• Some fundamental questions of international financialmanagers are:

- What are the determinants of exchange rates?

- Are changes in exchange rates predictable?

• The economic theories that link exchange rates, price levels, and interest rates together are called international parity conditions.

• These international parity conditions form the core of the financial theory that is unique to international finance.

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Prof. Dr. Pornchai Chunhachinda

International Parity Conditions

• If the identical product or service can be sold in two different markets, and no restrictions exist on the sale or transportation costs of moving the product between markets, the products price should be the same in both markets.

• This is called the law of one price.

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Prof. Dr. Pornchai Chunhachinda

1. The Law of One Price

• A primary principle of competitive markets is that prices will equalize across markets if frictions (transportation costs) do not exist.• Comparing prices then, would require only a conversion

from one currency to the other:

P$ x S = P�

•Where the product price in US dollars is (P$), and the price in Baht is (P�) the spot exchange rate is (S)(Direct Quote).

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Prof. Dr. Pornchai Chunhachinda

• If the law of one price were true for all goods and services, the purchasing power parity (PPP) states that exchange rate could be found from any set of prices.

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Prof. Dr. Pornchai Chunhachinda

2. Absolute Purchasing Power Parity

• By comparing the prices of identical set of products denominated in different currencies, we could determine the “real” or PPP exchange rate that should exist if markets were efficient.

PI$ x S = PI�

Where the prices of identical set of products in US dollars is (PI$), the prices of identical set of products in Baht is (PI�) and the spot exchange rate is (S) (Direct Quote).• This is the absolute version of the PPP theory.

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Prof. Dr. Pornchai Chunhachinda

• If the assumptions of the absolute version of the PPP theory are relaxed a bit more, we observe what is termed relative purchasing power parity (RPPP).

• RPPP holds that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period.

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Prof. Dr. Pornchai Chunhachinda

3. Relative Purchasing Power Parity

• More specifically, if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate.

S1 = 1+I�

S0 1+I$

S1, S0 = Spot Exchange Rate (�/ $) at time 1, 0I� = Inflation Rate of ThailandI$ = Inflation Rate of U.S.A.

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Prof. Dr. Pornchai Chunhachinda

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Prof. Dr. Pornchai Chunhachinda

Purchasing Power Parity (PPP)Percent change in the spot exchangerate for foreign currency

Percent difference inexpected rates of inflation

(foreign relative tohome country)

2

4

-5

-4

-1-3 -1-4 -2 2 41 3 5

3

1

-2

-3

-6 6

P

• Empirical testing of PPP and the law of one price has been done, but has not proved PPP to be accurate in predicting future exchange rates.

• Two general conclusions can be made from these tests:

- PPP holds up well over the very long run but poorly for shorter time periods.

- The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets.

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Prof. Dr. Pornchai Chunhachinda

Empirical Test of PPP• 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

• This equation reduces to (in approximate form):i = (1+r)(1+ �)-1

= r + � + r�= r + �

Where i = nominal interest rater = real interest rate � = expected inflation.

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Prof. Dr. Pornchai Chunhachinda

4. The Fisher Effect

• “Currencies with high rates of inflation should bear higher interest rates than currencies with lower rates of inflation.”

1+ �d = 1+id

1+ �f 1+if

• Empirical Tests of Fisher Effect1. For short-term, the Fisher Effect holds.

2. For long-term, the Fisher Effect affected byincreased financial risks.

3. For private securities, the comparison areinfluenced by unequal creditworthiness of the issuers.

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Prof. Dr. Pornchai Chunhachinda

• The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the InternationalFisher Effect.

• “Fisher-open”, as it is termed, states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries.

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Prof. Dr. Pornchai Chunhachinda

5. The International Fisher Effect

• More formally:S0 – S1

• Where i$ and i� are the respective national interest rates and S is the spot exchange rate using direct quotes ( /$).

• Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates.

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Prof. Dr. Pornchai Chunhachinda

S1x 100 = i$ - i�

• “Currencies with lower interest rates are expected toappreciate relative to currencies with higher interestrates.”

S1 = S0 1+i�

1+i$

• Empirical Tests of International Fisher Effect1. Lend some support to the International FisherEffect.

2. Indicate the long-run tendency for interestdifferentials to offset exchange rate changes.

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Prof. Dr. Pornchai Chunhachinda

• The theory of Interest Rate Parity (IRP) provides the linkage between the foreign exchange markets andthe international money markets.

• The theory states: The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs.

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Prof. Dr. Pornchai Chunhachinda

6. Interest Rate Parity• The forward rate is calculated for any specific

maturity by adjusting the current spot exchange rate by the ratio of eurocurrency interest rates of the same maturity for the two subject currencies.

