Chapter 5 :International Parity Relationships

and Forecasting Foreign Exchange Rates

Outline
• Interest Rate Parity
– Covered Interest Arbitrage – lock a rate with forward contract
– IRP and Exchange Rate Determination
– Currency Carry Trade
– Reasons for Deviations from IRP
• Purchasing Power Parity
– PPP Deviations and the Real Exchange Rate
– Evidence on Purchasing Power Parity
• Fisher Effects
• Forecasting Exchange Rates
– Efficient Market Approach
– Fundamental Approach
– Technical Approach
– Performance of the Forecasters
6-1
Prof. Doaa Salman - 2022
International Parity Relationships
• Law of one price (LOP)
– Requirement that similar commodities or securities should
be trading at the same or similar prices
– Prevails when the same or equivalent things are trading at
the same price across different locations or markets,
precluding profitable arbitrage opportunities
• Arbitrage equilibrium
– Arbitrage is the act of simultaneously buying and selling
the same or equivalent assets or commodities for the
purpose of making certain, guaranteed profits

6-2
Prof. Doaa salman
 Interest Rate Parity Defined
• Interest rate parity (IRP) is an arbitrage condition
that must hold when international financial markets
are in equilibrium
– Manifestation of the LOP applied to international money
market instruments and provides a linkage between interest
rates in two different countries
– Interest rate parity (IRP) is a theory according to which the
interest rate differential between two countries is equal
to the differential between the forward exchange rate
and the spot exchange rate.

6-3
Prof. Doaa salman
Interest Rate Parity - Example
• Suppose you have $1 to invest over a one-year period,
and you will only consider default-free investments.
• There are two alternative ways on investing your fund:
1. Invest domestically at the U.S. interest rate
• If you choose this option, the maturity value in one year will be
$1(1 + is), where is is the U.S. interest rate
2. Invest in a foreign country, say, the U.K., at the foreign
interest rate and hedge the exchange risk by selling the
maturity value of the foreign investment forward. This option
requires the following steps:

6-4
Prof. Doaa salman
Interest Rate Parity – Example (Continued)
• Suppose you have $1 to invest over a one-year
period. There are two alternative ways on investing
your fund:
• Exchange $1 for a pound, that is, £(1/S) amount at the prevailing spot
exchange rate (S)
• Invest the pound amount at the U.K. interest rate (i£), with the maturity
value of £(1/S)(1+i£)
• Sell the maturity value of the U.K. investment forward in exchange for
a predetermined dollar amount, that is, $[(1/S)(1+i£)]F, where F
denotes the forward exchange rate

6-5
Prof. Doaa salman
Interest Rate Parity: Equivalent Investments
• U.S. and U.K. investment examples are equivalent
• Future dollar proceeds from investing in the two
equivalent investments must be the same, implying the
following:
or

An example of interest rate parity would be to suppose that the current exchange rate,
or spot exchange rate, between the US and another country is $1.2544/£1.00.
Suppose that the US has an interest rate of 4% and the second country has a rate of 2%.
This would result in a forward rate of $1.279/£1.00.

6-6
Prof. Doaa salman
 Suppose you observe a spot exchange rate of
$1.50/€. If interest rates are 5% APR in the U.S.
and 3% APR in the euro zone, what is the no-
arbitrage 1-year forward rate?

The spot exchange rate is $1.50/€ and interest rates are 5% apr in the U.S. and 3%
apr in the euro zone.

6-7
Prof. Doaa salman
 Suppose mid-market USD/CAD spot exchange rate is
1.2500 CAD and one year forward rate is 1.2380 CAD. Also
the risk-free interest rate is 4% for USD and 3% for CAD.
Check whether interest rate parity exist between USD and
CAD?

Ratio of Forward to Spot

= 1.2380 ÷ 1.2500 = 0.9904
Ratio of Returns
= [(1+3%) ÷ (1+4%)]^1 =≈ 0.9904

6-8
Prof. Doaa salman
 Arbitrage
• IRP can be derived by constructing an arbitrage
portfolio, which involves the following:
– No net investment
– No risk
– No net cash flow generated in equilibrium
• When IRP does not hold, the situation gives rise
to covered interest arbitrage opportunities,
allowing certain arbitrage profits to be made
without the arbitrageur investing any money out
of pocket or bearing any risk
6-9
Prof. Doaa salman
IRP and Exchange Rate Determination
• Reformulating the IRP relationship in terms of the
spot exchange rate yields:

• Forward exchange rate can be viewed as the

expected future spot exchange rate conditional
on all relevant information being available

