Chapter 6

International Parity Relationships.

• Interest Rate Parity.
Covered Interest Arbitrage.
Currency Carry Trade.
• Purchasing Power Parity
• Fisher Effect/International Fisher Effect

Linkage of interest rates, inflation, spot exchange rates, and forward exchange
rates.

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International Parity Relationships 1

• International parity relationships are manifestations of law of one

price that must hold to avoid arbitrage opportunities.
• Law of one price (LOP) prevails when the same or equivalent things
are trading at the same price across different locations or markets,
precluding profitable arbitrage opportunities.
• Arbitrage is the act of simultaneously buying and selling the same or
equivalent assets or commodities for the purpose of making certain,
guaranteed profits.

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International Parity Relationships 2

• Interest Rate Parity: LOP applied to international money market

instruments and provides a linkage between interest rates in two
different countries.
• Purchasing Power Parity: LOP applied to a standard consumption
basket and provides a linkage between prices in two different countries.
• International parity relationships help us understand how exchange
rates are determined and how we can forecast exchange rates.

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International Parity Relationships
Convert 1$ to Euro at 1. Receive 1/S Euro from
spot rate (S $/E) spot rate conversion
Have 1$ 2. sell forward (1/S) * (1+ie)
Euros for conversion to $ at
forward rate (F $/E)

Invest 1$ in US
Market at i$
Invest 1/S in Euro
Market at ie
(1)
Receive (1+ i$) $
Convert E to $ at
forward rate (F $/E) Receive (1/S)*(1+ie) E.
(2)
Receive (F/S)*(1+ie) $

For no arbitrage, (1) = (2) as all interest rates, forward rates and spot rates are known now.

Thus, (1+ i$) = F/S*(1+ie)

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Interest Rate Parity 2

Covered Interest Parity

1 𝑖
𝐹 𝑆
1 𝑖

Note: Spot and forward rates are expressed in Home/Foreign.

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Deriving Interest Rate Parity 4

• IRP can also be derived by constructing an arbitrage portfolio that

involves no net investment and no risk:
• Borrow $S at the dollar interest rate and buy 1€ at the prevailing spot
exchange rate of S.
• Lend 1€ at the Euro interest rate.
• Sell the maturity value of the Euro loan repayment in forward market.

• Since no one should be able to make certain profits by holding this

self–financing portfolio, the net cash flow at maturity should be zero in
equilibrium.
(1+ie)F – (1+i$)S = 0

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Covered Interest Arbitrage
• When IRP does not hold, the situation gives rise to covered interest
arbitrage opportunities, allowing certain profits to be made without the
arbitrageur investing any money out of pocket or bearing any risk.
• For example, consider the following market conditions:
• U.S. interest rate is 5 percent.
• U.K. interest rate is 8 percent.
• Spot exchange rate is $1.80/£.
• One-year forward exchange rate is $1.78/£.
• An arbitrager can borrow $1,000,000 or £555,556.

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Covered Interest Arbitrage 2

• Let’s first check if IRP holds:

F
1  i$   S 1  i£ 
• (1 + 0.05) < (1.78/1.80)(1 + 0.08)

• 1.05 < 1.068 • IRP does not hold.

• Since the interest rate in the U.S. is lower than the interest rate in the
U.K. after adjusting for exchange rates, arbitrage should involve
borrowing in the U.S. and lending in the U.K.

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Covered Interest Arbitrage Execution
Data

Convert 1 million to £ at 1. Receive 1 million/1.80 = 1. US Interest

Borrow 1 spot rate of $1.8/£ 555,556 £ Rate = 5%
million $ 2. sell 1 year forward 2. UK Interest
555,556*1.08 = 600,000 £ Rate = 8%
for conversion to $ at 3. Spot Rate =
forward rate 1.78 $/£ $1.8/£
4. Forward Rate
Pay interest of 5%
= $1.78/£

Invest £ 555,556 in UK
Market at 8%
(1)
Repay $1,050,000
Convert to $ at forward
rate of 1.78 $/£ Receive 600,000 £
(2)
Receive 600,000/1.78
= $ 1,068,000

Arbitrage Profit = 1,068,000 – 1,050,000 = $18,000 per million dollars borrowed.

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Covered Interest Arbitrage
• As soon as deviations from IRP are detected, informed
traders will carry out CIA transactions. As a result of these
transactions, IRP will eventually be restored.

