International Parity

Relationships 3
Week 3

4-1
 International Parity Relationships

Learning objectives:

• Understand how foreign exchange rates are

determined
• Examines several key international parity
relationships

2
 How to forecast / determine the
foreign exchange rate?
• Interest rate parity (IRP)
• Purchasing power parity (PPP)
• Other approaches to forecast exchange rate:
(a) the efficient market approach,
• (b) the fundamental approach, and
• (c) the technical approach.

3
 Topics
• Interest Rate Parity (IRP)
• Covered Interest Arbitrage (CIA)
• Uncovered Interest Rate Parity (UIRP)

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 Interest Rate Parity
• Interest rate parity explains the linkage
between foreign exchange rates and the
interest rates of involved countries.

5
 Interest Rate Parity
• IRP represents an “no arbitrage” condition
that should hold in the absence of barriers to
inter-national capital flows.
• Term arbitrage can be defined as:
the act of simultaneously buying and selling
the same or equivalent assets or commodities
for the purpose
…almostofallmaking certain, guaranteed
of the time!
profits.

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 Interest Rate Parity
• IRP is an “no arbitrage” condition.
• If IRP did not hold, then it would be possible
for an astute trader to make unlimited
amounts of money exploiting the arbitrage
opportunity.
• Since we don’t typically observe persistent
arbitrage…almost
conditions,
all ofwe
thecan
time!safely assume
that IRP holds.

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 Interest Rate Parity
Consider two alternative one-year investments for $1,000:
1. Invest in the U.S. at i$. Maturity value = $1,000 × (1 + i$)

2. Invest in the U.K. at i£ and hedge the exchange rate risk by

selling the maturity value of the U.K. investment forward
F$/£
Maturity value = $1,000(1 + i£) ×
S$/£
Since you are assured a predetermined dollar amount, this
alternative is a perfect substitute for the domestic
investment

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 Interest Rate Parity
• If IRP did not hold, one will have arbitrage
opportunities and can lock in guaranteed
profit by borrowing in one currency and
lending in another, with exchange risk hedged
via forward contract.
• Since we don’t typically observe persistent
arbitrage…almost
conditions,
all ofwe
thecan
time!safely assume
that IRP holds.

4-9
 Alternative 2: $1,000 IRP
Send your $ on
S$/£
a round trip to
Step 2:
Britain
Invest those
pounds at i£
$1,000 Future Value =
$1,000
 (1+ i£)
S$/£
Step 3: repatriate
Alternative 1: future value to the
invest $1,000 at i$ U.S.A.
$1,000
$1,000×(1 + i$) =  (1+ i£) × F$/£
S$/£
IRP

Since both of these investments have the same risk, they must
4-10 have the same future value—otherwise an arbitrage would exis
IRP and the Forward Premium/Discount

IRP implies: 1+i F$/ £

=
$

1+ i£ S$/ £

which can be approximated as

i$ – i£ F–S
≈
S

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 IRP and the Forward Premium/Discount

• Interest rate parity (IRP) holds that the

forward premium or discount should be equal
to the interest rate differential between two
countries.

…almost all of the time!

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IRP and the Forward Premium/Discount

• IRP implies that in the short run, the exchange

rate depends on (a) the relative interest rates
between two countries, and (b) the expected
future exchange rate.
• Other things being equal, a higher (lower)
domestic interest rate will lead to appreciation
(depreciation) of the domestic currency.

13
 IRP and the Forward Premium
• Interest rate parity (IRP) holds that the forward
premium or discount should be equal to the interest
rate differential between two countries.
• For example, suppose S($/€) = 1.25 to F180($/€) = 1.30
• Then, the forward premium is given by:
F180($/€) – S($/€) 360 $1.30 – $1.25
f180,€ = × = × 2 = 0.08
S($/€) 180 $1.25
IRP implies that the (annualized) interest rate differential,
i$ – i £ , should equal 0.08 (or 8%).

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 Interest Rate Parity
• The scale of the project is unimportant

$1,000  (1+ i ) × F
$1,000×(1 + i$) = £ $/£
S$/£

F$/£
(1 + i$) = × (1+ i£)
S$/£

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Questions

?
 Why should IRP hold?
• If IRP failed to hold, an arbitrage opportunity
would exist—we refer to this arbitrage
opportunity as “covered interest arbitrage”.

F$/£
For example, if (1 + i$) < × (1+ i£) ,
S$/£
how can you trade to profit from this
opportunity?

