International Parity Conditions

BITS Pilani Dr. Shrabana Tripathi

Department of Economics & Finance
 BITS Pilani

MBA ZG518/ PDFI ZG518, Multinational Finance

Lecture No. 6 & 7
Learning Objectives

6.1 Examine how price levels and price level changes (inflation)
in countries determine the exchange rates at which their
currencies are traded.
6.2 Show how interest rates reflect inflationary forces within
each country and drive currency exchange rates.
6.3 Explain how forward markets for currencies reflect
expectations held by market participants about the future
spot exchange rate.
6.4 Analyze how, in equilibrium, the spot and forward currency
markets are aligned with interest differentials and
differentials in expected inflation.

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International Parity
Conditions (1 of 2)
• Some fundamental questions managers of M N E s,
international portfolio investors, importers, exporters and
government officials must deal with every day are:
– What are the determinants of exchange rates?
– Are changes in exchange rates predictable?
• The economic theories that link exchange rates, price
levels, and interest rates together are called International
Parity Conditions.
• These international parity conditions form the core of the
financial theory that is unique to international finance.

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International Parity
Conditions (2 of 2)
• These theories do not always work out to be “true” when
compared to what students and practitioners observe in
the real world, but they are central to any understanding
of how multinational business is conducted and funded in
the world today.
• The mistake is often not with the theory itself, but with the
interpretation and application of said theories.

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Prices and Exchange Rates
(1 of 2)

• If the identical product or service can be:

– 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 product’s price should be the same in both
markets.
• This is called the Law Of One Price.

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Prices and Exchange Rates
(2 of 2)

• A primary principle of competitive markets is that prices

will equalize across markets if frictions (transportation
costs) do not exist.
• Comparing prices then would require only a conversion
from one currency to the other:
P $  S ¥ = $1.00 = P ¥

• Where the product price in U.S. dollars is ( P $ )

• the spot exchange rate is ( S ¥$ )
• the price in Yen is ( P ) .
¥

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Purchasing Power Parity
and the Law of One Price
• If the law of one price were true for all goods and services,
the purchasing power parity (P P P) exchange rate could
be found from any individual set of prices.
• By comparing the prices of identical products
denominated in different currencies, we could determine
the “real” or P P P exchange rate that should exist if
markets were efficient.
• This is the absolute version of the PPP theory.
• A fun example is the Big Mac Index published annually by
the Economist. Exhibit 6.1 illustrates.

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Exhibit 6.1 (1 of 2)
Selected Rates from the Big Mac Index
Country Currency (1) (2) (3) (4) (5)
Big Mac Actual Dollar Big Mac Implied Under/
Price in Local Exchange Rate Price in PPP of the overvaluation
Currency July 2017 Dollars Dollar against Dollar
United
States $Dollar sign

5.66 Blank

5.66 Blank Blank

Britain £ Pound

3.29 1.3489* 4.44 1.7204* −21.6%

Minus 21.6 percentage.

C$ −6.6%
Canadian dollar

Canada 6.77 1.2803 5.29 1.1961 Minus 6.6 percentage.

China Yuan 22.4 6.4751* 3.46 3.9576* −38.9%

Minus 38.9 percentage.

Denmark DK 30.0 6.1207 4.90 5.3004 −13.4%

Minus 13.4 percentage.

Euro area € Euro

4.25 1.2151 5.16 1.3318 −8.8%

Minus 8.8 percentage.

India Rupee 190.0 73.390 2.59 33.569 −54.3%

Minus 54.3 percentage.

−33.9%
Minus 33.9 percentage.

Japan ¥ Yen

390 104.295 3.74 68.905

Mexico Peso 54.0 20.1148 2.68 9.5406 −52.6%
Minus 52.6 percentage.

Norway kr 52.0 8.5439 6.09 9.1873 7.5% 7.5 percentage.

−41.9%
Minus 41.9 percentage.

Peru Sol 11.9 3.6207 3.29 2.1025

Russia Ruble 135.0 74.63 1.81 23.852 −68.0%
Minus 68.0 percentage.