CIA transaction Effect

Borrow in the U.S. U.S. interest rate goes up (iS↑)
Buy £ at the spot rate Spot exchange rate goes up (S↑)
•Lend
In inthe
thefollowing
U.K. table, read ‘is’ as rate
U.K. interest i subgoes
s; ‘idown
£’ as (ii₤sub
↓) £

Sell £ forward Forward exchange rate goes down (F↓)

F
1  i$   S 1  i£ 

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Covered Interest Arbitrage class
Consider the following market conditions:
• 3 month U.S. interest rate (annualized) is 4.32%.
• 3 month German interest rate (annualized) 2.51%
• Spot rate is 1.08$/E
• 3 month forward exchange rate is $1.09 $/E.
Is IRP violated?

If so, find arbitrage profit per million $ or E depending on which currency

you borrow in.

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Reasons for Deviations from IRP
• IRP holds quite well, but it may not hold precisely all the time due to
(primarily) two main reasons:

• Transaction costs:

– Interest rate at which the arbitrager borrows tends to be higher than

the rate at which he lends, reflecting the bid–ask spread.
– The foreign exchange market also has bid–ask spread, as the
arbitrager must buy currencies at the higher ask price and sell at
the lower bid price.
• Capital controls:
– Governments sometimes restrict capital flows, impose taxes, or put
outright bans.

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Exhibit 6.4 Interest Rate Parity with Transaction
Costs

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16
IRP and Exchange Rate Determination 1

• Reformulating the IRP relationship in terms of the spot exchange rate

yields:
1 𝑖
𝑆 𝐹
1 𝑖

• Forward exchange rate can be viewed as the expected future spot

exchange rate conditional on all relevant information being available.

F  E  St 1 | I t 
Combining the two equations yields the following:

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IRP and Exchange Rate Determination 2

• Two things are noteworthy from the following equation (presented on

previous slide):
1 𝑖
𝑆 𝐸 𝑆 |𝐼
1 𝑖

1. “Expectation” plays a key role in exchange rate determination (that is,

when people “expect” the exchange rate to go up in the future, it goes
up now).
2. Exchange rate behavior will be driven by news events.

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Uncovered Interest Parity
Take the equation and rewrite as
𝐸 𝑆 |𝐼 1 𝑖
𝑆 1 𝑖
Subtracting 1 from both sides, we get

𝐸 𝑆 𝐼 𝑆 𝑖 𝑖
𝑖 𝑖
𝑆 1 𝑖
Thus, if we denote 𝑒 as the return from holding foreign currency
(measured in home terms), then we have
E𝑒 𝑖 𝑖
Uncovered interest rate parity states that interest rate differential between
a pair of countries is (approximately) equal to the expected rate of change
in the exchange rate.
Note: This can also be derived separately as the International Fisher
Effect.

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Currency Carry Trade
• Unlike IRP, the uncovered interest rate parity often does not hold,
giving rise to uncovered interest arbitrage opportunities.
• Currency carry trade involves buying a high–yielding currency and
funding it with a low–yielding currency, without any hedging.
• The carry trade is profitable if the interest rate differential is greater
than the appreciation of the funding currency against the investment
currency.
On Jan 4, 2021
INR/USD exchange rate = 73.01
US Interest rate (1 year) = 0.10%
India interest rate (1 year) = 3.67%

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Currency Carry Trade

If we believe that actual appreciation of USD will be lower, then we should

borrow in USD, invest in INR government, and exchange INR to USD at
the end of 1 year.
If we believe actual appreciation of the USD will be higher, we should
borrow in INR and invest in USD

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Currency Carry Trade
Suppose we did this (example: believe that the Indian Central Bank will
intervene), then how would we have done?
On Jan 5, 2022, exchange rate was 74.32 INR/USD.
1 1
% 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝐼𝑁𝑅 74.32 73.01 1.76%
1
73.01

Alternately, the actual appreciation of the USD was

74.32 73.01
% 𝐴𝑝𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑈𝑆𝐷 1.79%
73.01

Expected Appreciation of the USD

based on interest rate difference= 𝑖 𝑖 = 3.67-.1=3.57%

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Currency Carry Trade
Thus, a carry trade would have been profitable. Specifically,
1. borrow 1 million USD, convert to INR to get 73.01 million INR.
2. Invest 73.01 million at 3.67%.
3. In one year, get 75.689 million INR
4. Convert to USD at current spot rate of 74.32 to get $1.0184 million.
5. Repay loan with interest = $1.001 million.
Profit = $17,426

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Currency Carry Trade
Say you repeated the trade in 2022
Exchange rate (Jan 2022) : 74.32 INR/$
[Link]
Exchange rate (Jan 2022) : INR/$
US 1 year interest rate = 0.4%
Indian 1 year interest rate = 4.486%

Expected Depreciation of INR = 4.086% based on interest rate differential.

