5

The Foreign Exchange Market

and Parity Conditions

Chapter Objectives
1. To describe the size of the foreign exchange market.

2. To list major participants in the foreign exchange market and their functions.

3. To distinguish between the spot and forward markets.

4. To explain how to read foreign-currency quotations as they appear in The Wall

Street Journal.

5. To discuss five theories of exchange rate determination and their relationships:

purchasing power parity, Fisher Effect, International Fisher Effect, interest-rate
parity, and forward rate as a predictor of the future spot rate.

6. To explain different types of arbitrage and how to take advantage of covered

interest arbitrage opportunities.

Chapter Outline
I. The Foreign Exchange Market
A. The foreign exchange market is a market where one country’s currency
can be exchanged for another country’s. It has three tiers of operations:
i. Individuals and corporations buy and sell foreign exchange
through their commercial banks.
ii. Commercial banks trade in foreign exchange with other
commercial banks in the same financial center.
iii. Commercial banks trade in foreign exchange with commercial
banks in other financial centers.
1. The first is the retail market; the last two are the interbank
market.
B. Major Participants

The Foreign Exchange Market and Parity Conditions 58

 i. Commercial Banks
1. They operate the payment mechanism meaning a collection
system that transfers money by drafts, notes, etc.
2. They extend credit both secured and unsecured.
3. Help to reduce risk by using a letter of credit.
a. A letter of credit is a document issued by a bank at
the request of an importer and in the document the
bank guarantees to honor a draft drawn on the
importer.
4. Most banks do not have a large amount of currency trading,
the market is dominated by a few large banks.
ii. Global and National Market
1. Banks throughout the world serve as market makers in
foreign exchange.
2. All foreign exchange banks are linked together using
telecommunication.
3. Local banks may have an advantage trading their specific
currency (e.g. Sterling in London), but all foreign exchange
banks have global level activities.
4. The foreign exchange market is 24 hour.
iii. Central Banks
1. They attempt to control the growth of the money supply
within their jurisdictions.
2. They also attempt to control the value of their own
currency against any foreign currency.
a. For fixed exchange rates, this involves absorbing
the difference between supply of and demand for
foreign exchange to maintain the par value.
b. For flexible exchange rates, this involves
intervening to maintain orderly trading conditions.
3. Central bank activities include transaction with other
central banks, various international organizations, and
exchange rate intervention.
4. Serve as their government’s banker for domestic and
international payments.
II. Foreign Exchange Rate Quotation
A. The spot rate is the rate paid for delivery of a currency within two business
days after the day of the trade.
i. A few number of currencies have a different rate for financial or
commercial transactions.
ii. The direct quote is a home currency price per unit of a foreign
currency.
iii. The indirect quote is a foreign currency price per unit of a home
currency.
iv. A cross rate is an exchange rate between two non-home currencies.

The Foreign Exchange Market and Parity Conditions 59

 v. Percentage change is the ending rate minus the beginning rate then
divided by the beginning rate.
vi. The bid price is the price at which the bank is ready to buy a
foreign currency and the ask price is the price at which the bank is
ready to sell a foreign currency.
1. The bid-ask spread is the spread between the bid and ask
rates.
B. The forward rate is the rate to be paid for delivery of a currency at some
future date.
i. The rate is determined at the time the contract is made but payment
and delivery are not required until maturity.
ii. If the forward rate is less than the spot rate, this is a discount.
iii. If the forward rate is more than the spot rate, this is a premium.
iv. There are four participants types in the forward rate:
1. Arbitrageurs who seek to earn riskless profits by taking
advantage of differences in interest rates among countries.
2. Traders who use forward contracts to eliminate possible
exchange losses on export or import orders denominated in
foreign currencies.
3. Hedgers who engage in forward contracts to protect the
home-currency value of foreign-currency denominated
assets and liabilities.
4. Speculators who expose themselves in risk by engaging in
forward contracts to make a profit from exchange rate
fluctuation.
III. International Parity Conditions
A. There is a relationship between the money market and the foreign
exchange market and there are five major theories that can be used to
determine exchange rate levels, which will be discussed below.
B. An efficient exchange market exists when exchange rates reflect all
available information and adjust quickly to new information. This
removes all profits in excess of the minimum from the system. It depends
on three hypotheses:
i. Market prices, such as product prices, interest rates, spot rates, and
forward rates, should reflect the market’s consensus estimate of the
future spot rate.
ii. Investors should not earn unusually large profits from forward
speculation.
iii. It is impossible for any market analyst to beat the market
consistently.
1. These conditions do not completely exist in practice.
C. The Theory of Purchasing Power Parity (PPP)
i. The absolute version of this theory states that the equilibrium
exchange rate between domestic and foreign currencies equals the
ratio between domestic and foreign prices.