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Exhibit 6.1 (2 of 2)

Country Currency (1) (2) (3) (4) (5)

Big Mac Actual Dollar Big Mac Implied Under/
Price in Local Exchange Rate Price in PPP of the overvaluation
Currency July 2017 Dollars Dollar against Dollar

Singapore S$
S Dollar sign

5.90 1.3308 4.43 1.0424 −21.7%

minus 21.7 percentage.

Thailand Baht 128.0 30.1300 4.25 22.6148 −24.9%

minus 24.9 percentage.

Note:* These exchange rates are stated in US$ per unit of local currency,

** Percentage under/overvaluation against the dollar is calculated as (Implied –

Actual)/(Actual), except for the Britain and Euro area calculations, which are (Actual –
Implied)/(Implied). $ = £1.00 and $ = €1.00

Britain and the Euro area are exceptions because their exchange rates are quoted in
dollars per currency unit, whereas other countries are quoted in currency units per dollar.
So the formula is reversed to maintain consistent valuation comparisons.

Source: Data for columns (1) and (2) drawn from “The Big Mac Index Tells You about
Currency Wars,” The Economist, July 12, 2021.

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Relative Purchasing Power
Parity (1 of 2)
• If the assumptions of the absolute version of the P P P
theory are relaxed a bit more, we observe what is termed
relative purchasing power parity (relative PPP).
• Relative P P P holds that P P P is not particularly helpful in
determining what the spot rate is today, but that the
relative change in prices between two countries over a
period of time determines the change in the exchange
rate over that period.

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Relative Purchasing Power
Parity (2 of 2)
• More specifically, with regard to relative PPP:
“If the spot exchange rate between two countries starts
in equilibrium, any change in the differential rate of
inflation between them tends to be offset over the long
run by an equal but opposite change in the spot
exchange rate.”

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Empirical Tests of
Purchasing Power Parity
• Empirical testing of P P P and the law of one price has
been done, but has not proved P P P to be accurate in
predicting future exchange rates.
• Two general conclusions can be made from these tests:
– P P P holds up well over the very long run but poorly for
shorter time periods
– The theory holds better for countries with relatively
high rates of inflation and underdeveloped capital
markets.

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Exchange Rate Indices:
Real and Nominal
• Individual national currencies often need to be evaluated
against other currency values to determine relative
purchasing power to discover whether a nation’s
exchange rate is “overvalued” or “undervalued” in terms of
PPP.
• This problem is often dealt with through the calculation of
exchange rate indices, such as the nominal effective
exchange rate index. $
C
$ $
ER = E N 
C FC
• Exhibit 6.2 illustrates real effectives exchange rate
indexes for Japan, the euro area, and the United States.

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Exhibit 6.2
Real Effective Exchange Rate Indexes (Base Year 2010 = 100)

Source: Bank for International Settlements, [Link]/statistics/eer/. B I S effective

exchange rate (E E R), Real (C P I-based), narrow indices, monthly averages, January 1980–
March 2021.

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Exchange Rate Pass-
Through (1 of 3)
• Exchange rate pass-through is a measure of the
response of imported and exported product prices to
changes in exchange rates.

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Exchange Rate Pass-
Through (2 of 3)
• Price elasticity of demand is an important factor when
determining pass-through levels.
• The own-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 good’s price.

%Qd
Price elasticity of demand = ε p =
%P

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Exchange Rate Pass-
Through (3 of 3)
• A number of emerging market countries have chosen in
recent years to change their objectives and choices.
• These countries have shifted from choosing a pegged
exchange rate and independent monetary policy over the
free flow of capital (point A in Exhibit 6.3) to policies
allowing more capital flows at the expense of a pegged or
fixed exchange rate (toward point C in Exhibit 6.3).

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Exhibit 6.3
Pass-Through, the Impossible Trinity, and Emerging Markets

Many emerging market countries have chosen to move from Point A to

Point C, exchanging fixed exchange rates for the chance of attracting
capital inflows. The result is that these countries are now subject to
varying levels of exchange rate pass-through.

