International Parity

Condition

Maica Jimena BatiancelaBSBA Financial Management

Saint Louise de Marillac College of Sorsogon

DEFINITION

The parity conditions are equilibrium conditions that establish linkage between financial prices in the

absence of arbitrage.

IMPLICATION

☺Provide guidelines for financial strategic decisions suggested by each side of parity condition.

☺The parity conditions define international financial ´break-even points encompassing alternative strategies yielding identical financial outcomes suggested by each side of parity condition.

☺ 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 exposure.

☺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 macroeconomic policies

International

Arbitrage

• 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 made.

• As applied to foreign exchange and international money markets, arbitrage takes three common forms:–locational arbitrage–triangular arbitrage–covered interest arbitrage

LOCATIONAL 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.

• ExampleBank C Bid Ask Bank D Bid AskNZ$ $.635 $.640NZ$ $.645 $.650

• Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645. Profit = $.005/NZ$.

TRIANGULAR ARBITRAGE

• Triangular arbitrage is possible when a cross exchange rate quote differs from the rate calculated from spot rate quotes.

• Example Bid AskBritish pound (£) $1.60 $1.61Malaysian ringgit (MYR) $.200 $.202British 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.

• Example£ spot rate = 90-day forward rate = $1.60U.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.

Currency Future

DEFINITION☺Are standardized contracts, with fixed,

standardized contract sizes and fixed expiration dates, that are exchange-traded, i.e., traded as securities on organized exchanges.

☺Futures contracts have secondary markets, can be traded many times during life of contract, like a bond (vs. bank loan).

PARTICIPANTS IN FUTURES

1. Speculators Pure speculative bet/investment using

futures contracts, with no business interest in the underlying commodity/currency

2. Hedgers 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, importers, etc.

Currency Option

DEFINITION☺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 purchased.

☺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

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 power globally.

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 two countries.

In mathematical terms:

where et = future spot rate

e0 = spot rate

ih = home inflation

if = foreign inflation

t = the time period

tf

tht

i

i

e

e

1

1

0

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

tf

th

ti

iee

1

10

THE FISHER EFFECT

• states that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations.

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•

tf

tht

r

r

e

e

)1(

)1(

0

Simplified IFE equation:(if rf is relatively small)

rh - rf = e1 - e0

e0

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

(1+iF)

i.e.

forward = (1 + home interest rate) – 1

premium (1 + foreign interest rate)