The Foreign Exchange Market and Parity Conditions 60

 1. The world is very complex with many impediments to the
equalization of prices for identical goods worldwide.
ii. The relative version of the theory states that in the long run, the
exchange rate between the home currency and the foreign currency
will adjust to reflect changes in the price levels of the two
countries.
iii. The PPP theory can be used to forecast exchange rates.
iv. The weaknesses of the theory are that:
1. It assumes goods are easily traded.
2. It assumes tradable goods are identical across countries.
3. It is dependent on the use of price indexes.
4. Many other factors influence exchange rates beyond
relative prices.
D. The Fisher Effect
i. The nominal interest rate of each country is equal to a real interest
rate plus an expected rate of inflation.
1. The real interest is determined by the productivity in an
economy plus a risk premium. It is relatively stable.
2. The nominal interest includes an inflation premium to
compensate lenders or investors for a loss in purchasing
power.
ii. Real interest rates are equalized across countries through arbitrage.
iii. The theory works well for short-term government securities.
iv. The theory suffers from an increased financial risk inherent in
fluctuations of a bond market value prior to maturity, by the
unequal creditworthiness of the issuers, and from the fact that
long-term rates are not the sensitive to price changes.
E. The International Fisher Effect
i. This states that the future spot rate should move in an amount
equal to, but in the opposite direction from, the difference in
interest rates between two countries.
1. When investors purchase the currency of country to take
advantage of higher interest rates abroad, they must also
consider any possible losses due to fluctuations in the value
of the foreign currency prior to maturity of their
investment.
ii. It is also hold that the interest differential between two countries
should be an unbiased predictor of the future change in the sport
rate.
1. This is because, at least in terms of short-term behavior, the
exchange rate moves in the same direction as the difference
in interest rates between two countries.
F. The Theory of Interest-Rate Parity
i. This theory states that the spread between a forward rate and a spot
rate should be equal, but opposite in sign, to the difference in
interest rates between two countries.

The Foreign Exchange Market and Parity Conditions 61

 1. In a free market, the currency with the higher interest rate
will sell at a discount in the forward market and vice versa.
2. This outcome is a result of arbitrageurs who enter into
forward contracts to avoid the exchange-rate risk.
G. The Forward Rate and the Future Spot Rate
i. If speculators think that a forward rate is higher than their
prediction of a future spot rate, they will sell the foreign currency
forward.
1. This transaction will bid down the forward rate until it
equals the expected future spot rate.
ii. These speculative transactions will bid up the forward rate until it
reaches the expected future rate thereby removing any incentive to
buy or sell a foreign currency forward.
H. Synthesis of International Parity Conditions
i. In the absence of predictable exchange market intervention by
central banks, an expected rate of change in a spot rate, differential
rates of national inflation and interest, and forward premiums or
discounts are all directly proportional to each other.
1. Due to efficient markets, these variables adjust very
quickly to changes in any one of them.
IV. Arbitrages
A. Arbitrage is the purchase of something in one market and its sale in
another market to take advantage of price differential.
i. The goal is to profit on price differences.
B. Geographic Arbitrage
i. Exchange rates for a given currency are not the same in every
geographic market and this creates the opportunity for arbitrage.
C. Two-Point Arbitrage
i. This is an arbitrage transaction between two currencies to take
advantage of difference in exchange rates in different markets.
D. Three-Point Arbitrage, also known as Triangle Arbitrage
i. This is an arbitrage transaction among three currencies take
advantage of unequal cross rates between markets.
E. Covered-Interest Arbitrage
i. This is the movement of short-term funds between countries to
take advantage of interest differentials with exchange risk covered
by forward contracts.
ii. These activities lead to equilibrium, i.e. interest rate parity.
iii. This arbitrage leads to four tendencies:
1. The spot rate of currency one against currency two will
tend to appreciate as investors buy currency one against
currency two.
2. The forward rate of currency one against currency two will
tend to depreciate as investors sell currency one against
currency two.

The Foreign Exchange Market and Parity Conditions 62

 3. Interest rates will tend to rise in country two as investors
borrow currency two.
4. Interest rates will tend to fall in country one as investors
borrow currency one.
V. Summary

Key Terms and Concepts

Spot Rate is the rate paid for delivery of a currency within two business days after the
day of the trade.