• Combining the two equations yields the following:

6-10
Prof. Doaa salman
 IRP and Exchange Rate
Determination Continued
• Two things are noteworthy from the following
equation (presented on previous slide):

1. “Expectation” plays a key role in exchange rate

determination (i.e., when people “expect” the
exchange rate to go up in the future, it goes up now)
2. Exchange rate behavior will be driven by news events

6-11
Prof. Doaa salman
 Uncovered Interest Rate Parity
• When the forward exchange rate F is replaced
by the expected future spot exchange rate,
E(St+1), we obtain:

• Uncovered interest rate parity

– Interest rate differential between a pair of countries is
(approximately) equal to the expected rate of change in
the exchange rate
6-12
 Suppose interest rate is 5.0 % in the United States & 3.5 % in Germany, and
that the spot exchange rate is $1.12/€ & the forward exchange rate, with one-
year maturity, is $1.16/€. If you can borrow up to $1,000,000 is there arbitrage
profit
Step 1 :IRP, the arbitrage opportunity
exist: 1+5%<(1.16/1.12)(1+3.5%)=1.0720< 1.16

Step 2 : Start by borrow ( 1Million $ /1.12)= €892,857 then save with 3.5%
=€924,107 for 1 year forward

Step 3: Sell € 924,107×1.16 = $1,071,964

Step 4: since u borrow 1 million with interest 5% than you had to pay back
$1,050,000, then arbitrage profit is =
$1,071,964 - $1,050,000= $21,964.

Prof. Doaa salman

• Time 0 = Borrow $1 million at 4%, € 689,6551.72 +
save it at 3% then it will be € 710,344.83
• Then sell at $1.48= 1 €

• After 1 year ; € 710,344.83 sell at $1.48/ €

710,344.83 which will give = $ 1,051,310
• They repay loan $1,040,000
• Profit = 1,051,310 - $1,040,000 =11,310

Prof. Doaa salman

 Currency Carry Trade
• Unlike IRP, the uncovered interest rate parity often
does not hold, giving rise to uncovered interest
arbitrage opportunities
• Currency carry trade involves buying a high-
yielding currency and funding it with a low-yielding
currency, without any hedging
• The carry trade is profitable if the interest rate
differential is greater than the appreciation of the
funding currency against the investment currency

6-15
Prof. Doaa salman
 Currency Carry Trade
• A currency carry trade is a strategy in which an investor
borrows money in a currency with a low interest rate and
invests it in a currency with a higher interest rate, with the goal
of earning a profit from the difference between the interest
rates. The profit comes from the interest rate differential, as the
investor earns more interest on the currency they invested in
than they pay on the currency they borrowed.

Prof. Doaa salman

 Currency Carry Trade
let's say an investor borrows $1 million USD at a 1% interest rate and converts it
into Japanese yen at an exchange rate of 110 yen per dollar. They then invest the 110
million yen in a Japanese government bond with a 2% interest rate. Over the course of
the year, the investor earns 2% interest on the bond, which amounts to 2.2 million yen.
At the same time, they pay 1% interest on the US dollar loan, which amounts to
$10,000 USD or about 1.1 million yen. The investor would therefore earn a profit of
about 1.1 million yen, or roughly 1% of the initial investment.

Currency carry trades can be profitable when interest rate differentials are favorable
and currencies remain relatively stable. However, they can also be risky, as exchange
rates can fluctuate and erode any potential profits. Additionally, borrowing in a foreign
currency can expose investors to exchange rate risk and potential losses if the borrowed
currency appreciates against their home currency.

Prof. Doaa salman

Interest Rate Spreads and Exchange Rate Changes: Six-Month Carry
Trade Periods for Australian Dollar–Japanese Yen Pair

6-18
Prof. Doaa salman
 Reasons for Deviations from IRP
• IRP holds quite well, but it may not hold precisely all
the time due to (primarily) two main reasons:
1. Transaction costs
• Interest rate at which the arbitrager borrows tends to be
higher than the rate at which he lends, reflecting the bid-ask
spread
• There exist bid-ask spreads in the foreign exchange market
as well, as the arbitrager must buy currencies at the higher
ask price and sell at the lower bid price
2. Capital controls
• Governments sometimes restrict capital flows, inbound
and/or outbound via jawboning, imposing taxes, or outright
bans 6-19
Prof. Doaa salman
 Purchasing Power Parity
• When the law of one price is applied international to a
standard consumption basket, we obtain the theory of
purchasing power parity (PPP)
– PPP states the exchange rate between currencies of two
countries should be equal to the ratio of the countries’
price levels of a commodity basket
– Let P$ be the dollar price of the standard consumption
basket in the U.S. and P£ the pound price of the same
basket in the U.K.
– Absolute version of PPP states the exchange rate
between the dollar and pound should be:
6-20
Prof. Doaa salman
 Purchasing Power Parity
• PPP is often used to compare living standards and
economic productivity between countries. By
adjusting for differences in the cost of living, PPP
can provide a more accurate measure of
the relative wealth and standards of living in
different countries. However, PPP does not
always hold in practice due to factors such
as trade barriers, transportation costs, and
differences in quality and availability of goods.

