PPP, IRP and IFE

Dr. Anurag Agnihotri

Parity Conditions

Exp % change of
spot rate of foreign
currency
-3%
IFE

UFR

PPP
Forward discount
or premium on
foreign currency
-3%

Interest rate
differential
+3%

IRP

FE

Expected inflation
rate differential
+3%

UFR=Forward rates as
unbiased predictors of
future spot rates
PPP=Purchasing power
parity
IFE=International Fisher
effect

Arbitrage and Law of One Price

So many relationships in international finance, including

the parity conditions, depends on arbitrage activities.

Arbitrage is defined as simultaneous purchase and sale of

the same assets or commodities on different markets to
profit from price discrepancies.

Law of one price (LOP) stems from arbitrage and states

that:

In competitive markets free of transportation costs and

official barriers to trade, identical goods sold in different
countries must sell for the same price when their prices
are expressed in terms of the same currency.
i
PUS
i
i
PUS (i E$ BP ) PGBR ( E$ BP ) i
Mathematically, for good
PGBR

Arbitrage and Law of One Price

Example:
If a DVD sells for $30 in New York, and if the $/BP=1.50
(BP=British Pound), based on the law of one price, same
DVD must sell for 20 BP in London.
Suppose the price in US is $28 for the same DVD. In that
case, US exporters and British importers will have an
incentive to buy the DVD in New York and ship it to
London for a profit (of course, in the absence of any
transportation costs and barriers to trade). This will

push the prices up in New York, and

push the prices down in London

until the price of same DVD equalized in both locations.

Hence, international arbitrage enforces the law of one

price.

Purchasing Power Parity

In its absolute version, PPP states that price levels should be equal

worldwide when expressed in a common currency a unit of home

currency should have the same purchasing power around the world. In
other words, exchange rate between two currencies should be equal
to the ratio of the countries price levels. When one countrys inflation
rate rises relative to that of another country, decreased exports and
increased imports depress the countrys currency.
The theory of purchasing power parity (PPP) attempts to quantify this
inflation - exchange rate relationship.

( E$

BP )

PUS
PGBR

where PUS and PGBR are the prices of the reference currency baskets.
Hence, PPP theory predicts that a fall in a currency's domestic purchasing power
(increase in the domestic price level) will be associated with a proportional
currency depreciation in the foreign exchange market.
If, for example, the reference basket costs $200 in US and 120 British
pounds in UK, PPP predicts price of BP as 1.67 (200/120).
5

Purchasing Power Parity

If law of one price holds (for all commodities), then

absolute PPP must hold. Could we say that law of one
price must hold if absolute PPP holds?
Note that absolute PPP ignores
Transportation costs
Tariffs, quotas and other restrictions
Product differentiation
Law of one price and absolute PPP (to a degree) are best
illustrated by the Big Mac index (initially put together by
The Economist).

Rationale behind Purchasing Power

Parity
The absolute form of PPP, or the law of one price,
suggests that similar products in different countries
should be equally priced when measured in the same
currency.
The relative form of PPP accounts for market
imperfections like transportation costs, tariffs, and
quotas. It states that the rate of price changes should
be similar.
Suppose U.S. inflation > U.K. inflation.

U.S. imports from U.K. and U.S. exports to

U.K., so appreciates.
This shift in consumption and the appreciation of the
will continue until
in the U.S., priceU.K. goods priceU.S. goods, &
7 in the U.K., priceU.S. goods priceU.K. goods.

Purchasing Power Parity

For example, a Big Mac cost 1.99 BP in London, while its

price is $2.71 in US.
Implied PPP exchange rate for $/BP can be calculated by
(2.71/1.99)=1.36
Implied PPP exchange rate for BP/$ can be calculated
by (1.99/2.71)=0.73
Actual price of dollar was 0.63 BP on that date, implying
US dollar was undervalued and BP was overvalued.

0.73 - 0.63 =+16% (note we used Price

of dollar)

0.63
whatare
is included
in the price of awith
Big Mac:
Ignores
What
the problems
the Big Mac approach?
- cost of real estate; local taxes ;local services
In other words, it includes both traded and non-traded goods and services.

So, absolute PPP doesnt make sense if the baskets are different.
8

Purchasing Power Parity

Relative PPP, which is mostly used, states that the

percentage change in the exchange rate over any period
equals the difference between the percentage changes in
national price levels. In other words, exchange rates should
change to offset differences in inflation rates.
For example, if inflation is 5% in US and 1% in Japan, then
the dollar value of Japanese Yen must rise by about 4% to
equalize the dollar price of goods in the two countries
(dollar depreciates).
In mathematical terms,

e1 (1 ih ) t

e0 (1 i f ) t
9

where

e1 = future spot rate

e0 = spot rate
ih= home inflation
if = foreign inflation
t = time period
and e is the price of foreign currency ($/BP)

Purchasing Power Parity

Assumehome countrys price index (Ph) =foreign countrys price index
(Pf)
When inflation occurs, the exchange rate will adjust to maintain PPP:
Pf (1 + If ) (1 + ef ) = Ph (1 + Ih )
where
If
ef

Ih
=
=

= inflation rate in the home country

inflation rate in the foreign country
% change in the value of the foreign currency

If purchasing power parity is expected to hold, then the best prediction for
the one-period spot rate should be

e1 e0

(1 ih ) t
(1 i f )

e1 e0
ih i f
e0

10

A more simplified but less precise relationship is

PPP says the currency with the higher inflation

rate is expected to depreciate relative to the
currency with the lower rate of inflation.