Direct Quote is a home currency price per unit of a foreign currency.

Indirect Quote is a foreign currency price per unit of a home currency.

Cross Rate is an exchange rate between two currencies when it is obtained from the rates
of these two currencies in terms of a third currency.

Bid Price is the price at which a bank is ready to buy a foreign currency.

Ask Price is the price at which a bank is ready to sell a foreign currency.

Bid-Ask Spread is the spread between bid and ask rates for a currency; this spread is the
bank's fee for executing the foreign exchange transaction.

Forward rate is the rate to be paid for delivery of a currency at some future date.

Efficient Exchange Markets exist when exchange rates reflect all available information
and adjust quickly to new information.

Theory of Purchasing Power Parity (PPP) holds that the exchange rate must change in
terms of a single currency so as to equate the prices of goods in both countries.

Fisher Effect named after the economist Irving Fisher, assumes that the nominal interest
rate in each country is equal to a real interest rate plus an expected rate of inflation.

International Fisher Effect states that the future spot rate should move in an amount
equal to, but in a different direction from, the difference in interest rates between two
countries.

Interest-Rate Parity Theory holds that the difference between a forward rate and a spot
rate equals the difference between a domestic interest rate and a foreign interest rate

Arbitrage is the purchase of something in one market and its sale in another market to
take advantage of a price differential.

The Foreign Exchange Market and Parity Conditions 63

Two-Point Arbitrage is the arbitrage transaction between two currencies.

Three-Point Arbitrage, also known as triangle arbitrage, is the arbitrage transaction

among three currencies and can occur if any of the three cross rates is out of line.

Covered Interest Arbitrage is the movement of short-term funds between countries to

take advantage of interest differentials with exchange risk covered by forward contracts.

The Foreign Exchange Market and Parity Conditions 64

Multiple Choice Questions
1. The foreign exchange market is referred to as a market where one country's currency
is exchanged for another currency. The currency exchange is usually made through
the following methods .
A. buyers and sellers of foreign exchange meet at a physical location.
B. buyers and sellers of foreign exchange meet through a telephone network
C. buyers and sellers of foreign exchange meet through computer communications
D. A and B
E. B and C

2. Which of the following is not a function of a commercial bank in the foreign

exchange market?
A. they operate the payment mechanism
B. they determine exchange rates
C. they extend credit
D. they help reduce foreign exchange risk
E. they buy and sell foreign exchange

3. A black market for currencies exists in some countries where .

A. there is a huge balance of payments surplus
B. there is a huge trade surplus
C. currencies are pegged and exchange controls exist
D. all of the above
E. none of the above

4. Which of the following is not a characteristic of speculation .

A. profit motive
B. exchange rate fluctuation
C. hedging
D. risk taking
E. deliberate uncovered position

5. The International Monetary Market is part of the following exchange .

A. the New York Stock Exchange
B. the Chicago Mercantile Exchange
C. the Philadelphia Stock Exchange
D. the Singapore Stock Exchange
E. none of the above

6. A U.S. company is expected to receive £100,000 in 120 days. If the company wants
to minimize the risk of foreign exchange, then it would .
A. buy British pounds forward
B. sell British pounds forward
C. buy British pounds 120 days from now
D. sell British pounds 120 days from now

The Foreign Exchange Market and Parity Conditions 65

 E. sell British pounds in the current spot market

7. Speculation in foreign exchange markets entails .

A. covering in the forward market
B. covering in the money market
C. hedging in the option market
D. buying in the current spot market and selling in the future spot market
E. covering in the futures market

8. Foreign exchange markets are efficient if .

A. good information is available at no or little cost
B. you have inside information
C. markets are highly regulated
D. market information is secretive
E. most foreign exchange dealers are speculators

9. The theory of purchasing power parity says that .

A. the inflation rates in two countries are unrelated
B. the exchange rate reflects the inflation rate difference between two countries in
the opposite direction
C. the inflation rate is greater than the interest rate
D. the interest rate is greater than the inflation rate
E. the interest rate and the inflation rate are identical

10. The Fisher Effect assumes that the .

A. real interest rate is equal to the nominal interest rate
B. nominal interest rate is equal to the real interest rate plus the inflation rate
C. inflation rate is equal to the real interest rate
D. nominal interest rate is equal to the inflation rate
E. nominal interest rate is lower than the inflation rate

