Chapter 5

Relationships among
Inflation, Interest Rates, and
Exchange Rates

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Parity conditions
Arbitrage is the simultaneous purchase
and sale of the same assets or
commodities on different markets to profit
from price discrepancies.
Law of one price
Forward premium or discount
Forward premium Forward rate- Spot rate x 360
or discount = Spot rate Forward
contract
number days
 Relationships (spot rate, forward
rate, inflation rate and interest rate)
 Five Parity Conditions Result From
These Arbitrage
1. Purchasing Power Parity (PPP)
et = e0 *(1+ih)/( 1+ if) *note: e= $/foreign (being US home)

2. The Fisher Effect (FE)

r nominal = a real + i rh rf = ih if

3. The International Fisher Effect (IFE)

et = e0 (1+ rh ) / (1+rf) * note: e= $/foreign (being US home)

4. Interest Rate Parity (IRP)

(f1 e0)/e0 = rh rf * note: f = $/foreign (being US home)

5. Unbiased Forward Rate (UFR)

ft = expected future exchange rate
 PPP
Price levels adjusted for exchange rates should
be equal between countries
et

1 ih
t
or
e0 1 i f
t

where et = future spot rate

e0 = spot rate
ih = home inflation
if = foreign inflation
t = the time period
 PPP
A more simplified but less precise
relationship is
et
ih i f
e0

that is, the percentage change should be

approximately equal to the inflation rate
differential.
 Purchasing power parity
Purchasing power parity (Cassel, 1918)
Price levels should be equal worldwide when
expressed in common currency (absolute)
The Big Mac Index
Britain cost 1.90 (March 30,1999)
US $2.43
$2.43 / 1.90 = $1.28/ or 1.90/ $2.43 =0.78/$
Actual exchange rate $1.61/ (1/0.62)
The pound was 26% overvalued on March 30,2000

Brazilian real?
-30%
 Purchasing power parity
The foreign exchange rate must change by
(approximately) the difference between
domestic and foreign rates of inflation (relative
version)
Exchange rate change = inflation differential
Currencies with high rate of inflation should
devaluate relative with currencies with lower
rates of inflation
Inflation up exchange rate down
Inflation down exchange rate up

Notice et is the foreign currency exchange rate

 Purchasing power parity
US and Switzerland annual inflation rate
5% and 3% respectively, and spot rate is
SFr 1= $0.75, calculate the PPP rate for
the Swiss franc in three years
PPP = currencies with high rates of inflation
should devaluate relative to currencies with
lower rates of inflation
 Purchasing power parity

et= 0.75*(1.05/1.03)^3 = 0.79$/SFr

One-period version
et= 0.75(1.05/1.03)=0.77$/SFr

can be approximated
e = ih if = 0.02
then
et = 0.75*(1+0.02)
Purchasing power parity
A in equilibrium

B in
disequilibrium
Foreign
currency is
under valuated
 Purchasing power parity
Nominal exchange rate vs real exchange rate

Real exchange rate is the nominal exchange

rate adjusted for changes in the relative
purchasing power of each currency since some
base period
Pf and Ph are the foreign and home price level
at t period both indexed to 100 at time t=0
 Purchasing power parity
Nominal exchange rate vs real exchange rate

1980-1995, the /$ exchange rate moved from

226.63/$ to 93.96. And the CPI in Japan rose
from 91.0 to 119.2 vs US 82.4 to 152.4.
If PPP had held, what would the /$ exchange rate
have been in 1995?
What happened to the real value of the yen in terms
of dollars during this period?
 Nominal exchange rate vs real exchange rate

1980-1995, the /$ exchange rate moved from 226.63/$ to 93.96.

And the CPI in Japan rose from 91.0 to 119.2 vs US 82.4 to 152.4.
If PPP had held, what would the /$ exchange rate have been in 1995?
What happened to the real value of the yen in terms of dollars during
this period?

226.63* (119.2/91)/(152.4/82.4)= 160.23 /$

1/93.96*(119.2/91)/(152.4/82.4)= 0.007538$/
1/160.23 = 0.006230$/
To interpret this real exchange rate and see how it changed
since 1980, we compare it to the real exchange rate in 1980,
which just equals the nominal rate at that time of
1/226.63 = $0.004412/
(because the real and nominal rates are equal in the base
period).