6-21
Prof. Doaa salman
 Purchasing Power Parity
• When the PPP relationship is presented in the “rate of
change” form, instead of price level as in the absolute
version of PPP, we obtain the relative version of PPP:

Where:
• e is the rate of change in the exchange rate
• π$ and π£ are the inflation rates in the United States and
U.K., respectively

6-22
Prof. Doaa salman
PPP Deviations and the Real Exchange Rate
• If there are deviations from PPP, changes in nominal
exchange rates cause changes in the real exchange
rates, affecting the international competitive positions of
countries
• Real exchange rate, q, is found by:

• If PPP holds, the real exchange rate will be unity (i.e., q

= 1), but when PPP is violated, the real exchange rate
will deviate from unity
6-23
Prof. Doaa salman
 Evidence on PPP
• PPP has been the subject of a series of tests, yielding
generally negative results, especially over short horizons
• Generally unfavorable evidence about PPP suggests that
substantial barriers to international commodity arbitrage
exist
– As long as there are nontradables (e.g., haircuts, housing,
etc.), PPP will not hold in its absolute version
– If PPP holds for tradables and the relative prices between
tradables and nontradables are maintained, then PPP can hold
in its relative version

6-24
Prof. Doaa salman
 Fisher Effects
• The Fisher effect holds that an increase (decrease) in the expected
inflation rate in a country will cause a proportionate increase
(decrease) in the interest rate in the country
• Formally, the Fisher effect is written as follows:

• Fisher effect implies that the expected inflation rate is the different
between the nominal and real interest rates in each country, that is,

6-25
Prof. Doaa salman
 Fisher Effects Continued
• If we assume the real interest rate is the same between
countries, that is, ρ$ = ρ£, we obtain the international
Fisher effect (IFE), which suggests the nominal interest
rate differential reflects the expected change in exchange
rate

• When the international Fisher effect is combined with

IRP, we obtain the forward expectations parity (FEP),
which states any forward premium or discount is equal to
the expected change in the exchange rate

6-26
Prof. Doaa salman
Forward expectations parity (FEP)
Forward expectations parity (FEP) is an economic
theory that suggests that the difference between
the forward exchange rate and the expected
future spot exchange rate is equal to the interest
rate differential between two countries. This
theory assumes that investors expect the future
spot exchange rate to equal the forward exchange
rate, and that interest rates are the primary driver
of exchange rate movements in the short term.

6-27
Prof. Doaa salman
Forward expectations parity (FEP)
FEP can be useful in understanding the relationship between
interest rates and exchange rates in the short term, but it does
not account for other factors that can influence exchange rates,
such as economic growth, political events, and market
sentiment. Therefore, FEP may not always hold in practice.

For example, let's say that the current exchange

rate between the US dollar and the euro is 1 USD = 0.85
EUR. The one-year interest rate in the United States is
2%, while the one-year interest rate in the Eurozone is
1%. Based on FEP, the expected future spot exchange
rate in one year should be 1 USD = 0.85 EUR * (1 + 2%) /
(1 + 1%) = 0.8585 EUR. 6-28
Prof. Doaa salman
Forward expectations parity (FEP)
If the one-year forward exchange rate is trading at a
different rate, say 1 USD = 0.86 EUR, then according to
FEP, this implies that investors expect the euro to
appreciate by 0.0015 EUR (0.86 EUR - 0.8585 EUR) over
the next year to reach the expected future spot exchange
rate. This difference in exchange rates implies that the
interest rate differential between the two countries is 1.5
basis points (2% - 1.5% = 0.5%), which is equal to the
difference between the forward exchange rate and the
expected future spot exchange rate.

