Slide 0Slide 1Chapter OutlineInterest Rate ParityInterest Rate Parity DefinedInterest Rate Parity Carefully DefinedIRPSlide 8Slide 9Slide 10Slide 11IRP and Covered Interest ArbitrageSlide 13Arbitrage IInterest Rate Parity & Exchange Rate DeterminationArbitrage Strategy ISlide 17Arbitrage Strategy IIArbitrage IIIRP and Hedging Currency RiskIRP and a Money Market HedgeMoney Market HedgeSlide 23Money Market Hedge: an ExampleAnother Money Market HedgeSlide 26Generic Money Market Hedge: Step OneGeneric Money Market Hedge: Step TwoGeneric Money Market HedgeForward PremiumReasons for Deviations from IRPTransactions Costs ExampleSlide 32Slide 33Why This Seems ConfusingSetting Dealer Forward Bid and AskSetting Dealer Forward Bid PriceSetting Dealer Forward Ask PricePurchasing Power ParityPurchasing Power Parity and Exchange Rate DeterminationSlide 41Slide 42Purchasing Power Parity and Interest Rate ParityExpected Rate of Change in Exchange Rate as Inflation DifferentialExpected Rate of Change in Exchange Rate as Interest Rate DifferentialQuick and Dirty Short CutEvidence on PPPApproximate Equilibrium Exchange Rate RelationshipsThe Exact Fisher EffectsInternational Fisher EffectSlide 51Exact Equilibrium Exchange Rate RelationshipsForecasting Exchange RatesEfficient Markets ApproachFundamental ApproachTechnical ApproachPerformance of the ForecastersEnd Chapter SixINTERNATIONALFINANCIALMANAGEMENTEUN / RESNICKFifth EditionCopyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/IrwinChapter Objective:This chapter examines several key international parity relationships, such as interest rate parity and purchasing power parity.6Chapter SixInternational Parity Relationships and Forecasting Foreign Exchange Rates6-2Chapter OutlineInterest Rate ParityPurchasing Power ParityThe Fisher EffectsForecasting Exchange RatesInterest Rate ParityCovered Interest ArbitrageIRP and Exchange Rate DeterminationReasons for Deviations from IRPPurchasing Power ParityThe Fisher EffectsForecasting Exchange RatesInterest Rate ParityPurchasing Power ParityPPP Deviations and the Real Exchange RateEvidence on Purchasing Power ParityThe Fisher EffectsForecasting Exchange RatesInterest Rate ParityPurchasing Power ParityThe Fisher EffectsForecasting Exchange RatesInterest Rate ParityPurchasing Power ParityThe Fisher EffectsForecasting Exchange RatesEfficient Market ApproachFundamental ApproachTechnical ApproachPerformance of the ForecastersInterest Rate ParityPurchasing Power ParityThe Fisher EffectsForecasting Exchange Rates6-3Interest Rate ParityInterest Rate Parity DefinedCovered Interest ArbitrageInterest Rate Parity & Exchange Rate DeterminationReasons for Deviations from Interest Rate Parity 6-4…almost all of the time!Interest Rate Parity DefinedIRP is an “no arbitrage” condition.If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity.Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds.6-5S$/£ ×F$/£ =(1 + i£)(1 + i$)Interest Rate Parity Carefully DefinedConsider alternative one-year investments for $100,000: 1. Invest in the U.S. at i$. Future value = $100,000 × (1 + i$) 2. Trade your $ for £ at the spot rate, invest $100,000/S$/£ in Britain at i£ while eliminating any exchange rate risk by selling the future value of the British investment forward. S$/£F$/£Future value = $100,000(1 + i£)×S$/£F$/£(1 + i£) × = (1 + i$)Since these investments have the same risk, they must have the same future value (otherwise an arbitrage would exist)6-6IRPInvest those pounds at i£$1,000 S$/£$1,000Future Value = Step 3: repatriate future value to the U.S.A.Since both of these investments have the same risk, they must have the same future value—otherwise an arbitrage would existAlternative 1: invest $1,000 at i$ $1,000×(1 + i$) Alternative 2:Send your $ on a round trip to BritainStep 2: $1,000S$/£ (1+ i£) × F$/£ $1,000S$/£ (1+ i£)=IRP6-7Interest Rate Parity DefinedThe scale of the project is unimportant(1 + i$) F$/£S$/£ × (1+ i£)=$1,000×(1 + i$) $1,000S$/£ (1+ i£) × F$/£=6-8Interest Rate Parity DefinedFormally, IRP is sometimes approximated as i$ – i¥ ≈SF – S1 + i$1 + i¥S$/¥F$/¥=6-9Interest Rate Parity Carefully DefinedDepending upon how you quote the exchange rate (as $ per ¥ or ¥ per $) we have:1 + i$1 + i¥S¥/$ F¥/$ =1 + i$1 + i¥S$/¥F$/¥=or…so be a bit careful about that.6-10Interest Rate Parity Carefully DefinedNo matter how you quote the exchange rate ($ per ¥ or ¥ per $) to find a forward rate, increase the dollars by the dollar rate and the foreign currency by the foreign currency rate:…be careful—it’s easy to get this wrong.1 + i$1 + i¥F$/¥ = S$/¥ ×or1 + i$1 + i¥F¥/$ = S¥/$ ×6-11IRP and Covered Interest ArbitrageIf IRP failed to hold, an arbitrage would exist. It’s easiest to see this in the form of an example.Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.Spot exchange rate S($/£) = $2.0000/£360-day forward rate F360($/£) = $2.0100/£U.S. discount rate i$= 3.00%British discount rate i£ = 2.49%6-12IRP and Covered Interest ArbitrageA trader with $1,000 could invest in the U.S. at 3.00%, in one year his investment will be worth $1,030 = $1,000  (1+ i$) = $1,000  (1.03)Alternatively, this trader could 1. Exchange $1,000 for £500 at the prevailing spot rate, 2. Invest £500 for one year at i£ = 2.49%; earn £512.453. Translate £512.45 back into dollars at the forward rate F360($/£) = $2.01/£, the £512.45 will be worth $1,030.6-13Arbitrage IInvest £500 at i£ = 2.49% $1,000£500£500 = $1,000×$2.00£1In one year £500 will be worth £512.45 = £500  (1+ i£)$1,030 = £512.45 ×£1F£(360)Step 3: repatriate to the U.S.A. at F360($/£) = $2.01/£ Alternative 1: invest $1,000 at 3%FV = $1,030Alternative 2:buy poundsStep 2:£512.45$1,0306-14Interest Rate Parity & Exchange Rate DeterminationAccording to IRP only one 360-day forward rate, F360($/£), can exist. It must be the case that F360($/£) = $2.01/£Why? If F360($/£)  $2.01/£, an astute trader could make money with one of the following strategies:6-15Arbitrage Strategy IIf F360($/£) > $2.01/£ i. Borrow $1,000 at