Exchange Rate process and Interest Rate

Parity
Mauricio Bedoya
javierma36@gmail.com
September 2014
To understand this blog, we must know:
1. It o Product Rule.
2. Interest Rate Parity.
3. It o Calculus.
Denition: It o Product Rule.
This rule state, that if you have the product of two stochastic process
1
X and Y, then:
d(X Y )
X Y
= dX Y +X dY +dX dY (1)
for the last term, we must consider the multiplication table (stochastic calculus), that state:
dt dt = 0; dt dw = 0 and dw dw = dt.
Defnition: Interest Rate Parity (Wikipedia).
Is a no-arbitrage condition representing an equilibrium state under which investors will be
indierent to interest rates available on bank deposits in two countries. Mathematically, the
evolution of the exchange rate can be expressed
X
(t)
= X
(0)
e
(rfrd)t
(2)
with rd (domestic interest rate), rf (foreign interest rate) constant. Now, lets try to unders-
tand this equation with an example. Imagine that we are a Colombian (COP) citizen that
is going to invest 1000 COP in Europe (e). In this case, X
(t)
characterize an
e
COP
relations-
hip. If we capitalize the numerator and denominator by their corresponding interest rate, we get
1
Check any Stochastic process or search in google for a denition.
1
$1000COP X
(t)

1+r
(e)
1+r
(COP)
Assuming that both interest rate are close to zero, we can assume that the previous equation
is an Euler approximation of
$1000COP X
(t)
e
r
(e)
r
(COP)
The previous expression allow to characterize the evolution of an investment in the foreign
market, were randomness comes only from the exchange rate evolution.
Because the exchange rate can NOT be negative, we can use the Geometric Brownian Motion
to characterize the relative change.
dX
(t)
X
(t)
= dt + dw (3)
with (mean rate), (volatility) constant, and dw N[0,

dt].
Now, lets apply the It o product rule to equation 2
dX
(t)
= dX
(0)
e
(rfrd)t
+X
(0)
(rf rd) dt e
(rfrd)t
+dX
(0)
(rf rd) dt e
(rfrd)t
replacing dX
(0)
with equation 3, we get
dX
(t)
X
(t)
= ( +rf rd) dt + dw
to make this Martingala (drift-less), we make a change of variable
dX
(t)
X
(t)
= [
( +rf rd) dt

+dw]

dw
(4)
Then, to eliminate the drift: = rdrf. Replacing in equation 3 the value of and integrating
in the interval [0,T], we get:

T
0
dX
(t)
X
(t)

Lebesgue Integral
=

T
0
(rd rf) dt

Lebesgue Integral
+

T
0


dw

Ito Integral
(5)
The It o integral requires some knowledge that you can found in any Stochastic process book.
The primary dierence between Lebesgue and Ito calculus is the quadratic variation. Lets solve
the Ito integral:
2
d( w
(t)
) =

dw +
1
2

2
dt

T
0


dw =

T
0
d( w
(t)
)

T
0
1
2

2
dt

T
0


dw = w
(T)

1
2

2
T
(6)
Solving the Lebesgue integrals and remplacing equation 6 in 5, we get
X
(T)
= X
(0)
e
(rdrf
1
2

2
)T+

w(T)
(7)
3