Maica Jimena Batiancela
BSBA Financial Management
Saint Louise de Marillac College of Sorsogon
The parity conditions are equilibrium
conditions that establish linkage
between financial prices in the absence
☺Provide guidelines for financial strategic
decisions suggested by each side of parity
☺The parity conditions define international
financial break-even points encompassing
alternative strategies yielding identical
financial outcomes suggested by each side of
☺ From private investors point of view, parity
conditions help to make optimal (beneficial)
financial decisions regarding the choice of
currency for borrowing , location of plants in
different countries, measuring currency risk
☺From public policy makers point of
view, parity conditions help to evaluate the
strength of national currencies, the
efficiency of national capital markets , and
the effectiveness of fiscal and monetary
policies towards achieving
• Arbitrage can be loosely defined as
capitalizing on a discrepancy in quoted
prices to make a riskless profit.
• The effect of arbitrage on demand and
supply is to cause prices to realign, such
that no further risk-free profits can be
• As applied to foreign exchange and
international money markets, arbitrage
takes three common forms:
–covered interest arbitrage
• Locational arbitrage is possible when a bank’s
buying price (bid price) is higher than another bank’s
selling price (ask price) for the same currency.
Bank C Bid Ask Bank D Bid Ask
NZ$ $.635 $.640 NZ$ $.645 $.650
• Buy NZ$ from Bank C @ $.640, and sell it to Bank D
@ $.645. Profit = $.005/NZ$.
• Triangular arbitrage is possible when a cross exchange rate
quote differs from the rate calculated from spot rate quotes.
• Example Bid Ask
British pound (£) $1.60 $1.61
Malaysian ringgit (MYR) $.200 $.202
British pound (£) MYR8.10 MYR8.20
• MYR8.10/£ X $.200/MYR = $1.62/£
• Buy £ @ $1.61, convert @ MYR8.10/£, then sell MYR @ $.200.
Profit = $.01/£.
COVERED INTEREST ARBITRAGE
• Covered interest arbitrage is the process of
capitalizing on the interest rate differential between
two countries while covering for exchange rate risk.
• Covered interest arbitrage tends to force a
relationship between forward rate premiums and
interest rate differentials.
£ spot rate = 90-day forward rate = $1.60
U.S. 90-day interest rate = 2%
U.K. 90-day interest rate = 4%
Borrow $ at 3%, or use existing funds which are
earning interest at 2%. Convert $ to £ at $1.60/£ and engage in
a 90-day forward contract to sell £ at $1.60/£. Lend £ at 4%.
Note: Profits are not achieved instantaneously.
☺Are standardized contracts, with
fixed, standardized contract sizes and fixed
expiration dates, that are exchange-
traded, i.e., traded as securities on organized
☺Futures contracts have secondary
markets, can be traded many times during life
of contract, like a bond (vs. bank loan).
PARTICIPANTS IN FUTURES
Pure speculative bet/investment using
futures contracts, with no business interest in
the underlying commodity/currency
Someone with a business/personal
interest in the underlying currency, and is
using futures trading to minimize, eliminate
or control currency
risk, e.g., MNCs, banks, exporters, importer
☺A contract that grants the holder the right, but not
the obligation, to buy or sell currency at a specified
exchange rate during a specified period of time.
☺For this right, a premium is paid to the broker, which
will vary depending on the number of contracts
☺Currency options are one of the best ways for
corporations or individuals to hedge against adverse
movements in exchange rates.
☺Investors can hedge against foreign currency risk by
purchasing a currency option put or call.
☺For example, assume that an investor believes that
the USD/EUR rate is going to increase from 0.80 to
0.90 (meaning that it will become more expensive for
a European investor to buy U.S dollars). In this case,
the investor would want to buy a call option on
USD/EUR so that he or she could stand to gain from
an increase in the exchange rate (or the USD rise).
Parity Conditions Resulting Arbitrage Activities:
1. Purchasing Power Parity (PPP)
2. The Fisher Effect (FE)
3. The International Fisher Effect (IFE)
4. Interest Rate Parity (IRP)
PURCHASING POWER PARITY (PPP)
• states that spot exchange rates between
currencies will change to the differential in
inflation rates between countries.
• Can be:
– Absolute Purchasing Power Parity
– Relative Purchasing Power Parity
ABSOLUTE PURCHASING POWER PARITY
• Price levels adjusted for exchange rates
should be equal between countries
• One unit of currency has same purchasing
RELATIVE PURCHASING POWER PARITY
• states that the exchange rate of one
currency against another will adjust to
reflect changes in the price levels of the
In mathematical terms:
where et = future spot rate
e0 = spot rate
ih = home inflation
if = foreign inflation
t = the time period
• If purchasing power parity is expected to hold, then
the best prediction for the one-period spot rate
THE FISHER EFFECT
• states that nominal interest rates (r) are a function of
the real interest rate (a) and a premium (i) for
R = a + I
• According to the Fisher Effect , countries with higher
inflation rates have higher interest rates.
THE INTERNATIONAL FISHER EFFECT (IFE)
• the spot rate adjusts to the interest rate differential
between two countries.
• IFE = PPP + FE
Interest Rate Parity (IRP)
• As a result of market forces, the forward rate differs from
the spot rate by an amount that sufficiently offsets the
interest rate differential between two currencies.
• Then, covered interest arbitrage is no longer feasible, and
the equilibrium state achieved is referred to as interest
rate parity (IRP).
• When IRP exists, the rate of return achieved from covered
interest arbitrage should equal the rate of return available
in the home country.
• End-value of a $1 investment in covered interest arbitrage
= (1/S) x (1+iF) x F
= (1/S) x (1+iF) x [S x (1+p)]
= (1+iF) x (1+p)
• where p is the forward premium.
• End-value of a $1 investment in the home country
= 1 + iH
• Equating the two and rearranging terms:
p = (1+iH) – 1
forward = (1 + home interest rate) – 1
premium (1 + foreign interest rate)