This comparison reveals that during the 15-year period 1980

1995, the yen appreciated in real terms by
(0.007538 0.004412)/0.004412 = 71%.

This dramatic appreciation in the inflation-adjusted value of the

Japanese yen put enormous competitive pressure on Japanese
exporters as the dollar prices of their goods rose far more
than the U.S. rate of inflation would justify.
 The Fisher Effect
Nominal rate (r), is the rate of exchange between current
and future dollars
E.g. Nominal interest rate of 8%on a one-year loan that is $1.08
must be repaid in one year for $1.00 borrowed today
Real interest rate (a), the rate at which current goods are
being converted into future goods

(i) expected inflation

The Fisher effect states (approximated equation)
r=a+i

ah = af (no arbitrage) then

rh rf = ih if

That is called The Fisher Effect

 The Fisher Effect
The Fisher Effect says that currencies with
high rates of inflation should bear higher
interest rates than currencies with lower
rates of inflation.

r1= a1 + i1
r2= a2 + i2

No arbitrage requires a1=a2

The Fisher Effect
 The International Fisher Effect
(1 + rh)t = et approx. e = rh rf
(1 + rf)t e0

et = e0 (1+ rh ) / (1+rf) * note: e= $/foreign (being US home)

IFE says that currencies with low interest rates are

expected to appreciate relative to currencies with high
interest rates

Interest differential between two countries is an unbiased

predictor of the future change in the spot rate of
exchange

inflation up interest up exchange rate down

The International Fisher Effect
 Interest rate parity theory
(f1 e0)/e0 = rh rf * note: f = $/foreign (being US home)

The movement of funds between two currencies is the major

determinant of the spread between forward and spot rates.

Interest rate parity, says that the currency of the country with lower
interest rate should be at a forward premium (in terms of currency
of the country with the higher rate, that is $ in our case, where US is
the home country)

Interest differential = forward differential (interest rate parity)

Covered interest differential = 0 when Interest parity holds

Covered interest differential = nonzero Covered interest arbitrage

 Interest rate parity theory
Suppose an investor with $1,000,000 to invest
for 90 days
$ at 8% annual
at 6% annual
Current spot rate is 0.7400/$
90 day forward rate is 0.736372/$
 Covered interest differential = 0
interest interest
US 8%annual 2.00%90 days
Europe 6%annual 1.50%90 days

interest differential 0.5%

Spot rate 0.74/$

Discount on the
Forward -90 0.736372/$ -0.5% dollar

The dollar has the higher interest rate --> Forward discount

Borrow Convert Invest Convert Loan payment Profit

$ 1,000,000 740,000 751,100 $1,020,001 $1,020,000 $1

1,000,000 $ 1,351,351 $ 1,378,378 1,014,999 1,015,000 -1

Covered interest differential = 0
Interest rate US 10% annual
Interest rate Japan 7%
Exchange rate $0.0038/ Y
Interest parity condition holds, forward in
90 days?
 Covered interest differential = 0

interest interest
US 10%annual 2.50%90 days
Europe 7%annual 1.75%90 days

interest differential 0.8%

Spot rate 0.0038$/Yen

Forward -90 X $/Yen

F-90= Spot x (1+rh)/(1+rf) = $0.00382801/Y

 Covered interest arbitrage
Interest rate 12% for the pound in London
Interest rate 7% for the $ in NY
Pound spot rate $1.95 and the one-year
forward rate $1.87
Is there covered interest arbitrage?
 Covered interest arbitrage
interest interest
London 12%annual 12.00%one year
New York 7%annual 7.00%one year

interest differential 5.0%

Spot rate 1.95$/pound

one-year Discount on the
forward 1.87$/pound -4.1% dollar

The dollar has the higher interest rate --> Forward discount

Borrow Convert Invest Convert Loan payment Profit

1,000,000 $ 1,950,000 $ 2,086,500 1,115,775 1,120,000 - 4,225

$ 1,000,000 512,821 574,359 $ 1,074,051 $ 1,070,000 $ 4,051