4-17
 Why should IRP hold?
• What is covered interest arbitrage?
• Covered interest arbitrage is the investment
strategy where the arbitrager borrow one
currency at its interest rate and at the same
time lent / invest another currency at its
interest rate with exchange rate risk fully
covered via forward hedging (buying / selling
foreign currency at forward rate).

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 Covered Interest Arbitrage
1. Borrow in ___________
2. Buy ___________ spot
3. Lend in ___________
4. Sell / Buy ____________ forward

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Will the arbitrage opportunity last forever?
Adjustments of the interest rates and exchange
rates induced by CIA:
1. i$ will rise/fall
2. i£ will rise/fall
3. S will rise/fall
(i.e., the pound appreciate/depreciate in the spot market)
4. F will rise/fall
(i.e., the pound appreciate/depreciate in the forward
market)

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 IRP and Arbitrage Opportunities
If IRP failed to hold, an arbitrage would exist. It’s
easiest to see this in the form of an example.
Consider the following set of foreign and domestic
interest rates and spot and forward exchange
rates.
Spot exchange rate S($/£) = $2.0000/£
360-day forward rate F360($/£) = $2.0100/£
U.S. discount rate i$ = 3.00%
British discount rate i£ = 2.49%

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 IRP and Covered Interest Arbitrage
A trader with $1,000 could invest in the U.S. at 3.00%, in one
year his investment will be worth
$1,030 = $1,000  (1+ i$) = $1,000  (1.03)
Alternatively, this trader could
1. Exchange $1,000 for £500 at the prevailing spot rate,
2. Invest £500 for one year at i£ = 2.49%; earn £512.45
3. Translate £512.45 back into dollars at the forward rate
F360($/£) = $2.01/£, the £512.45 will be worth $1,030.

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 Step 2: I. F360($/£) = $2.1/£
buy pounds
£500
£1 Step 3:
£500 = $1,000×
$2.00 Invest £500 at
i£ = 2.49%
$1,000 £512.45 In one year £500
will be worth
£512.45 =
Step 4: repatriate £500 (1+ i£)
to the U.S.A.
Step 1:
borrow $1,000 More F£(360)
Step 5: Repay than $1,030 $1,030 < £512.45 ×
£1
your dollar loan
with $1,030.
If F£(360) > $2.01/£ , £512.45 will be more than enough to
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repay your dollar obligation of $1,030. The excess is your profit.
 Interest Rate Parity
& Exchange Rate Determination
According to IRP only one 360-day forward rate,
F360($/£), can exist. It must be the case that

F360($/£) = $2.01/£
Why?
If F360($/£)  $2.01/£, an astute trader could make
money with one of the following strategies:

6-
 Arbitrage Strategy I
• If F360($/£) > $2.01/£ , Let’s assume F360($/£) = 2.02:
• (1+I$) = 1.03 vs (1+I£)(F/S) = (1.0249)(2.02/2) = 1.035
• Thus, IRP is not holding. We have CIA opportunity!
• Under this situation, expected return on the foreign currency (£)
investment > local currency ($), so we should:
i) Borrow local currency $1,000 at t = 0 at i$ = 3%.
ii) Exchange local currency $1,000 for foreign currency £500 at the
prevailing spot rate, (note that £500 = $1,000 ÷ $2/£) and invest £500
at 2.49% (i£) for one year to achieve £512.45. At the same time, we
need to sell £512.45 at forward rate to fix the amount of USD proceeds
in the pound investment at maturity.
iii) Translate (Sell) £512.45 back into dollars at forward rate
>>>>>Profit: $1035 - $1030 = $5
 Step 2: Arbitrage I
buy pounds
£500
£1 Step 3:
£500 = $1,000×
$2.00 Invest £500 at
i£ = 2.49%
$1,000 £512.45 In one year £500
will be worth
£512.45 =
£500 (1+ i£)
Step 4: repatriate
to the U.S.A.
Step 1:
borrow $1,000 F£(360)
More
than $1,030 $1,030 < £512.45 ×
Step 5: Repay £1
your dollar loan
with $1,030.
If F£(360) > $2.01/£ , £512.45 will be more than enough to repay
your dollar obligation of $1,030. The excess is your profit.
6-
 Arbitrage Strategy II
• If F360($/£) < $2.01/£ , let’s assume F360($/£) = 2.00:
• (1+I$) = 1.03 vs (1+I£)(F/S) = (1.0249)(2.00/2) = 1.0249
• Thus, IRP is not holding. We have CIA opportunity!
• Under this situation, expected return on the foreign currency (£)
investment < local currency ($), so we should:
i. Borrow foreign currency £500 at t = 0 at i£= 2.49% and make a
forward contract to buy £512.45 at F360($/£) = 2.00. Total cost is $1025.
ii. Exchange £500 for local currency $1,000 at the prevailing spot
rate, invest $1,000 at 3% for one year to achieve $1,030.
iii. $1,030 will be more than enough to repay your debt of £512.45,
which is equal to $1,025 (= £512.45 X $2.00/£)
>>>>>Profit: $1030 - $1025 = $5
 Step 2:
buy dollars Arbitrage II
£500
$2.00
$1,000 = £500× Step 1:
£1
borrow £500
$1,000
More Step 5: Repay
Step 3: your pound loan
Invest $1,000 than
with £512.45 .
at i$ = 3% £512.45
Step 4:
repatriate to
the U.K.
In one year
F£(360)
$1,000 will be $1,030 $1,030 > £512.45 ×
worth £1

