DEPARTURE FROM PPP

In the real world, there may be deviations from parity due to many reasons. They are: As the PPP theory has its origin in the law of one price, all assumptions that underlie the law of one price are equally applicable to PPP. Non traded items such as immovable goods (land, building), highly perishable (milk, vegetables), and hospitability services may cause departure from PPP. This is because they cannot be moved from one country to another to cash on the price differential between the countries. The limitations of price indices as a measure of price level changes make PPP an approximate measure. Different countries uses different basket of goods and services in the construction of price index. The PPP theory holds only in the long run. In other words, long run changes in exchange rates are in line with long run differences in inflation rates.

INTEREST RATE PARITY

The interest rate parity theory states that the differences in the interest rates (risk free) on two currencies should be equal to the difference between the forward exchange rate and the spot exchange rate if there are to be no arbitrage opportunities. In other words according to IRP theory, financial products that are equal to each other sells for the same price. Thus, the currency of a country with a higher/lower interest rate should be at a discount/premium in term of the currency of another country with a lower/higher interest rate.

ARBITRAGE:
Locational arbitrage Triangular arbitrage Covered interest arbitrage: Borrowing in one currency and lending in another, investing in securities denominated in another currency with the currency risk covered (or hedged) in the forward market, is known as covered interest arbitrage.

 Example: Let us assume that an investor borrowed NC 16 million in the Nepal for one year at the interest rate of 6% per annum. He converted NC 16 million into Indian Currency at an exchange rate of NRS/INR 1.60 and received INR 10 million. He has invested INR 10 million in the INR denominated bank deposit for one year, at an interest rate of 8%.. Simultaneously he sold forward the maturity value of deposit (INR 10.80) in exchange for the Nepalese Currency amount at the forward rate of INR/NRS 1.65. Thus after one year the investor received NRS 17.82 million, repaid the loan amount with interest (NRS 16.96 million) and finally made a profit of NRS 0.86 million, without commitment of his fund and bearing risk.

Example
Suppose XYZ has $ 10,000 to invest, and suppose he has two investment alternatives. Either he will invest in dollar deposit or he will invest in pound deposit for one year. In the later case he knows that he must worry about transactions foreign exchange risk, so he decided fully hedge his investment. Suppose that XYZ has the following data. USD interest rate 8% p.a. GBP interest rate 12% p. a. Spot exchange rate $ 1.60/ 1-year forward exchange rate $1.53/ Which of these deposits provides the higher dollar return? If these were actually market prices, what you expect to happen.

Follow the following process: Convert dollar into pound at the given spot rate, Set up a one year deposit account in British bank. Engage in a forward contract to sell pound 1 year forward, When the deposit matures, convert the pounds to USD at the rate that was agreed upon in the forward contract. Compare this amount with the amount which will be received after 1 year if deposited in US bank.

 In this example borrowing NRS and investing in INR has resulted in a profit. This is possible if and only if: (1+KNP)t < Ft(INR/NRS)/S0(INR/NRS)*(1+KIN)t
Where, KNP=Interest rate on Nepalese currency denominated deposit/investment KIN= Interest rate on Indian currency denominated deposit/investment. If inequality exists, there will be profitable arbitrage opportunities. However, if inequality of the above equation reverse, then borrowing in INR and investing in the NRS deposit will be profitable.

Covered interest rate parity (CIP):

covered interest rate parity refers to the condition in which a forward contract has been used to cover (eliminate exposure to) exchange rate risk. Each form of the parity condition demonstrates a unique relationship with implications for the forecasting of future exchange rates: the forward exchange rate and the future spot exchange rate. When the no-arbitrage condition is satisfied with the use of a forward contract to hedge against exposure to exchange rate risk, interest rate parity is said to be covered. Investors will still be indifferent among the available interest rates in two countries because the forward exchange rate sustains equilibrium such that the dollar return on dollar deposits is equal to the dollar return on foreign deposit, thereby eliminating the potential for covered interest arbitrage profits. Furthermore, covered interest rate parity helps explain the determination of the forward exchange rate.

 The following equation represents covered interest rate parity, Or Ft/St=( 1 +i$)/ (1 + ic) Or for small interest rate: i$ - ic =(F-S)/S where, Ft is the forward exchange rate at time t. The dollar return on dollar deposits, , is shown to be equal to the dollar return on euro deposits,

Covered interest rate parity (CIRP) is found to hold when there is open capital mobility and limited capital controls, and this finding is confirmed for all currencies freely traded in the present-day.

 Example: i$ = 5%, iY = 3%. Suppose S = 0.0068 dollars per Yen. What should be the 90-day forward rate? 0.05 0.03 = (F 0.0068)/0.0068 F = 0.0068 + 0.02 * 0.0068 = 0.00694

Uncovered Interest Rate Parity

The uncovered interest rate parity condition defines a relationship between the interest rates and exchange rates for two countries in equilibrium. It hypothesizes that an investor will make his investment decision by comparing the rate of return to assets, based on his expectation of the depreciation rate. Thus, the rate or return to assets should be equalized across countries, or all investment would flood the country with a higher expected return. uncovered interest rate parity holding in the foreign exchange market states that the returns from investing domestically are equal to the returns from investing abroad.