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Interest Rates and
Exchange Rates (1 of 3)

• 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.
• This equation reduces to (in approximate form):

i=r +
• Where i = nominal interest rate, r = real interest rate and
•  = expected inflation.
• Empirical tests (using ex-post) national inflation rates
have shown the Fisher effect usually exists for short-
maturity government securities (treasury bills and notes).

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Interest Rates and
Exchange Rates (2 of 3)

• The relationship between the percentage change in the

spot exchange rate over time and the differential between
comparable interest rates in different national capital
markets is known as the International Fisher Effect.
• “Fisher-open,” as it is termed, states that the spot
exchange rate should change in an equal amount but in
the opposite direction to the difference in interest rates
between two countries.

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Interest Rates and Exchange
Rates (3 of 3)

More formally:

S1 − S2
 100 = i $ − i ¥
S2

• Where i $ and i ¥ are the respective national interest rates

and S is the spot exchange rate using indirect quotes
( ¥/$ ) .
• Justification for the international Fisher effect is that
investors must be rewarded or penalized to offset the
expected change in exchange rates.

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The Forward Rate (1 of 4)

• A forward rate is an exchange rate quoted 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.

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The Forward Rate (2 of 4)

• The forward rate is calculated for any specific maturity by

adjusting the current spot exchange rate by the ratio of
eurocurrency interest rates of the same maturity for the two
subject currencies.
• For example, the 90-day forward rate for the Swiss
franc/U.S. dollar exchange rate (F SF/ $90) is found by
multiplying the current spot rate (S SF/ $) by the ratio of the
90-day euro-Swiss franc deposit rate ( iSF ) over the 90-day
eurodollar deposit rate ( i$ ) .

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The Forward Rate (3 of 4)

• Formulaic representation of the forward rate:

  SF 90  
1 +  i  360  
  
F SF/$
90 =S SF/$

  $ 90  
1 +  i  360  
  

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The Forward Rate (4 of 4)

• The forward premium or forward discount is the

percentage difference between the spot and forward
exchange rate, stated in annual percentage terms.

Spot − Forward 360

f SF =   100
Forward days

• This is the case when the foreign currency price of the

home currency is used (SF/$).
• See Exhibit 6.4.

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Exhibit 6.4

Currency Yield Curves and the Forward Premium

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Interest Rate Parity (IRP)

• The theory of Interest Rate Parity (I R P) provides the

linkage between the foreign exchange markets and the
international money markets.
• The theory states, “The difference in the national interest
rates for securities of similar risk and maturity should be
equal to, but opposite in sign to, the forward rate discount
or premium for the foreign currency, except for transaction
costs.”
• See Exhibit 6.5

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Exhibit 6.5

Interest Rate Parity (IRP)

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Covered Interest Arbitrage
(CIA)
• The spot and forward exchange rates are not constantly in
the state of equilibrium described by interest rate parity.
• When the market is not in equilibrium, the potential for
“risk-less” or arbitrage profit exists.
• The arbitrager will exploit the imbalance by investing in
whichever currency offers the higher return on a covered
basis.
• See Exhibit 6.6.

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Exhibit 6.6

Covered Interest Arbitrage (CIA)

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Uncovered Interest
Arbitrage (UIA)
• In the case of Uncovered Interest Arbitrage (U I A),
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
not 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.
• See Exhibit 6.7.

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Exhibit 6.7

Uncovered Interest Arbitrage (UIA): The Yen Carry Trade

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Equilibrium Between Interest
Rates and Exchange Rates
• Exhibit 6.8 illustrates the conditions necessary for
equilibrium between interest rates and exchange rates.
• The disequilibrium situation, denoted by point U, is
located off the interest rate parity line.
• However, the situation represented by point U is unstable
because all investors have an incentive to execute the
same covered interest arbitrage, which is virtually risk-
free.

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Exhibit 6.8
Interest Rate Parity and Equilibrium

If market interest rates were at point U, covered interest arbitrage profits are
available and would be undertaken until the market drives interest rate
differences back to point X, Y, or Z.

