Chapter 4

International Parity Conditions

Prepared by Shafiq Jadallah

To Accompany
Fundamentals of Multinational Finance
Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman

Interest Rate Parity (IRP)

i $ = 8.00 % per annum
(2.00 % per 90 days)

Start
$1,000,000

S = SF 1.4800/$

End
1.02

$1,020,000

Dollar money market

$1,019,993*

90 days

F90 = SF 1.4655/$

Swiss franc money market

SF 1,480,000

1.01

SF 1,494,800

i SF = 4.00 % per annum

(1.00 % per 90 days)
Note that the Swiss franc investment yields $1,019,993, $7 less on a $1 million investment.

Covered Interest Arbitrage (CIA)

Eurodollar rate = 8.00 % per annum

Start
$1,000,000

End
1.04
Dollar money market

S = 106.00/$

180 days

$1,040,000
$1,044,638

F180 = 103.50/$

Yen money market

106,000,000

1.02
Euroyen rate = 4.00 % per annum

108,120,000

Arbitrage
Potential

Uncovered Interest Arbitrage (UIA):

The Yen Carry Trade
Investors borrow yen at 0.40% per annum

Start
10,000,000
Then exchanges

End
1.004
Japanese yen money market

10,040,000 Repay
10,500,000 Earn
460,000 Profit

the yen proceeds

for US dollars,
S = 120.00/$
investing in US

360 days

S360 = 120.00/$

dollar money
US dollar money market

markets for
one year

$ 83,333,333

1.05
Invest dollars at 5.00% per annum

$ 87,500,000

Forward Rates as an Unbiased Predictor

Exchange rate
F2

S2

Error

Error

S1
F1

F3
Error

S3
S4

Time

t1

t2

t3

t4

The forward rate available today (Ft,t+1), time t, for delivery at future time t+1, is used as a predictor of the
spot rate that will exist at that day in the future. Therefore, the forecast spot rate for time S t2 is F1; the actual
spot rate turns out to be S2. The vertical distance between the prediction and the actual spot rate is the forecast
error. When the forward rate is termed an unbiased predictor, it means that the forward rate over or
underestimates the future spot rate with relatively equal frequency and amount, therefore it misses the mark in
a regular and orderly manner. The sum of the errors equals zero.

Prices, Interest Rates and

Exchange Rates in Equilibrium

(A) Purchasing power parity

forecasts the change in the spot rate on the basis of differences in expected rates
of inflation

(B) Fisher effect

nominal interest rates in each country are equal to the required real rate of return
(r) plus compensation for expected inflation ()

(C) International Fisher effect

the spot exchange rate should change in an amount equal to but in the opposite
direction of the difference in interest rates between countries

(D) Interest rate parity

the difference in the national interest rates should be equal to, but opposite in sign
to, the forward rate discount or premium for the foreign currency, except for
transaction costs

(E) Forward rate as an unbiased predictor

the forward rate is an efficient predictor of the future spot rate, assuming that the
foreign exchange market is reasonably efficient

Summary of Learning Objectives

Parity conditions have traditionally been used by economists to

help explain the long run trend in an exchange rate
Under conditions of free floating rates, the expected rate of
change in the spot rate, differential interest and inflation rates,
and the forward rate are all directional and proportional to each
other
If two products are identical across borders and there are no
transaction costs, the products price should be the same in both
countries. This is the law of one price
The absolute theory of PPP states that the spot rate is determined
by the relative prices of similar goods
The relative theory of PPP states that if the spot rate starts in
equilibrium, any change in the differential inflation rates should
be offset over the long run by an opposite change in the spot rate

Summary of Learning Objectives

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 The international Fisher
Effect states that the spot rate should change in an equal amount
but in the opposite direction to the difference in interest rates
between two countries
The IRP theory states that the difference between national
interest rates for similar securities should be equal to, but
opposite sign to, the forward discount or premium rate
excluding transaction costs
When the forward and spot market rates are not in equilibrium,
the opportunity for risk free arbitrage exists. This is termed
covered interest arbitrage
If markets are believed to be efficient, then the forward rate is
considered an unbiased predictor of the future spot rate