This document discusses several international parity conditions that can be used to predict foreign exchange rates: 1. Purchasing power parity (PPP) states that exchange rates should equalize price levels between countries based on a basket of goods. 2. The international Fisher effect (IFE) states that exchange rates adjust to equalize interest rate differentials between countries. 3. Interest rate parity (IRP) focuses on spot and forward exchange rates between countries' money and bond markets and establishes a break-even condition for returns. 4. Forward rates are expected to be an unbiased predictor of future spot rates according to the expectations theory of exchange rates. These parity conditions are interrelated

1. International Parity
Conditions
By : Madam Zakiah Hassan
9 February 2010

2. Introduction
Exchange rates are influenced by interest rates and inflation
rates and together, they influence markets for
exchange rates in the future, known as forward rates.
Means that, the main determinants of exchange rates are
relative inflation rate, interest rates, national income
and political stability.
The linkages among these variables are called ‘parity
conditions’
Parity conditions are key relationship used to predict
movements in exchange rates.
Since arbitrage plays a critical role in this discussion, we
should define it upfront.

3. Objective
Learn how to predict foreign exchange
rates using arbitrage arguments.

4. What is arbitrage
Business operation involving the purchase of foreign exchange
gold, financial securities or commodities in one market and their
almost simultaneous sale in another market, in order to profit
from price differentials existing between the markets.
Arbitrage generally tends to eliminate price differentials between
markets.
So,
the act of simultaneously buying and selling the same or
equivalent assets or commodities for the purpose of making
certain profit.

5. Structure of IPC
Purchasing power parity (PPP) and Law of one price (LOP)
International Fisher Effect (IFE)
Fisher Effect (FE)
Interest Rate Parity (IRP)
Forward rates as unbiased predictors of future spot rates
(UFR)

6. Diagram of Parity Conditions
Exchange Rate Forecasts
Unbiased
Forward Purchasing Power
Rate Parity
Forward Rate International Differences in
Premium or Fischer Effect Inflation Rates
Discount
Fisher Effect
Interest Rate
Parity
Differences in Interest Rates

7. Interrelationship between Parity Conditions
The four parity conditions are all inter linked.
A change in price level ( inflation rate ) in the commodity
market will affect the market interest rate.
A change in the market interest rate will then, in turn, affect
the future spot rate (IFE) and the forward market through
IRP.
The four main theoretical relationship among the S, F, P (inf),
and I are shown in previous graph.

8. Purchasing power parity (PPP) and Law of one price
PPP is based on law of one price (LOP) and the no arbitrage condition.
LOP states : identical goods sell for the same price worldwide
Stated that in the absence of transportation cost, taxes and other
restrictions, meanwhile the price of a product stated in a common
currency such as USD should be the same in every country.
This means ‘ same product, same price’’ in one common currency.
Since the product is sold in different countries, the product’s price
must be stated in different currency terms, but the price of the
product should still be the same when expressed in one common
currency.

9. So, PPP states : the exchange rate between
two countries’ currencies should be equal to
the ratio of their price levels.
PPP is a manifestation of the LOP applied
internationally to a standard commodity
basket.

10. Purchasing power parity (PPP)
(1) Absolute PPP
Goods and services should cost the same regardless of the
country
This simply requires replacing a single product with a price index.
Example : if the price index in USD is the price of basket of goods
in the US and a price index in AUD is the price of a similar
basket of goods in Australia, then :
Price index USD = Price index AUD ( spot USD/AUD)
Problem : difficult of getting similar basket goods for both
countries, because due to each country’s different consumption
patterns.

11. Purchasing power parity (PPP)
(2) Relative PPP
The exchange rate is expected to adjust in order to reflect
expected relative differences in purchasing power.
-----the exchange between HC and any FC will adjust of reflect
changes in the price levels ( inflation) of two countries.