 When the no-arbitrage condition is satisfied without the use of a forward contract to hedge against exposure to exchange rate risk, interest rate parity is said to be uncovered. Investors are indifferent among the available interest rates in two countries because the exchange rate between those countries is expected to adjust such that the dollar return on dollar deposits is equal to the dollar return on foreign deposits, thereby eliminating the potential for uncovered interest arbitrage profits. Uncovered interest rate parity helps explain the determination of the spot exchange rate . The following equation represents uncovered interest rate parity.

 The exact version of the UIRP condition hypothesizes the equalization of the rate of return across countries:

(1 + rh) = (1 + rf )(s*t+1/st)
Where, t is the current period, (t + 1) is the next period, rh and rf are the current domestic and foreign interest rates, st is the spot exchange rate, s* t+1 is the expected spot exchange rate in the following period. Think of t as the date an investment is made and (t+1) as the date the investment matures. All the variables in equation are known with certainty except s* t+1.

 The UIRP condition is called uncovered because the investor is uncovered for the risk associated with the uncertainty of s* t+1. His expectation of the next periods exchange rate is often different from the spot exchange rate that is realized in the following period. There is an opportunity to make a profit if he can get a forecast closer to the next periods spot exchange rate.

Problem-1
The interest rate in India and the US are 8% and 6% per annum respectively. The current spot rate between USD and INR is 39.4354. if interest rate parity holds, what is the three month forward rate. (Ans. INR 39.6297 & annualized premium 1.97%)

Problem-2
The spot rate of the NC against the USD is 75. The interest rate in US is 8% and in Nepal it is 6%. What is the forward rate premium and or discount of the NC with respect to the USD if interest rate parity exists? What is the forward rate (one year) of the USD in terms of the NC. Solution: from the perspective of Nepalese investor, P = (1 + Kh)/(1 + Kf) -1 (Ans. Discount 1.85%) Ft = So(1+p) (Ans. 1 year forward rate 73.61)

Forward Rate Parity

The Forward Rate Parity states that forward rates are unbiased predictors of future spot exchange rate. In other words, the forward rate of a currency relative to another currency reflects the future spot rate of exchange. The relationship between the forward exchange rate and the expected future spot rate between two currencies can be stated as: Ft(X/Y) = ESt(X/Y) Where, Ft(X/Y) = forward rate of one unit of currency X in terms of currency Y for delivery in t times. ESt(X/Y) = expected spot rate of one unit of currency X in terms of currency Y on the maturity date of the forward contract.

 Example: Suppose ESt(X/Y)= INR/USD = 45 & six month. Ft(X/Y) = INR/USD = 46, in six month. Market participants would sell USD forward at INR 46 and expects to buy the same at INR 45 when they are required to deliver the dollars. The speculator expects to make profit of INR 1 on each USD traded. When many participants do same, the forward rate will go down until it is no longer greater than the expected future spot rate. Conversely, if the expected spot rate in the six month period is INR 45 and the forward rate for six month is INR 44, speculators would buy USD forward at INR 44 and expects to sell the same at INR 45 to make a profit of INR 1 on each USD. Than, the demand of forward USD increases, that will drive up the forward rate until it is no longer lower than the expected future spot rate. In this way, when the forward rate is no longer greater or lower than the expected future spot rate, the forward rate and expected future spot rate are in equilibrium (Ft=E(St)). (Ft So)/So = (E(St) So)/So

The Fisher Effect:

The Fisher Effect, or the Fisher equation, represents the relationship between the nominal interest rate, the real interest rate and the expected rate of inflation in a country. This theory states that, interest rate in any country rise by an amount approximately equal to anticipated rate of inflation. If the basic interest rate is 3% a year, when there is no inflation, and if inflation is then anticipated to equal 5% a year, the rate of interest will rise to approximately 8% a year. This theory argues that weak currencies have higher interest rates because the interest rate differential equals the expected rate of change of the exchange rate.

 This theory argues that weak currencies have higher interest rates because the interest rate differential equals the expected rate of change of the exchange rate. According to Irving Fisher, the nominal rate of interest (the rate of exchange between the current money and future money) consists of two components: the real rate of interest (measured in purchasing power of money) and the expected rate of inflation.

Real interest rate parity

When both UIRP (particularly in its approximation form) and PPP hold, the two parity conditions together reveal a relationship among expected real interest rates, where in changes in expected real interest rates reflect expected changes in the real exchange rate. This condition is known as real interest rate parity (RIRP) and is related to the international Fisher effect. The following equations demonstrate how to derive the RIRP equation.

 Where represents inflation If the above conditions hold, then they can be combined and rearranged as the following:

 RIRP rests on several assumptions, including efficient markets, no country risk, and zero change in the expected real exchange rate. The parity condition suggests that real interest rates will equalize between countries and that capital mobility will result in capital flows that eliminate opportunities for arbitrage. There exists strong evidence that RIRP holds tightly among emerging markets in Asia and also Japan. The half-life period of deviations from RIRP have been examined by researchers and found to be roughly six or seven months, but between two and three months for certain countries. Such variation in the half-lives of deviations may be reflective of differences in the degree of financial integration among the country groups analyzed.

 RIRP does not hold over short time horizons, but empirical evidence has demonstrated that it generally holds well across long time horizons of five to ten years..

Examples:

Answer: