Chapter 6
International Parity Conditions
◼ Learning Objectives
1. Examine how price levels and price level changes (inflation) in countries determine the
exchange rate at which their currencies are traded
2. Show how interest rates reflect inflationary forces within each country and drive currency
exchange rates
3. Explain how forward markets for currencies reflect expectations held by market
participants about the future spot exchange rate
4. Analyze how, in equilibrium, the spot and forward currency markets are aligned with
interest differentials and differentials in expected inflation
◼ Chapter Outline
I. Prices and Exchange Rates
A. Purchasing Power Parity and the Law of One Price
B. Relative Purchasing Power Parity
C. Empirical Tests of Purchasing Power Parity
D. Exchange Rate Indices: Real and Nominal
E. Exchange Rate Pass-Through
Complete versus Partial Pass-Through
Price Elasticity of Demand
Pass-Through and Emerging Market Currencies
II. Interest Rates and Exchange Rates
F. The Fisher Effect
G. The International Fisher Effect
H. The Forward Rate
I. Calculation of Forward Premiums
Foreign Currency Terms
Home Currency Terms
Chapter 6 International Parity Conditions 33
J. Interest Rate Parity (IRP)
K. Covered Interest Arbitrage (CIA)
Rule of Thumb
Arbitrage Rule of Thumb
L. Uncovered Interest Arbitrage (UIA)
M. Equilibrium Between Interest Rates and Exchange Rates
III. Forward Rates as an Unbiased Predictor of the Future Spot Rate
IV. Prices, Interest Rates, and Exchange Rates in Equilibrium
A. Relation A: Purchasing Power Parity (PPP)
B. Relation B: The Fisher Effect
C. Relation C: International Fisher Effect
D. Relation D: Interest Rate Parity (IRP)
E. Relation E: Forward Rate as an Unbiased Predictor
◼ Questions
1. Law of One Price. Define the law of one price carefully, noting its fundamental
assumptions. Why are these assumptions so difficult to find in the real world in order to
apply the theory?
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2. Purchasing Power Parity. Define the two forms of purchasing power parity, absolute and
relative.
3. Big Mac Index. How close does the Big Mac Index conform to the theoretical requirements
for a one price measurement of purchasing power parity?
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11. Approximate Form of Fisher Effect. Why is the approximate form of the Fisher Effect
frequently used instead of the precise formulation? Does this introduce significant analysis
error?
12. The International Fisher Effect. Define the international Fisher effect. To what extent do
empirical tests confirm that the international Fisher effect exists in practice?
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13. Interest Rate Parity. Define interest rate parity. What is the relationship between interest
14. Covered Interest Arbitrage. Define the terms covered interest arbitrage and uncovered
interest arbitrage. What is the difference between these two transactions?
15. Uncovered Interest Arbitrage. Explain what expectations an investor or speculator would
need to undertake an uncovered interest arbitrage investment?
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16. Forward Rate Calculation. If someone you were working with argued that the current
forward rate quoted on a currency pair is the market’s expectation of where the future spot
rate will end up, what would you say?
17. Forward Rate as an Unbiased Predictor of the Future Spot Rate. Some forecasters believe
that foreign exchange markets for the major floating currencies are “efficient” and forward
exchange rates are unbiased predictors of future spot exchange rates. What is meant by
“unbiased predictor” in terms of the reliability of the forward rate in estimating future spot
exchange rates?
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18. Transaction Costs. If transaction costs for undertaking covered or uncovered interest
arbitrage were large, how do you think it would influence arbitrage activity?
19. Carry Trade. The term carry trade is used quite frequently in the business press. What
does it mean, and what conditions and expectations do investors need to hold to undertake
carry trade transactions?
20. Market Efficiency. Many academics and professionals have tested the foreign exchange
and interest rate markets to determine their efficiency. What have they concluded?