12. PURCHASING POWER
PARITY
1.In mathematical terms:
et
=
( +
1 ih )t
e0 (1+ if )t
where et = future spot rate
e0 = spot rate
ih = home inflation
if = foreign inflation
t = the time period

13. PURCHASING POWER
PARITY
2. If purchasing power parity is
expected to hold, then the best
prediction for the one-period
spot rate should be
et =0
e
( +)
1 ih
t
( + )
1 i f
t

14. Example PPP
US inflation 4%
Australia inflation 8%
Current spot is USD 0.8034 per AUD
Answer :
Spot rate = (1 + 0.04) / ( 1 + 0.08 ) * 0.8034
= USD 0.7736 per AUD

15. THE INTERNATIONAL FISHER EFFECT (IFE)
IFE STATES:
the spot rate adjusts to the interest rate differential
between two countries.

16. THE INTERNATIONAL FISHER
EFFECT
IFE = PPP + FE
et (1 + h ) t
r
=
e0 (1 + f )
r t

17. EXAMPLE IFE
► Malaysia interest rate for 6-month 4%
► Australia interest rate for 6 month 8%
► Current spot rate is MYR2.8735/AUD
► What is forecast future spot rate of the MYR/AUD if the
interest rate in Australia were rise to 10% p.a?
► Future spot rate = 2.8735 [ 1 + 0.04/20] / [1 + (0.1/2)] =
2.7914

18. Interest Rate Parity (IRP)
Theory
► IRP focuses on the spot and forward (expected)
exchange rates with international money and
bond markets.
► The parity condition implied by this theory
establishes the break-even condition where the
return on a domestic currency investment is
identical with the return on a foreign
currency investment covered against exchange
rate risk

19. EXAMPLE OF IRP
Example :
Assume that American has USD 1 M to invest either in the
UK or USA given the following information:
Spot rate USD 1.68/GBP
Forward rate USD 1.6066/GBP
UK interest rate 13 % p.a
USA interest rate 8.0625% p.a

20. Two alternative :
Alternative 1 : invest in USA & get USD
1,080,625 after one year ( 1M X 1.080625)
Alternative 2 :
Take advantage of the higher interest rate by
investing in UK

21. Alternative 2:
► Take advantage of the higher interest rate by investing in UK
► IF INVESTOR CHOOSE AT ALTERNATIVE 2, HE MUST
PERFORM THE FOLLOWING STEPS:
► Step 1: Convert USD 1 Million into pounds at spot rate because
bankers only accept pounds.
USD 1 Million / 1.68 = GBP 595,238.
► Step 2 : Invest GBP 595,238 at 13% after one year.
GBP 595,238 X 1.13 = GBP 672,619
► Step 3 :
Sell immediately one year forward at forward rate to get back
USD
GBP 672,619 X 1.6066 = USD 1,080,630.
Arbitrage profit = USD 1 M – USD 1,080,630 = USD 80,630

22. Why doing covered interest rate because to
protect against risk that pound will
depreciate in one year.

23. UNCOVERED INTEREST RATE PARITY
Example :
Suppose that the current one year interest
rate in the US is 9.4% and the UK interest
rate is 11%. The spot rate is USD1.5 per
GBP.
► What is expected one year forward rate for
USD/GBP?
► [ 1 + 0.094] / [1 + 0.11] = f / s
► [ 1 + 0.094] / [1 + 0.11] = f / 1.5
► So one year USD/GBP = 1.478

24. EXPECTATION THEORY OF THE EXCHANGE
RATE.
► Theory seeks to answer the question: is the forward
rate an accurate forecast of future spot rate?
► Actually investor want to know whether the forward
rate is an unbiased predictor of the future spot rate.
► The expectation theory state that forward rate
approximately = the expected future spot but
does not means they same, because forward rate
will, on average, over estimate and under estimate
the actual future spot rate.
► The rationale behind that is the foreign exchange is
reasonable efficient.

25. Conclusion
In this chapter, we learned about five parity conditions or
relationship apply to spot rates, inflation rates and interest
rates in different currencies: PPP, FE, IFE,IRP and forward
rates as an unbiased forecast of the future spot rate or
UFR.
International trade or exchange of goods and services across
borders gives rise to international settlement with
payments being made in different currencies.
Discrepancies may arise as a consequences when the
settlement is executed in one currency as against the other
currency. Moreover, economic conditions and changes in
economic conditions in different countries may take effect
on the value of goods measured in different currencies and
the relative values and opportunity costs of these
currencies.

26. International parities are important since they establish relative
currency values and their evolution in terms of economic
circumstances and cross broader arbitrage may be possible
when they are violated.