Page 79 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes 3. Relative form of PPP theory accounts for market imperfections such as transportation
costs, tariffs and quotas.
4. Substantial Empirical research has been done to test the validity of PPP theory.

5. The absolute PPP theory postulates that the equilibrium exchange rate between currencies
of two countries is equal to the ratio of the price levels in the two nations.
6. Relative PPP theory accepts that because of market imperfections prices of similar products
in different countries will necessarily be the same when measured in a common currency.

5.2 Interest Rate Parity (IRP)

Interest rate parity is an economic concept, expressed as a basic algebraic identity that relates
interest rates and exchange rates. The identity is theoretical, and usually follows from assumptions
imposed in economic models. There is evidence to support as well as to refute the concept.
Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in
one currency, exchanging that currency for another currency and investing in interest-bearing
instruments of the second currency, while simultaneously purchasing futures contracts to convert
the currency back at the end of the holding period, should be equal to the returns from purchasing
and holding similar interest-bearing instruments of the first currency. If the returns are different,
an arbitrage transaction could, in theory, produce a risk-free return. Looked at differently,
interest rate parity says that the spot price and the forward or futures price of a currency
incorporate any interest rate differentials between the two currencies. According to interest rate
parity the difference between the (risk free) interest rates paid on two currencies should be equal
to the differences between the spot and forward rates.

If interest rate parity is violated, then an arbitrage opportunity exists. The simplest example of
this is what would happen if the forward rate was the same as the spot rate but the interest rates
were different, than investors would:
1. Borrow in the currency with the lower rate.
2. Convert the cash at spot rates.
3. Enter into a forward contract to convert the cash plus the expected interest at the same rate.
4. Invest the money at the higher rate.

5. Convert back through the forward contract.
6. Repay the principal and the interest, knowing the latter will be less than the interest
received.

5.2.1 Types of Interest Rate Parity (IRP)

There are two types of interest rate parity. These are: (1) Covered Interest Rate Parity and
(2) Uncovered Interest Rate Parity.

Covered Interest Rate Parity

Assuming the arbitrage opportunity described above does not exist, then the relationship for US
dollars and pounds sterling is:

(1 + r )/(1 + r ) = (£/$ )/(£/$ )
£ $ f s
where r is the sterling interest rate (till the date of the forward),
£
r is the dollar interest rate,
$

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