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Forward Rate as an Unbiased
Predictor of the Future Spot Rate

• Some forecasters believe that forward exchange rates are

unbiased predictors of future spot exchange rates.
• Intuitively this means that the distribution of possible
actual spot rates in the future is centered on the forward
rate.
• Unbiased prediction simply means that the forward rate
will, on average, overestimate and underestimate the
actual future spot rate in equal frequency and degree.
• Exhibit 6.9 illustrates this theory.

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Exhibit 6.9
Forward Rate as an Unbiased Predictor of Future Spot

The forward rate available “today”(Ft ) for delivery at a future time (t + 1) is used as a

forecast or predictor of the spot rate at time t + 1. The difference between the spot rate
which and the forward rate is the forecast error. When the forward rate is termed an
“unbiased predictor of the future spot rate,” it means that the errors are normally distributed
around the mean future spot rate (the sum of the errors equals zero).
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Prices, Interest Rates, and
Exchange Rates in Equilibrium
• Exhibit 6.10 illustrates all of the fundamental parity
relations simultaneously, in equilibrium, using the U.S.
dollar and the Japanese yen.

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Exhibit 6.10
International Parity Conditions in Equilibrium (in approximate
form)

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Appendix 1
Long description for Exhibit 6.2
The graph has three curves representing the exchange rate indexes for U.S. dollar, Japanese
yen, and Euro Area euro. The following list outlines the trends demonstrated by the graph. All
rates are based on base year 2010 = 100. All values are estimated. The index for the U.S. dollar
started at 106 in January 1980, before rising to a peak at 145 around August 1984. The index
then fell to a low at 95 in December 1991, before fluctuating between 95 and 130 during the
period from 1991 and 2021. The index for the dollar reached notable peaks at 125 in 2001, at
112 in 2008, at 129 in 2016, and at 130 in 2020. The index reached notable valleys at 95 in
1991, 2007, and 2010. By 2021, the index for the U.S. dollar was at 120. The index for the
Japanese yen started at 73 in January 1980. Despite fluctuations of up to 30 points over 2
years, the index generally rose between the years 1982 and 1995, with notable peaks at 115 in
1998 and at 142 in 1995. From 1995 to 2021, the index for the yen then generally declined.
During this period, the index had notable peaks at 123 in 2001 and at 108 in 2011. The index
had notable valleys at 93 in 1997, at 75 in 2006, and at 72 in 2014. By 2021, the index for the
Japanese yen was at 75. The index for the Euro Area euro started at 98 in 1980, before falling to
near 80 by 1981. From 1981 to 1984, the index for the euro fluctuated between 78 and 88,
before rising to near 98 in 1986. From 1986 to 1998, the index fluctuated between 85 and 100,
ending at 95. The index then fell to near 74 in 2000, before once again climbing to near 110 by
2007. From 2007 to 2021, the index for the euro generally fell, ending at 95

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Appendix 2
Long Description for Exhibit 6.3
A triangle has vertices that represent the pegged exchange rate, the free
flow of capital, and independent monetary policy. Points A, B, and C on the
sides of the triangle represent the changing approach of emerging market
nations to their exchange rates. The following list outlines this changing
approach. Emerging market nations generally start at point A on the side of
the triangle between the pegged exchange rate and independent monetary
policy. These nations traditionally value exchange rate stability and
monetary independence. Emerging market nations want to attract capital
inflows. So, they have shifted toward point C on the side of the triangle
between independent monetary policy and free flow of capital. Exchange
rate pass through has also led emerging market nations to shift toward
point B on the side of the triangle between pegged exchange rate and free
flow of capital. Now that these countries are experiencing changing
exchange rates, exchange rate pass through is a growing source of
inflationary pressure and price instability.

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Appendix 3

Long Description for the Forward Rate

F to the power of S, F divided by $90 equals start
expression S to the power of S, F divided by dollar sign end
expression times start fraction 1 plus left parenthesis i to the
power of S, F times 90 divided by 360 right parenthesis over
1 plus left parenthesis i to the power of dollar sign times 90
divided by 360 right parenthesis end fraction.

