudes of daily exchange rates.

    Head and shoulders pattern signals a reversal in an upward trending market.

Textbook notes

The law of one price- The requirement that similar commodities or securities should be trading at the same or similar prices.

Arbitrage- The act of simultaneously buying and selling the same or equivalent assets or commodities to make certain, guaranteed profits.

  • As long as there are profitable arbitrage opportunities the market can not be in equilibrium

  • Interest rate parity and purchasing power parity represent arbitrage equilibrium conditions.

Currency carry trade - Involves borrowing in currencies with low interest rates and investing in currencies with high interest rates, without any hedging.

  • Your carry trade will be profitable as long as the interest rate spread is greater than the rate of appreciation

When the dollar is at a forward discount, this implies that the dollar is expected to depreciate against the pound. If so, the dollar interest rate should be higher than the pound interest rate to compensate for the expected depreciation of the dollar.

All else equal, an increase in the U.S interest rate will lead to a higher foreign exchange value of the dollar. Because a higher U.S interest rate will attract capital to the U.S, increasing the demand for dollars. In contrast, a decrease in the U.S interest rate will lower the foreign exchange value of the dollar.

Even if absolute PPP does not hold, relative PPP may hold.