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Chapter Six
International Parity
Relationships and Forecasting
Foreign Exchange Rates

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 Chapter Outline 1

International Parity Relationships.

Interest Rate Parity.
• Deriving Interest Rate Parity.
• Covered Interest Arbitrage.
• IRP and Exchange Rate Determination.
• Currency Carry Trade.
• Reasons for Deviations from IRP.

Purchasing Power Parity.

• PPP Deviations and the Real Exchange Rate.
• Evidence on Purchasing Power Parity.

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 Chapter Outline 2

Fisher Effects.
Forecasting Exchange Rates.
• Efficient Market Approach.
• Fundamental Approach.
• Technical Approach.
• Performance of the Forecasters.

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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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 Deriving Interest Rate Parity 1

Suppose you have $1 to invest over a one–year period, and

you will only consider default–free investments.
There are two alternative ways of investing your fund:
1. Invest in a U.S. dollar security at the dollar interest rate.

• The maturity value in one year will be $1(1 + is ), where

is is the dollar interest rate.

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 Deriving Interest Rate Parity 2

2. Invest in a foreign currency denominated security, say British

pound, at the pound interest rate and hedge the exchange risk
by selling the maturity value of the foreign investment forward.
This option requires the following steps:
• Exchange $1 for a pound amount, that is, £(1/S), at the
prevailing spot exchange rate (S).
• Invest the pound amount at the pound interest rate (i£ ), with
the maturity value of £(1/ S )(1 + i£ ).
• Sell the maturity value of the pound investment forward in
exchange for a predetermined dollar amount, that is,
$[(1/ S )  (1 + i£ )]F , where F denotes the forward exchange
rate. We can simplify it as ( F / S )(1 + i£ ).

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 Deriving Interest Rate Parity 3

U.S. and foreign (pound) investments are equivalent

because both require:
• Same initial investment ($1).
• Same amount of risk (zero).
• Same investment period (one year).
Future dollar proceeds from investing in these two equivalent
investments must be the same:

1 + i$ 
(1 + i$ ) = S (1 + i£ )
F
or F =S 
 1 + i£ 

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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 pound interest rate.
• Sell the maturity value of the pound investment forward.
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 + i£ ) F − (1 + i$ ) S = 0

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 Covered Interest Arbitrage 1

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:

(1 + i$ ) =
F
(1 + i£ )
S
(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
Transactions
1. Borrow $1,000,000 in the U.S. Repayment in one year will be
$1,000,000 × (1 + 0.05) = $1,050,000
2. Buy £555,556 spot using $1,000,000.
$1,000,000 ÷ ($1.80/£) = £555,556.
3. Invest £555,556 in the U.K. The maturity value will be
£600,000 = £555,556 × (1 + 0.08).
4. Sell £600,000 forward in exchange for $1,068,000
$1,068,000 = (£600,000)($1.78/£).
5. In one year, receive the maturity value of £600,000, deliver this
to the forward contract counterparty, and receive $1,068,000.
Then repay $1,050,000.
Arbitrage profit will be $18,000 (= $1,068,000 − $1,050,000)
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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↑)

In the
Lend following
in the U.K. table, read ‘is’ asrate
U.K. interest i sub
goess;down
‘i£’ as
(i₤↓)i sub £

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

(1 + i$ ) = S (1 + i£ )
F

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 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:
 1 + i£ 
S=  E ( St +1 | I t )
1 + i $ 
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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 ( St +1 | I t )
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 Rate Parity
When the forward exchange rate F is replaced by the
expected future spot exchange rate, E ( St +1 ), we obtain
uncovered interest rate parity:
( i$ − i£ )  E ( e )
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.

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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.

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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

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

Access the text alternative for slide images.

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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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 Purchasing Power Parity 1

When the law of one price is applied internationally to a

standard consumption basket, we obtain the theory of
purchasing power parity (PPP).
• PPP states the exchange rate between currencies of two
countries should be equal to the ratio of the countries’ price
levels of a commodity basket.
• Let P$ be the dollar price of the standard consumption
basket in the U.S. and P£ the pound price of the same
basket in the U.K.
• Absolute version of PPP states the exchange rate
between the dollar and pound should be: S = P P
$ £

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 Purchasing Power Parity 2

When the PPP relationship is presented in the “rate of

change” form, instead of price level as in the absolute
version of PPP, we obtain the relative version of PPP:
 −  
e= $

   −
£

 1+  
$ £

Where:
e is the rate of change in the exchange rate.
 and  are the inflation rates in the United States and
$ £

U.K., respectively.