11. The International Fisher Effect says that the .

A. exchange rate difference reflects the inflation rate difference between two
countries
B. spot rate reflects the interest rate difference between two countries in the opposite
direction
C. future spot rate reflects the forward rate
D. interest rate is greater than the inflation rate
E. all of the above

12. The theory of interest rate parity means that the .

A. interest rates are equal in two countries
B. difference between the spot rate and the forward rate reflects the difference in
interest rates between two countries in the opposite direction
C. difference between the spot rate and the future spot rate reflects the interest rate
difference between two countries in the opposite direction

The Foreign Exchange Market and Parity Conditions 66

 D. future spot rate reflects the inflation difference between two countries
E. all of the above

13. A forward rate is equal to a future spot rate if foreign exchange markets are .
A. controlled by the government
B. efficient
C. controlled by speculators
D. are partially controlled by the International Monetary Fund
E. none of the above

14. For a US resident, ___is a direct quote while ___ is an indirect quote.
A. £0.66 per $ and $0.25 per Mexican peso
B. $1.50 per pound and $0.25 per Mexican peso
C. $0.75 per Canadian dollar and $1.50 per pound
D. £0.66 per $ and $1.50 per pound
E. $1.50 per pound and ¥120 per $

15. Which of the following currencies is directly linked to the value of gold?
A. U.S. dollar
B. Japanese yen
C. Deutsche mark
D. British pound
E. none of the above

16. If the spot rate of the Deutsche mark is $.30 and the six month forward rate of the
mark is $.32, what is the forward premium or discount on an annual basis?
A. premium; about 14.5%
B. discount; about 14.5%
C. premium; about 13.3%.
D. discount; about 13.3%.
E. premium; about 16.7%.

17. If the spot rate of the Deutsche mark is $.32 and the six month forward rate is $.30,
what is the forward premium or discount on an annual basis?
A. discount; 11.5%.
B. premium; 11.5%.
C. premium; 12.5%.
D. discount; 12.5%.
E. premium; 22.5%.

18. If the Canadian dollar is equal to $.86 and the German mark is equal to $.28, what is
the value of the German mark in terms of Canadian dollars?
A. about .3256 marks.
B. about .3568 marks.
C. about 1.2 marks.
D. about 1.5 marks.

The Foreign Exchange Market and Parity Conditions 67

 E. about .5600 marks.

19. If the German mark is equal to $.35 and the French franc is worth .31 German mark,
what is the franc/dollar exchange rate?
A. 3.556 French francs per dollar.
B. 5.776 French francs per dollar.
C. 6.896 French francs per dollar.
D. 9.228 French francs per dollar.
E. 10.00 French francs per dollar.

20. If the Japanese yen was worth $.0035 six months ago and is now worth $.0045 today,
how much has the yen appreciated or depreciated?
A. appreciated; about 29%.
B. appreciated; about 25%.
C. depreciated; about 20%.
D. depreciated; about 18%.
E. appreciated; about 15%.

21. Assume: (1) the U.S. annual interest rate = 10%; (2) the Germany annual interest rate
= 4%; and (3) the 90-day forward rate for the German mark = $.3864. At what current
spot rate will interest rate parity hold?
A. $.3922.
B. $.3855.
C. $.3807.
D. $.3752.
E. $.6000.

22. Suppose annual inflation rates in the U.S. and Brazil are expected to be 5% and 90%,
respectively over the next year. If the current spot rate for the Brazilian cruzeiro is
3342.62 cruzeiros per dollar, then the best estimate of the cruzeiro's future spot rate
one year from now is:
A. Cr$6053.27.
B. Cr$6350.99.
C. Cr$3342.62.
D. Cr$6685.24.
E. Cr$7800.00.

23. If the expected inflation rate is 4% and the real required return is 5%, what is the
nominal interest rate?
A. 1%.
B. 9%.
C. 6%.
D. 5%.
E. 11%.

Use the following information to answer the next three questions:

The Foreign Exchange Market and Parity Conditions 68

 Assume the following: you have $10,000 to invest; the current spot rate of British
pounds is $1.800; the 90-day forward rate of the pound is $1.780; the annual interest
rate in the U.S. is 4%; the annual interest rate in the U.K. is 6%.

24. Where would you invest your $10,000 to maximize your yield with no foreign
exchange risk?
A. in the United States.
B. in the United Kingdom.
C. cannot tell.
D. does not make any difference.
E. in Germany.

