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Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.6-0

INTERNATIONAL

FINANCIAL

MANAGEMENT

EUN / RESNICK

Fourth Edition

Chapter Objective:

This chapter examines several key international

parity relationships, such as interest rate parity and

purchasing power parity.

6Chapter SixInternational Parity

Relationships & ForecastingForeign Exchange Rates

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Chapter Outline

Interest Rate Parity

Purchasing Power Parity

The Fisher Effects Forecasting Exchange Rates

Interest Rate Parity

Covered Interest Arbitrage

IRP and Exchange Rate Determination

Reasons for Deviations from IRP

Purchasing Power Parity

The Fisher Effects

Forecasting Exchange Rates

Interest Rate Parity

Purchasing Power Parity

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

The Fisher Effects

Forecasting Exchange Rates

Interest Rate Parity

Purchasing Power Parity

The Fisher Effects Forecasting Exchange Rates

Interest Rate Parity

Purchasing Power Parity

The Fisher Effects Forecasting Exchange Rates

Efficient Market Approach

Fundamental Approach Technical Approach

Performance of the Forecasters

Interest Rate Parity

Purchasing Power Parity

The Fisher Effects Forecasting Exchange Rates

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Important conceptsArbitrage: actions that seek to take advantage of price discrepancies

between different markets for the purpose of making guaranteedprofits.

Law of One Price (LOP): similar goods cost the same in differentcountries of the world

LOP requires that there be no transportation costs, tariffs, monopolies,price restrictions

In an absence of these costs, arbitragers will ensure that similar goods

cost the same across countries by buying where the goods are cheapand selling where the goods are expensive.

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Interest Rate Parity (IRP)Uncovered Interest Rate Parity (UIRP) Condition:

Covered Interest Rate Parity (CIRP) Condition:

*(1 ) 1E

i i

S

*(1 ) 1F

i iS

E = expected spotrate on the future date

F = forward rate

i = domestic interest rate

i* = foreign interest rate

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Covered Interest Rate Parity (CIRP)

Consider alternatives one year investments for $1,000:

Option 1: Invest in the U.S. at i$. Future value1 = $1,000 (1 + i$)

Option 2: Trade your $ for at the spot rate, invest $1,000/S$/in

Britain at i while eliminating any exchange rate risk by sellingthe future value of the British investment forward.

S$/

F$/Future value2 = $1,000(1 + i)

S$/

F$/1,000(1 + i) = $1,000(1 + i$)

Since these investments have the same risk, they must havethe same future value (otherwise an arbitrage would exist)

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IRP

Invest thosepounds at i

$1,000

S$/

$1,000

Future Value =

Step 3: repatriate

future value to the

U.S.A.

Since both of these investments have the same risk, they must

have the same future valueotherwise an arbitrage would exist

Alternative 1:

invest $1,000 at i$

$1,000(1 + i$)

Alternative 2:

Send your $ on

a round trip to

BritainStep 2:

$1,000

S$/(1+ i) F$/

$1,000

S$/

(1+ i)

=

IRP

Step 1:

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Covered arbitrage and

Equilibrium exchange rateIf the CIRP does not hold. Suppose

Arbitrage strategy:

1. Borrow $x, pay back principal + interest =x(1+i$) dollarsExchange $X for x/S($/) pounds,and sell forward contract.

Investx/S($/)pounds.Receive x/S($/)(1+i) pounds.

Convert back to $:x/S($/)

(1+i

) F($/)

dollars

Net profit =x/S($/)(1+i) F($/) - x(1+i$) > 0

(1 + i$)F$/

S$/

(1+ i)