If F£(360) < $2.01/£ , $1,030 will be more than enough to

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repay your dollar obligation of £512.45. Keep the rest as
 Will the arbitrage opportunity
last forever?
Adjustments of the interest rates and exchange rates
induced by CIA:
1. i$ will rise/fall
2. i£ will rise/fall
3. S will rise/fall
(i.e., the pound appreciate/depreciate in the spot
market)
4. F will rise/fall
(i.e., the pound appreciate/depreciate in the forward
market)
 Uncovered Interest Rate Parity (UIRP)
• The IRP defined above,
F$/£
(1 + i$) = × (1+ i£)
S$/£
is often referred to as covered interest rate parity.
• When F$/£ = E(S$/£,t+1),
E(S$/£,t+1)
(1 + i$) = × (1+ i£)
S$/£,t
which is called uncovered interest rate parity (UIRP).
In the textbook, E(S$/£,t+1) is written as E(S$/£,t+1|It)

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 Covered vs. Uncovered

F$/£ E(S$/£,t+1)
× (1+ i£) vs. × (1+ i£)
S$/£ S$/£,t
(covered) (uncovered)
• Why do the two conditions have different
names?

• What trades do these expressions represent?

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 Covered vs. Uncovered
• The IRP is covered, in the sense that the future
exchange rate is already locked in at F$/£ , so the
investor is not exposed to any exchange rate risk.
• On the other hand, the UIRP is uncovered, because it
is based on an uncertain S$/£,t+1. All the investor does
is to form an expectation (i.e., forecast) about its
value, E(S$/£,t+1). The investor faces exchange rate
risk, as S$/£,t+1 may turn out to be different from
E(S$/£,t+1).

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 Covered vs. Uncovered
• Analogous to the approximate relationship for
IRP,
i$ – i £ ≈ F – S
S
we can also write an approximate relationship
for UIRP,
i$ – i £ ≈ E(e),
where E(e) is the expected rate of change of
the exchange rate, [E(St+1)-St]/St.

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 UIRP and Exchange Rate Determination

• We can write the UIRP as:

E(S$/£,t+1)
S$/£,t = × (1+ i£)
(1 + i$)
• Written in this way, the UIRP can be viewed as
a relationship that determines the current
spot exchange rate St.
 UIRP and Exchange Rate Determination

• In particular, the relationship implies that,

everything else equal, a higher domestic
(foreign) interest rate would lead to a domestic
currency appreciation (depreciation).
• Why would this happen?
 UIRP and Exchange Rate Determination

• At the same time, expected future exchange

rate, E(S$/£,t+1) also affects the current
exchange rate S$/£,t .
• In particular, when people expect the exchange
rate to rise in the future, it rises now—another
example of self-fulfilling expectations.
• Why would this happen?
 Reasons for Deviations from IRP
• Transactions Costs
– The interest rate available to an arbitrageur for
borrowing, ib may exceed the rate he can lend at, il.
– There may be bid-ask spreads to overcome, Fb/Sa < F/S
– Thus
(Fb/Sa)(1 + i¥l)  (1 + i¥ b)  0
• Capital Controls
– Governments sometimes restrict import and export of
money through taxes or outright bans.