6-29
Prof. Doaa salman
 Forecasting Exchange Rates
• Many business decisions are now made based on
forecasts, implicit or explicit, of future exchange
rates
• Forecasting techniques can be classified into three
distinct approaches:
1. Efficient market approach
2. Fundamental approach
3. Technical approach

6-30
Prof. Doaa salman
 Efficient Market Approach
• Efficient market hypothesis (EMH) states that
financial markets are informationally efficient in that
the current asset prices reflect all the relevant and
available information ( Transparent info)
– Implies that the exchange rate will change only when the
market receives new information
• Random walk hypothesis suggests today’s exchange rate is
the best predictor of tomorrow’s exchange rate
– To the extent that interest rates are different between two
countries, the forward exchange rate will be different
from the current spot exchange rate
6-31
Prof. Doaa salman
 Efficient Market Approach
• When the prices of its trade reflect perfectly and immediately
all known information
• Strong form of market efficiency is when prices
already reflect both publically available information and
inside information

• Weak form efficiency, also known as the random walk

theory, states that future securities' prices are random and
not influenced by past events

6-32
Prof. Doaa salman
Random walk hypothesis

6-33
Prof. Doaa salman
 Fundamental Approach
• Uses various models to forecast exchange rates
• Three main difficulties of this approach:
1. One must forecast a set of independent variables to
forecast the exchange rates, and forecasting the former
will certainly be subject to errors and may not be
necessarily easier than forecasting the latter
2. Parameter values that are estimated using historical data
may change over time because of changes in government
policies and/or the underlying structure of the economy
3. Model itself can be wrong

6-34
Prof. Doaa salman
 Technical Approach
• First analyzes the past behavior of exchange rates for the
purpose of identifying “patterns” and then projects them
into the future to generate forecasts
– Based on the premise that history repeats itself
– At odds with the efficient market approach
– Differs from fundamental approach in that it does not use
the key economic variables, like money supplies or trade
balances, for purpose of forecasting
• Two examples of technical analysis:
1. Moving average crossover rule
2. Head-and-shoulders pattern
6-35
Prof. Doaa salman
 Technical Approach
• Price trends
• Chart patterns
• Volume and momentum indicators
• Moving average

6-36
Prof. Doaa salman
Charts
• Maps price performance

• Sheds light on supply and

demand

• “investment roadmap”

• Price / volume relationship

important
 Chart Types - Line Charts
• Most basic of all charts

• Just a line that connects the

closing prices over a time
frame

• No trading range
 Chart Types – Bar Chart
• Vertical line represents highs/lows of the day
• Horizontal line represents closing price
• Red = down
• Blue/Black = up

Daily High
Closing Price
Daily Low Price Gap
 Chart Types – Candlestick Charts
• Vertical line represents the
trading range
• Wide bar represents open and
close
• White bar – Up and closes
above opening price
• Red Bar – down
• Black bar – up, but closes
below the opening price
 Chart Basics – Time Scale
• Time Scale
– Dates along bottom of chart (varies from seconds
to decades)

– Common Types: intraday, daily, weekly, monthly

– Subtle differences between different time scales

Chart Basics – Time Scale
Daily Chart Weekly Chart
 Price and Volume

Average
Volume
 Trends are your Friends
• Trend: general direction of stock
• Uptrend: higher highs, higher lows
Moving Average Crossover Rule: Golden Cross vs.
Death Cross

The golden cross occurs when a short-term moving average crosses over a major long-
term moving average to the upside and is interpreted by analysts and traders as signaling
a definitive upward turn in a market.

6-45
Prof. Doaa salman
Moving Average Crossover Rule: Golden Cross vs.
Death Cross

The golden cross occurs when a short-term moving average crosses over a major long-term
moving average to the upside and is interpreted by analysts and traders as signalling a
definitive upward turn in a market.

6-46
Prof. Doaa salman
Moving Average Crossover Rule: Golden Cross vs.
Death Cross

The death cross preceded the economic downturns in 1929, 1938, 1974, and
2008. There have been many times when a death cross appeared, such as in
the summer of 2016, when it proved to be a false indicator.

6-47
Prof. Doaa salman
Figure : Head-and-Shoulders Pattern:
A Reversal Signal

Prof. Doaa salman 6-48

 Performance of the Forecasters
• Can professional forecasters outperform the
market?
– Eun and Sabherwal (2002) study found that banks
could not outperform the random walk model, but
some banks significantly outperformed the random
walk model, especially in the longer run
– Beckmann and Czudaj (2017) suggest
professionals have a hard time predicting exchange
rates, and uncertainty regarding economic policy
and macroeconomic and financial conditions
significantly affects professionals’ forecast errors
6-49
Prof. Doaa salman