International parity conditionPresentation Transcript
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)