6-
 Exercise
• Currently, the spot exchange rate is $1.50/£ and the three-
month forward exchange rate is $1.52/£. The three-month
interest rate is 8.0% per annum in the U.S. and 5.8% per
annum in the U.K. Assume that you can borrow as much as
$1,500,000 or £1,000,000.
• a. Determine whether the interest rate parity is currently
holding.
• b. If the IRP is not holding, how would you carry out covered
interest arbitrage? Show all the steps and determine the
arbitrage profit.
• c. Explain how the IRP will be restored as a result of covered
arbitrage activities.
 Solution: Exercise
• Let’s summarize the given data first:
• S = $1.5/£; F = $1.52/£; I$ = 2.0%; I£ =
1.45%
• Credit = $1,500,000 or £1,000,000.
• Solution:
• (1+I$) = 1.02
• (1+I£)(F/S) = (1.0145)(1.52/1.50) = 1.0280
• Thus, IRP is not holding exactly.
 Exercise
• Currently, the spot exchange rate is $1.50/£ and the three-
month forward exchange rate is $1.52/£. The three-month
interest rate is 8.0% per annum in the U.S. and 5.8% per
annum in the U.K. Assume that you can borrow as much as
$1,500,000 or £1,000,000.
• a. Determine whether the interest rate parity is currently
holding.
• b. If the IRP is not holding, how would you carry out covered
interest arbitrage? Show all the steps and determine the
arbitrage profit.
• c. Explain how the IRP will be restored as a result of covered
arbitrage activities.
 Solution: Exercise
• (1) Borrow $1,500,000; repayment will be
$1,530,000.
• (2) Buy £1,000,000 spot using $1,500,000.
• (3) Invest £1,000,000 at the pound interest rate
of 1.45%; maturity value will be £1,014,500.
• (4) Sell £1,014,500 forward for $1,542,040
• Arbitrage profit will be $12,040
 Exercise
• Currently, the spot exchange rate is $1.50/£ and the three-
month forward exchange rate is $1.52/£. The three-month
interest rate is 8.0% per annum in the U.S. and 5.8% per
annum in the U.K. Assume that you can borrow as much as
$1,500,000 or £1,000,000.
• a. Determine whether the interest rate parity is currently
holding.
• b. If the IRP is not holding, how would you carry out covered
interest arbitrage? Show all the steps and determine the
arbitrage profit.
• c. Explain how the IRP will be restored as a result of covered
arbitrage activities.
 Solution: Exercise
• Following the arbitrage transactions described
above,
• The dollar interest rate will rise;
• The pound interest rate will fall;
• The spot exchange rate will rise;
• The forward exchange rate will fall.
• These adjustments will continue until IRP
holds.
 Interest Rate Parity: Implications
• Implications of the interest rate parity for the
exchange rate determination
– Assuming that the forward exchange rate is
roughly an unbiased predictor of the future spot
rate, IRP can be written as:
F$/£
S$/£ = × (1+ i£)
(1 + i$)
 Interest Rate Parity: Implications

• Implications of the interest rate parity for the

exchange rate determination
– The exchange rate is thus determined by the relative interest
rates, and the expected future spot rate, conditional on all the
available information, It, as of the present time.
– S = [(1 + I£)/(1 + I$)]E[St+1It].
– Hence, one can say that expectation is self-fulfilling. Since
the information set will be continuously updated as news hit
the market, the exchange rate will exhibit a highly dynamic,
random behavior.
 Interest Rate Parity: Implications
• IRP implies that in the short run, the exchange
rate depends on (a) the relative interest rates
between two countries, and (b) the expected
future exchange rate.
• Other things being equal, a higher (lower)
domestic interest rate will lead to appreciation
(depreciation) of the domestic currency.
• People’s expectations concerning future
exchange rates are self-fulfilling.
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 Warming-up Quiz…
• While you were visiting London, you purchased a Jaguar for £35,000,
payable in three months. You have enough cash at your bank in NYC,
which pays 0.35 percent interest per month, compounding monthly,
to pay for the car. Currently, the spot exchange rate is $1.45/£ and
the three-month forward exchange rate is $1.40/£. In London, the
money market interest rate is 2.0 percent for a three-month
investment. Think of two ways of paying for your Jaguar.
(a) Keep the funds at your bank in the U.S. and buy £35,000 forward.
(b) Buy a certain pound amount spot today and invest the amount in
the U.K. for three months so that the maturity value becomes equal
to £35,000.
Evaluate each payment method. Which method would you prefer?
Why?

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 Learning Activities
• Please recall what you learn in the lecture
today by creating a list of terms or ideas
related to it
 Summary
• Interest Rate Parity (IRP)
• Covered Interest Arbitrage (CIA)
• Uncovered Interest Rate Parity (UIRP)

2-50
 End of Week 3

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