Interest Rate Parity & Purchasing power parity

Presented by

Danish HasanRamiz

Junaid Zamir

Interest Rate Parity (IRP)

Interest Rate Parity

• The Interest Rate Parity states that the interest rate difference between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate.

• It plays essential role in foreign exchange markets.

• The difference between the interest rates in any two countries is the same as the difference between the forward and the spot rates of their respective currencies.

• Interest rate parity A currency is worth what it can earn.

• The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period.

• When the returns on two currencies are equal, interest rate parity prevails.

Explanation

The relationship can be seen when you follow the two methods an investor may take to convert foreign currency into U.S. dollars.

• Option A would be to invest the foreign currency locally at the risk-free rate for a specific time period. Then convert the proceeds from the investment into U.S. dollars at the maturity.

• Option B would be to invest the same dollars in

the (U.S.) market for the same time period. When no arbitrage opportunities exist, the cash flows from both options are equal.

Mathematically

Rate of return in localcurrency

Rate of return in foreigncurrency=

In equilibrium, returns on currencies will be the same i. e. No profit will be realized

and interest rate parity exits which can be written

(1 + rh) = F

(1 + rf) S

Violation of IRP

If interest rate parity is violated, then an arbitrage opportunity exists. The simplest example of this is what would happen if the forward rate was the same as the spot rate but the interest rates were different, then investors would:

• borrow in the currency with the lower rate • convert the cash at spot rates • enter into a forward contract to convert the cash plus the

expected interest at the same rate • invest the money at the higher rate • convert back through the forward contract • repay the principal and the interest, knowing the latter will

be less than the interest received.

Implications of IRP

• If domestic interest rates are less than foreign interest rates, you will invest in foreign country at higher interest rates.

• Domestic investors can benefit by investing in the foreign market

• If domestic interest rates are more than foreign interest rates, you will invest in domestic market at higher interest rates

• Foreign investors can benefit by investing in the domestic market

Implications of IRP

Purchasing power parity (PPP)

Purchasing power parity (PPP)

The purchasing power of a country’s currency. The number of units of currency required to purchase a basket of goods in Pakistan and the same basket of goods and services that a USD would buy in United states.

Need for PPP

• Because the exchange rates only reflects when goods are traded. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets. Also, different interest rates, speculation or interventions by central banks can influence the foreign-exchange market.

Purpose

• Differences in living standards between nations because PPP takes into account the relative cost of living and the inflation rates of the countries,

Assumption

• In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency.

Example

• For example, a TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver due to which the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again the same price.

Fluctuations

• PPP rate fluctuations are mostly due to different rates of inflation in the two economies which would result in the difference in prices at home and abroad

Reasons for different measures

The main reasons why different measures do not perfectly reflect standards of living are:

• PPP numbers can vary with the specific basket of goods used, making it a rough estimate.

• Differences in quality of goods are hard to measure and thereby reflect in PPP.

Range and quality of goods

• Local, non-tradable goods and services (like electric power) that are produced and sold domestically.

• Tradable goods such as non-perishable commodities that can be sold on the international market

Rank Country GDP (PPP) $M

1 United States 14,264,600

2 China 7,916,429

3 Japan 4,354,368

4 India 3,288,345

5 Germany 2,910,490

6 Russia 2,260,907

27 Pakistan 439,558

List by the International Monetary Fund (2008)

Factors effectingIRP and PPP

Factors of PPP

• Technology • Luxury goods • Raw materials • Energy prices

Factors for IRP

Factors that influence the level of market interest rates include:

- Expected levels of inflation- General economic conditions- Monetary policy- Foreign exchange market activity- Foreign investor- Levels of sovereign debt outstanding- Financial and political stability

Formulas

Fo = forward rateSo = current spot rateic = interest rate in country c ib = interest rate in country b

S1 = expected spot rateSo = current spot rateic = expected inflation rate in country c ib = expected inflation rate in country b

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PPP

IRP

QuestionIRP

A Canadian company is expected to receive Kuwaiti dinars in 1 years time. The spot rate is CAD/Dinar 5.4670. The company could borrow in dinars at 9% or in Canadian dollars at 14%. There is no forward rate for one year’s time. Predict what the exchange rate is likely to be in one year

Solution

So = 5.4670ic = 14% or 0.14ib = 9% or 0.09

F = 5.4670 x (1 + 0.14) (1 + 0.09)

F = 5.7178

QuestionPPP

The spot exchange rate between UK sterling and Danish kroner is £1 = 8 kroners. Assuming that there is now purchasing parity an amount of commodity costing £110 in UK will cost 880 kroners in Denmark. Over the next year price inflation in denmark is expected to be 5% while in UK it is expected to be 8%. What is the expected spot exchange rate at the end of the year?

Solution

So = 8ic = 5% or 0.05ib = 8% or 0.08

S1 = 8 x (1 + 0.05) (1 + 0.08)

S1 = 7.78

UK price = £110 x 1.08= £118.80Danish price = 880 x 1.05= 924

Kroner

= 924 = 7.78 118.80

Thank you