Actual Depreciation of INR = -10.30%

Would have lost 6 % on carry trade.

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Exhibit 6.3 Interest Rate Spreads and Exchange Rate Changes: Six-Month Carry
Trade Periods for Australian Dollar–Japanese Yen Pair

A$/Yen

• Source: Interest rates and exchange rates are obtained from Datastream.

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Purchasing Power Parity
Law of one price for goods
Absolute PPP: Exchange Rate is the ratio of the price of goods.
Thus, if French Fries were 5$ in Singapore and 4$ in the US, then the
exchange rate of USD/SGD should be 4/5 = 0.8 USD/SGD
S (home/foreign) = Price index (home)/Price index (foreign)
Relative PPP: The percentage change of exchange rates is equal to the
difference in inflation.
Thus, if US inflation is 5% and Singapore’s is 3%, then the return of a US
investor holding SGD should be 5-3=2%, i.e., SGD should appreciate 2%.
Denote e as the return from holding a currency in terms of home, and
π(home/foreign) denote home and foreign inflation. Then
e = π(home) - π(foreign)
Note: positive e implies home depreciates or foreign appreciates.

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Evidence on P P P

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World Economies by GDP (2024)

Nominal GDP by market

GDP by PPP exchange exchange rate
rate

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Evidence on PPP
• PPP has been the subject of a series of tests, yielding
generally negative results, especially over short horizons.
• Nontradable or nonstandardized goods.
• Shipping costs.
• Tariffs and quotas.

• PPP more valid over long term (over 5 years).

Connection to real exchange rates

Absolute PPP Real Exchange Rate = 1
Relative PPP Real Exchange Rate Return = 0

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PPP and Expectations
Recall Relative PPP
e = π(home) - π(foreign)

Since we don’t know the future inflation, we can also apply this at time t to
infer future exchange rates. Thus,

E(e) = E[π(home)] – E[π(foreign)]

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Fisher Effect
Recall
Higher Money supply = higher prices
Higher money supply growth = higher inflation

Thus, in higher inflation environments, people should demand

higher nominal interest rates.

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Fisher Effect
Turkey cuts interest rate to 42.5% after
inflation hits two-year low

Turkey’s central bank lowered its key interest

rate by 2.5 percentage points on Thursday,
its third consecutive cut, reacting to a
slowdown in inflation in the country.
Turkey lowered its benchmark one-week repo
rate from 45% to 42.5% on Thursday.
The decision came after official data showed
annual inflation dipping below 40% for the
first time in nearly two years.

[Link]
interest-rate-to-425-after-inflation-hits-two-year-low

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Fisher Effect
Define
Real Interest Rate = Nominal Interest Rate
– Expected Inflation

Thus, expected inflation = Nominal – Real

Fisher Effect: An increase in the Expected Inflation will

increase the nominal interest rate in a country.

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International Fisher Effect
With Free capital flows across countries and similar riskiness of countries,
Real Interest Rate should be equal.

Nominal interest rate (home) – Expected Inflation (home)

= Nominal interest rate (foreign) – Expected Inflation (foreign)

Or

Nominal interest rate (home) – Nominal interest rate (foreign)

= Expected Inflation (home) – Expected Inflation (foreign)
= E[π(home)] – E[π(foreign)]

But from PPP, the RHS = Expected Exchange Rate return = E[e]

E[e] = Nominal interest rate (home) – Nominal interest rate (foreign)

=𝑖 𝑖

Which is the same as Uncovered Interest Parity we derived earlier.

The IFE states that countries with high nominal interest rates are expected to
depreciate due to high expected inflation.

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Forward Expectations Parity
Recall in deriving the Uncovered Interest Parity, we had assumed
that
F  E  St 1 | I t 

Forward rate is unbiased predictor of the future spot rate.

Thus, E(e) = [F-S]/S

This is called the forward expectations Parity which is that the

forward rate premium or discount relative to the spot is an
unbiased predictor of the exchange rate return e (expressed in
terms of home/foreign)

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All together ..
E(e)

FEP
IFE
PPP

IRP 𝐹 𝑆
ihome-iforeign
𝑆

i = Nominal Interest Rate

π = Inflation
FE/IFE e = return from holding
foreign currency
S = spot rate (home/foreign)
𝐸 𝜋 𝐸 𝜋 F = forward rate
(home/foreign)
E[.] = Expectation

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