F = 1+id

S 1+if

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Prof. Dr. Pornchai Chunhachinda

• For example, the 90-day forward rate for the Swiss franc/US dollar exchange rate (FSF/$

90) is found by multiplying the current spot rate (SSF/$) by the ratio of the 90-day euro-Swiss franc deposit rate (iSF) over the 90-day eurodollar deposit rate (i$).

F = 1+id

S 1+if

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Prof. Dr. Pornchai Chunhachinda

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Prof. Dr. Pornchai Chunhachinda

Interest Rate Parity (IRP)

90 days

Dollar money market

Swiss franc money market

$1,000,000 $1,020,000$1,019,993*

S = SF 1.4800/$

SF 1,480,000 SF 1,494,800

F90 = SF 1.4655/$

x 1.01

x 1.02Start End

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

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.

• The forward premium or discount is the percentage difference between the spot and forward exchange rate, stated in annual percentage terms.

f SF = Spot – Forward

• This is the case when currency SF/$ is used.

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Prof. Dr. Pornchai Chunhachinda

Forward360days 100xx

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Prof. Dr. Pornchai Chunhachinda

Currency Yield Curves & The Forward Premium

Euro Swiss francyield curve

Interestyield

Days Forward60 12030 90 150 180

Eurodollaryield curve

Forward premium is thepercentage difference of 3.96%

1.0 %

3.0 %

4.0 %

5.0 %

6.0 %

2.0 %

7.0 %

8.0 %

9.0 %

10.0 %

• The spot and forward exchange rates are not, however, constantly in the state of equilibrium described by interest rate parity.

• When the market is not in equilibrium, thepotential for “risk-less” or arbitrage profit exists.

• The arbitrager will exploit the imbalance by investing in whichever currency offers the higher return on a covered basis.

• This is known as covered interest arbitrage (CIA).21

Prof. Dr. Pornchai Chunhachinda

7. Covered Interest Arbitrage

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Prof. Dr. Pornchai Chunhachinda

Covered Interest Arbitrage (CIA)

180 days

Dollar money market

Yen money market

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

S = ¥ 106.00/$

¥ 106,000,000 ¥ 108,120,000

F180 = ¥ 103.50/$

x 1.02

x 1.04Start End

Eurodollar rate = 8.00 % per annum

Euroyen rate = 4.00 % per annum

ArbitragePotential

• The following exhibit illustrates the conditions necessary for equilibrium between interest rates and exchange rates.

• The disequilibrium situation, denoted by pointU, is located off the interest rate parity line.

• However, the situation represented by point U is unstable because all investors have an incentive to execute the same covered interest arbitrage, which is virtually risk-free.

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Prof. Dr. Pornchai Chunhachinda

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Prof. Dr. Pornchai Chunhachinda

Interest Rates Parity (IRP) and Equilibrium

2

4

-5

-4

-1

-3 -1-4 -2 2 41 3 5

3

1

-2

-3

-6 6

XPercent difference between foreign (¥)and domestic ($) interest rates

Percentage premium onforeign currency (¥)

U

ZY

4.83

• Some forecasters believe that forward exchange rates are unbiased predictors of future spot exchange rates.

• Intuitively this means that the distribution of possible actual spot rates in the future is centered on the forward rate.

• Unbiased prediction simply means that the forward rate will, on average, overestimate and underestimate the actual future spot rate in equal frequency and degree.

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Prof. Dr. Pornchai Chunhachinda

8. Forward Rate as an Unbiased Predictor for Future Spot Rate

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Prof. Dr. Pornchai Chunhachinda

Forward Rate as an Unbiased Predictor for Future Spot Rate Exchange rate

Time

t 2 t 3 t 4t 1

S1

S2

S3

S4

F1

F2

F3ErrorError

Error

t 2 t 3 t 4t 1The 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 St2 is F1; the actual spotrate 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 of the future spot rate,” it means that the forward rateover or underestimates the future spot rate with relatively equal frequency and amount. It therefore “misses the mark” in a regular and orderly manner. The sum of the errors equals zero.

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Prof. Dr. Pornchai Chunhachinda

9. International Parity Conditions in Equilibrium (Approximate Form)

Forecast change inspot exchange rate

+ 4 %(yen strengthens)

Forward premiumon foreign currency

+ 4 %(yen strengthens)

Forecast differencein rates of inflation

- 4 %(less in Japan)

Difference in nominalinterest rates

- 4 %(less in Japan)

Forward rateas an unbiasedpredictor( E )

Interestrateparity( D )

InternationalFisher Effect

( C )

Purchasingpowerparity

( A )

Fishereffect( B )