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Appendix 4

Long Description for Exhibit 6.4

The graph has two yield curves for the euro dollar and euro Swiss
franc. Each curve rises with decreasing steepness from a point
on the positive vertical axis. The euro dollar yield curve rises from
(0, 3.5) through (90, 8.0) to (180, 8.6). At 80 days forward, the
interest yield for the euro dollar is 8.0 percent. The euro Swiss
franc yield curve rises from (0, 1.6) through (90, 4.0) to (180, 4.6).
At 80 days forward, the interest yield for the euro Swiss franc is
4.0 percent. The forward pendulum is the percentage difference
between interest yields. The percentage difference is equal to the
vertical distance between the curves at 80 days forward. The
percentage difference is 3.96 percent. All values estimated.

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Appendix 5
Long Description for Exhibit 6.5
A diagram demonstrates how the same U S dollar amount can generate very similar
final amounts when it passes through the U S dollar money market and the Swiss
franc money market over a 90-day period. The following list outlines the conversion
process in each market and compares the final amounts. With a start of 1,000,000
dollars enters the U. S. dollar money market and the Swiss franc money market. The
U.S. dollar money market uses the euro dollar interest rate of 8.00 percent, which is
equivalent to 2 percent for 90 days. 1,000,000 dollar times 1.02 equals 1,020,000
dollars. Before entering the Swiss franc money market, the starting amount is
converted using the spot exchange rate of S F 1.4800 equals 1.00 dollar. 1,000,000
dollar times 1.4800 equals S F 1,480,000. The Swiss franc money market uses the
Swiss franc interest rate of 4.00 percent per annum, which is equivalent to 1 percent
for 90 days. S F 1,480,000 times 1.01 equals S F 1,494,800. This Swiss franc amount
is then converted using the 90-day forward rate, or F 90, of S F 1.4655 equals 1.00
dollar. S F 1,494,800 divided by 1.4655 equals 1,019,993 dollar. At the end, the final
amount from the U S dollar money market is 1,020,000 dollars. The final amount from
the Swiss franc money market is 1,019,993 dollars. The amounts only differ by a
transaction cost of 7.00 dollars.

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Appendix 6
Long Description for Exhibit 6.6
A diagram demonstrates how the same U.S. dollar amount can generate different final
amounts when it passes through the U.S. dollar money market and the Japanese money
market over a 180-day period. The following list outlines the conversion process in each
market and compares the final amounts. With a start of 1,000,000-dollar entry the U.S.
dollar money market and the Japanese yen money market. The U.S. dollar money market
uses the euro dollar interest rate of 8.00 percent, which is equivalent to 4 percent for 180
days. 1,000,000 dollar times 1.04 equals 1,040,000 dollars. Before entering the Japanese
yen money market, the starting amount is converted using the spot exchange rate 106.00
yen equals 1.00 dollar. 1,000,000 dollar times 106 equals S F 106,000,000 yen. For the
Japanese yen money market, the investor uses a euro yen account with an interest rate of
4.00 percent per annum, which is equivalent to 2 percent for 180 days. 106,000,000 yen
times 1.02 equals 108,120,000 yen. This yen amount is then converted using the 180-day
forward rate, or F 180, of 103.50 yen equals 1.00 dollar. S F 108,120,000 yen divided by
103.50 equals 1,044,638 dollars.
End. The final amount from the U S dollar money market is $1,040,000. The final amount
from the Japanese yen money market is $1,044,638. The amounts only differ by an
arbitrage potential of $44,638.