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 PPP Deviations and the Real Exchange
Rate
If there are deviations from PPP, changes in nominal
exchange rates cause changes in the real exchange rates,
affecting the international competitive positions of countries
Real exchange rate, q, is found by:
1+ 
q= $

(1 + e )(1 +  £
)
If PPP holds, the real exchange rate will be unity (that is, q =
1), but when PPP is violated, the real exchange rate will
deviate from unity.

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 Evidence on P P P
PPP has been the subject of a series of tests, yielding
generally negative results, especially over short horizons.
PPP doesn’t hold precisely for a variety of reasons.
• Nontradable or nonstandardized goods.
• Shipping costs.
• Tariffs and quotas.

PPP–determined exchange rates still provide a valuable

benchmark.

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 Exhibit 6.8. How Large is Russia’s Economy?

Source: The World Bank, World Development Indicators.

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 Fisher Effects 1

The Fisher effect holds that an increase (decrease) in the

expected inflation rate in a country will cause a proportionate
increase (decrease) in the interest rate in the country.
Formally, the Fisher effect is written as follows:
i$ = ρ$ + E ( π$ ) + ρ$ E ( π$ )  ρ$ + E ( π $ )

Fisher effect implies that the expected inflation rate is the

difference between the nominal and real interest rates in
each country, that is,

E ( π $ ) = ( i$ − ρ$ ) / (1 + ρ$ )  i$ − ρ$
E ( π £ ) = ( i£ − ρ £ ) / (1 + ρ £ )  i£ − ρ £

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 Fisher Effects 2

If we assume the real interest rate is the same between

countries, that is, ρ$ = ρ £ , we obtain the international
Fisher effect (IFE), which suggests the nominal interest rate
differential reflects the expected change in exchange rate.
E ( e )  i$ − i£
When the international Fisher effect is combined with IRP, we
obtain the forward expectations parity (FEP), which states
any forward premium or discount is equal to the expected
change in the exchange rate.

( F − S ) / S = E (e)

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 Exhibit 6.9: International Parity Relationships
among Exchange Rates, Interest Rates, and Inflation
Rates

Access the text alternative for slide images.

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 Forecasting Exchange Rates
Many business decisions are now made based on forecasts,
implicit or explicit, of future exchange rates.
Forecasting techniques can be classified into three distinct
approaches:
1. Efficient market approach.
2. Fundamental approach.
3. Technical approach.

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 Efficient Market Approach
Efficient market hypothesis (EMH) states that financial
markets are informationally efficient in that the current asset
prices reflect all the relevant and available information.
• Implies that the exchange rate will change only when the
market receives new information.

Random walk hypothesis suggests today’s exchange rate

is the best predictor of tomorrow’s exchange rate.
• To the extent that interest rates are different between two
countries, the forward exchange rate will be different from
the current spot exchange rate.

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 Fundamental Approach
Uses various models to forecast exchange rates.
Three main difficulties of this approach:
1. One must forecast a set of independent variables to
forecast the exchange rates, and the former may not be
necessarily easier than forecasting the latter.
2. Parameter values that are estimated using historical data
may change over time.
3. Model itself can be wrong.

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 Technical Approach
First analyzes the past behavior of exchange rates for the
purpose of identifying “patterns” and then projects them into
the future to generate forecasts.
• Based on the premise that history repeats itself.
• At odds with the efficient market approach.
• Differs from fundamental approach in that it does not use
the key economic variables, like money supplies or trade
balances, for purpose of forecasting.
Two examples of technical analysis:
1. Moving average crossover rule.
2. Head-and-shoulders pattern.

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 Exhibit 6.10: Moving Average Crossover Rule:
Golden Cross versus Death Cross

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 Exhibit 6.11: Head–and–Shoulders Pattern: A
Reversal Signal

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 Can professional forecasters outperform
the market?
Eun and Sabherwal (2002) study found that banks as a
whole could not outperform the random walk model, but
some banks significantly outperformed the random walk
model, especially in the longer run.
Beckmann and Czudaj (2017) suggest professionals have a
hard time predicting exchange rates, and uncertainty
regarding economic policy and macroeconomic and financial
conditions significantly affects professionals’ forecast errors.
Ince and Molodtsova (2017) find that forecasting
performance is stronger for currencies of developed
countries compared to those of developing countries and
long–term forecasts are more accurate than short-term
forecasts.
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