Purchasing Power Parity

Example: Projected inflation rates for the U.S. and

Germany for the next twelve months are 10% and 4%,
respectively. If the current exchange rate is $.50/dm,
what should the future spot rate be at the end of next
twelve months?

et e0

1 ih

1 i

e1 .50(1.0577)

e1 $.529
11

e1

1.10

.50
1
1.04

$0.529 is the best prediction for the

future $/DM exchange rate.

Purchasing Power Parity

As it is clear now, exchange rate changes may indicate

nothing more than the reality that countries have different
inflation rates (outcome of PPP). Hence, changes in nominal
exchange rates may not be significant to evaluate the true
effects of currency changes on a firm.
Real exchange rate is the nominal exchange rate adjusted for
changes in relative purchasing power of each currency since
some base period (so home price of the foreign basket relative
to home basket).

e r t et

e t et
12

Pf
Ph

1 i f
1 ih

Where Pf is the foreign price level and Ph is the home price level
at time 1, both indexed to 100 at time 0.
Note that increases in the foreign price level and foreign
currency depreciation have offsetting effects on real exchange
rates.
An alternative way is using the inflation rates.
Note if PPP holds than er=e0.

Purchasing Power Parity

Example1: Assume Canadian reference commodity

basket costs Can100, and US basket costs $50 and the
nominal exchange rate is E$/Can=0.5 per Canadian dollar.
Er$/Can
=0.5*(100/50)=($50 per Canadian basket)/
($50 per US basket)

=1 US basket per Canadian basket

Assume the Canadian baskets cost increases to Can110.

Real exchange rate becomes 1.1 so we need to give 1.1
US basket for one Canadian basket real depreciation of
dollar against Canadian dollar (Fall in the purchasing
power of a US dollar within Canadian borders relative to
its purchasing power within US).

13

Purchasing Power Parity

Example2: Assume Yen/$ exchange rate moved from

Yen226.63/$ to Yen93.96/$ between 1980 and 1995. CPI
in Japan rose from 91.0 to 119.2, and US CPI rose from
82.4 to 152.4.

(a) If PPP hold, what would be the exchange rate in 1995

(according to PPP real rates do not change)?
Inflation in Japan was 31%, and in US was 85% over
that time period
Yen/$ PPP rate=226.63*(1.31/1.85)=Yen160.51/$ >
Yen93.96/$ , so Yen appreciated more than PPP would
suggest.
(b) What happened to real value of Yen?
Real rate=93.96*(1.85/1.31)=Yen132.69/$ n 1995
Real rate n 1980 is just equal to nominal rate,
Yen226.63/$. Yen appreciated in real terms by 71%.

14

Purchasing Power Parity

The distinction between nominal and real exchange rate

has important implications for foreign exchange risk
management. If real exchange rate remains constant,
changes in nominal exchange rate will be less important.

Empirical Evidence:
Law of one price doesnt hold (no surprise here)
There is a clear relationship between relative inflation rates
and changes in exchange rates. In general, it appears that
PPP holds well in the long-run, but doesnt perform well in
the short-run

we observe substantial deviations from PPP

predicted rates in the short-run, but there is a tendency to
move back to PPP predicted rates in the long-run. This is
called mean reversion and it is important for currency risk
management.
15

Purchasing Power Parity

Why do we see deviations in the short-run?

16

sticky prices in the short-run

transportation costs and restrictions
departures from free competition
differently constructed price indices
relative price changes
Non-traded goods and services

Fisher Effect

Investors care about real interest rates and not about the
nominal interest rates. However, almost all financial
contracts are stated in nominal terms.
The Fisher effect states that nominal interest rate, r, is a
function of

17

Real required rate of return, a, and

An inflation premium equal to the expected amount of
inflation, i
Formally,
1+Nominal rate=(1+Real rate)*(1+Expected
inflation rate)
1+r=(1+a)*(1+i)
r=a+i+a*i
This equation can be approximated by
r=a+i (under what conditions?)

Fisher Effect

Example: if a=3% and i=10%, Fisher equation tells us that

nominal interest rate, r, should be 13%.
Generalized version of Fisher effect:

Real returns tend towards equality across countries

(ah=af)

If ah>af then capital will flow from foreign to home

currency.
In the absence of government intervention, nominal
interest rate differential should be equal to expected
inflation differential between two currencies.

rh-rf= ih-if
How did we obtain this condition
(remember ah=af)?
Currencies with high rates of inflation should bear higher
nominal interest rates than currencies with lower inflation
rates.
18

Fisher Effect

Example: if inflation rates are 4% and 7% in US and UK, respectively,

nominal interest rates should be higher by about 3% in UK.