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Appendix 7
Long Description for Exhibit 6.7
A diagram demonstrates how the same Japanese yen amount can generate different final
amounts when it passes through the Japanese yen money market and the U S dollar
money market over a 360-day period. The following list outlines the conversion process in
each market and compares the final amounts. With a start of 10,000,000-yen entry the
Japanese yen money market and the U. S. dollar money market. For the Japanese yen
money market, the investor borrows yen for 360 days at 0.40 percent per annum.
10,000,000 yen times 1.004 equals 10,040,000. Before entering the U. S. dollar money
market, the starting amount is converted using the spot exchange rate of 120.00 yen
equals 1.00 dollar. 10,000,000 yen divided by 120.00 equals 83,333.33 dollars. The
investor deposits this amount in the U. S. dollar money market at 5.00 percent per annum.
83,333.33 dollar times 1.05 equals 87,500.00 dollars. The investor then converts this
dollar amount back to yen, using the expected spot exchange rate of 120.00 yen equals
1.00 dollar. 87,500.00 dollar times 120.00 equals 10,500,000 yen. At the end the final
amount from the Japanese yen money market is 10,040,000, which is repaid. The final
amount from the U. S. dollar money market is 10,500,000, which is earned. The amounts
differ by a profit of 4460,000 yen.

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Appendix 8

Long Description for Exhibit 6.8

The graph falls diagonally through the origin, point X at (4, negative 4),
point Y at approximately (4.41, negative 4.41), and point Z at (4.83,
negative 4.83). The line intersects a rectangular region in quadrant 4.
Counterclockwise from the top right, the rectangular region has vertices
at (4.83, 0), (0, 0), (0, negative 4), and point U at (4.83, negative 4).
Point X lies on the bottom side of the region, 0.83 units to the left of
point U. Point Z is 0.83 units below point U. If market interest rates were
at point U, covered interest arbitrage profits are available, and would be
undertaken until the market drove interest rate differences back to point
X, Y, or Z.

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Appendix 9
Long Description for Exhibit 6.9
The graph includes separate plots for spot rate S and forward rate F, as
described in the following list. The plot of spot rate S rises from (t sub 1,
S sub 1) to (t sub 2, S sub 2) and then falls through (t sub 3, S sub 3) to
(t sub 4, S sub 4). Vertical lines rise through the t axis at t sub 1, t sub 2,
t sub 3, and t sub 4. The vertical lines intersect the graph of S at S sub
1, S sub 2, S sub 3, and S sub 4, respectively. The plot of forward rate F
consists of three line segments with end points on the vertical lines at t
sub 1, t sub 2, t sub 3, and t sub 4. The first line segment falls from (t
sub 1, S sub 1) to (t sub 2, F sub 1), where F sub 1 is less than S sub 2.
The second line segment rises from (t sub 2, S sub 2) to (t sub 3, F sub
2), where F sub 2 is greater than S sub 3. The third line segment rises
from (t sub 3, S sub 3) to (t sub 4, F sub 3), where F sub 3 is greater
than S sub 4. On each vertical line, the distance between the S and F
values represents the error in the forward rate.

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Appendix 10
Long Description for Exhibit 6.10
The approximate model of equilibrium involves five relations identified by the letters
A, B, C, D, and E. The following list describes each relation based on changes to
exchange rates, interest rates, and inflation for the Japanese yen. Relation A:
purchasing power parity. The forecast change in the spot exchange rate is plus 4
percent, meaning the yen strengthens. The forecast difference in rates of inflation is
minus 4 percent, meaning less in Japan. Relation B: Fisher effect. The forecast
difference in rates on inflation is minus 4 percent, meaning less in Japan. The
difference in nominal interest rates is minus 4 percent, meaning less in Japan.
Relation C: International Fisher effect. The forecast change in the spot exchange
rate is plus 4 percent, meaning the yen strengthens. The difference in nominal
interest rates is minus 4 percent, meaning less in Japan. Relation D: Interest rate.
The difference in nominal interest rates is minus 4 percent, meaning less in Japan.
The forward premium on foreign currency is plus 4 percent, meaning the yen
strengthens. Relation E: forward rate as an unbiased predictor. The forward premium
on foreign currency is plus 4 percent, meaning the yen strengthens. The forecast
change in the spot exchange rate is plus 4 percent, meaning the yen strengthens.

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TEST

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magna aliqua. Ut enim ad minim veniam, quis nostrud
exercitation ullamco laboris nisi ut aliquip ex ea
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non proident, sunt in culpa qui officia deserunt mollit
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BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956