25. Given the U.S. interest rate, the U.K. interest rate, and the spot rate, what would be an
equilibrium forward exchange quotation?
A. 1.800
B. 1.780
C. 1.809
D. 1.905
E. 2.000

26. Given the spot rate, the forward rate, and the U.S. interest rate, what is the
equilibrium U.K. interest rate?
A. 6.0%
B. 8.9%
C. 4.0%
D. 6.0%
E. 8.4%

Use the following information to answer the following two questions:

Assume that the spot rate changed from $0.64 per Swiss franc on January 1 in one
recent year to $0.68 per Swiss franc on December 31 of that year.

27. What is the percentage change in the franc spot rate using direct quotes for a U.S.
company?
A. 5.55%
B. 6.25%
C. 7.55%
D. 8.00%
E. 9.99%

28. What is the percentage change in the franc spot rate using indirect quotes for a U.S.
company?
A. 6.25%
B. 7.77%
C. 8.88%
D. 9.45%

The Foreign Exchange Market and Parity Conditions 69

 E. 5.55%

29. The bid price is $0.64 for the German mark and the ask price is $0.68 for the German
mark. What is the bid-ask spread for the mark?
A. 6.77%
B. 7.77%
C. 8.75%
D. 6.25%
E. 5.25%

30. Is official exchange intervention effective?

A. Yes, sterilized interventions have been found to have a large impact on the
exchange rate.
B. No, sterilized interventions have been found to have a little impact on the
exchange rate.
C. No, because the value of the domestic currency is only loosely linked to value of
the domestic interest rate, so central bank actions to keep domestic interest rates in
target are ineffective.
D. Yes, the amount of central bank activity in countries such as Japan reflect the
importance of official exchange intervention.
E. Both A and D.

Answers
Multiple Choice Questions

1. E 11. B 21. C
2. B 12 B 22. A
3. C 13. B 23 B
4. C 14. E 24 A
5. B 15. E 25. C
6. B 16. C 26. E
7. D 17. D 27. B
8. A 18. A 28. A
9. B 19. D 29. D
10. B 20. A 30. B

Solutions

16. Solution: use Equation (5-4)

[(.32 - .30)/.30] x (360/180) = 13.3%

17. Solution: use Equation (5-4)

[(.30 - .32)/.32] x (360/180) = -12.5%

The Foreign Exchange Market and Parity Conditions 70

18. Solution: cross rate
.28/.86 = .3256

19. Solution: cross rate

DM.31/FF: FF1/DM.31 = FF3.23/DM
FF3.23/$.35 = FF9.228/$

20. Solution: use Equation (5-1)

[(.0045 - .0035)/.0035 = 29%

21. Solution: use Equation (5-8)

[(.3864 - S)/S) x (360/90)] = .10 - .04
S = .3807

22. Solution: use Equation (5-6). Remember that Cr$3342.63 = $0.0002991.

new exchange rate = $0.0002991[(1 + .05)/(1 + .90)]
= $.0001652/Cr$;
or Cr$1/$.0001653 = Cr$6053.27/$

23. Solution: Use Equation (5-7): nominal rate = real rate + inflation rate.
nominal rate = 5% + 4% = 9%

Solution: invest in the U.S.: $10,000 x 1.01 = $10,100

invest in the U.K. and cover in the forward market.

buy pounds at the present spot rate:

$10,000/1.8 = £5,555
invest in the U. K:
£5,555 x 1.015 = £5,638
sell pounds forward: £5,638 x 1.78 = $10,036

The investor would earn $64 more by investing in the United States instead of
the United Kingdom.

25. Solution: use Equation (5-8) and solve for the forward rate:
[(F - 1.800)/1.800 x (360/90)] = 0.04 - 0.06
F = £1.809

26. Solution: use Equation (5-8) and solve for the U.K. interest rate.
[(1.780 - 1.800)/1.800 x (360/90)] = 0.04 - if
if = 0.084

27. Solution: Use Equation (5-1).

% Change = (0.68 - 0.64)/0.64 = 0.0625 or 6.25%

The Foreign Exchange Market and Parity Conditions 71

28. Solution: Converting the above example into indirect quotations, the Swiss
franc changes from 1.5625 francs to 1.4706 francs. Use Equation (5-2) to
solve this problem.
% Change = (1.5625 - 1.4706)/1.4706 = 6.25%

29. Solution: Use Equation (5-3).

Spread = (0.68 - 0.64)/0.64 = 0.0625 or 6.25%

The Foreign Exchange Market and Parity Conditions 72