Is D an equilibrium point?

Interest Differential
(rh-rf)

Parity Line

-2
Inflation differential
C

-2
-3

19

Do we expect capital to flow from

home country to foreign country to
take advantage of the real
difference?

Fisher Effect

Empirical Evidence:
- Evidence is consistent with the hypothesis that most of
the variation in nominal interest rates across countries can
be attributed to differences in inflationary expectations.
- It is much harder to test the hypothesis that real returns are
equal between countries. However, arbitrage will force pretax real interest rates to converge across all the major
nations, if arbitrage is permitted to operate unhindered and
capital markets are integrated worldwide.
-

20

Capital market integration means that real interest

rates are determined by the global supply and
demand for funds.
Capital market segmentation means that real interest
rates are determined by local credit conditions.

Fisher Effect
Empirical evidence shows that capital markets are
becoming increasingly integrated worldwide.
However, we still observe real interest rate differential
across countries (not arbitraged away).

- Political risk and currency risk (higher inflation risk

Canada example)

- Different tax policies

- Regulatory barriers to free flow of capital

Hence, real interest rates tend to be higher in
developing countries.
Furthermore, integration of capital markets (and
resulting flow of funds) impose some discipline on
mismanagement of economies in developing nations.

21

International Fisher Effect

Combine PPP and FE to find IFE.

Remember PPP is denoted as:

e1 e0
ih i f
e0
e1 e0
rh r f ,
e0

et e0

And FE as rh-rf= ih-if.

where e1 is expected rate

1 rh

1 r
f

22

t
t

Is this familiar?
Currencies with low interest rates are expected
to appreciate relative to currencies with high
interest rates. Is this consistent with our earlier
discussions?

International Fisher Effect

Fisher postulated:

1. The nominal interest rate differential should reflect the

inflation rate differential.
2. Expected rates of return are equal in the absence of
government intervention.

Remember, changes in the nominal interest differential

can have two sources:

1. Changes in real interest differential

2. Changes in inflationary expectations

These two have opposite effects on currency values.

If the change is due to a higher real interest rate in the
home country, value of home countrys currency will rise.
If the change is because of an increase in inflationary
expectations in home country, value of home countrys
currency will fall.
23

International Fisher Effect

If the /$ spot rate is 108/$ and the interest rates

in Tokyo and New York are 6% and 12%,
respectively, what is the future spot rate two
years from now?

et

e2
24

1 rh

1.06

e0
e2 108
t
2
1 rf
1.12
1.1236

108
1.2544

e2 96.74 / $

Interest Rate Parity Theory

The Theory states:

The forward rate (F) differs from the spot rate (S) at equilibrium by an
amount equal to the interest differential (rh - rf) between two countries.
The forward premium or discount equals the interest rate differential.
F - S/S = (rh - rf)
where rh = the home rate
rf = the foreign rate
THE UNBIASED FORWARD RATE
States that if the forward rate is unbiased, then it should reflect the
expected future spot rate.
ft = et
25

Currency Forecasting

Important for financial executives of multinational

corporations
Currency forecasting can lead to consistent profits only
if the forecaster

26

Has superior forecasting model

Has access to private information consistently, or
has access to public information with a time lead
Can exploit small, temporary deviations from
equilibrium
Can predict the nature of government intervention
in the foreign exchange market (more applicable
for countries who manage their currencies to
some extent)

Currency Forecasting

Market-Based Forecasts
Extract the predictions already included in interest and
forward rates
Forward rate is an unbiased estimate of the future
spot rate limited to forecast horizon of one year
Interest rate differential can be used to predict
future interest rates exist for longer time periods
Model-Based Forecasts
Fundamental analysis involves the examination of
macroeconomic variables and policies. Simplest is
to use PPP.
Technical analysis focuses on the past price and
volume movements try to discover price patterns.
27

Currency Forecasting

The possibility of consistent profit-making through

currency forecasting is inconsistent with the efficient
market hypothesis. According to efficient market
hypothesis current exchange rates reflect all publicly
available information.
Note the forecast doesnt have to be accurate. It needs to
be profitable.
Example: Yen/$ spot rate is Yen110 per $. A 90-day
forward rate is Yen109/$. If our forecast for 90-day is
Yen102/$, we should buy the Yen forward.
Buy $1million worth of Yen forward = 109,000,000 Yen. If
the spot exchange rate 90-day from now turns out to be
Yen108/$, sell Yen spot for a profit of $9259. Our forecast
was off by 6%, but we made a profit.
Assume our forecast was Yen111/$. We would sell Yen
forward and we would lose $9259. Our forecast was more
28
accurate, it was off by 3% only.