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101 Concepts for the Level I Exam

Essential Concept 14: International Parity Conditions


Covered interest rate parity states that an investment in a foreign money market instrument that is completely hedged against exchange rate risk should yield exactly the same return as an otherwise identical domestic money market investment.

\mathrm{F}}_{\mathrm{f/d}}\mathrm{=}{\mathrm{S}}_{\mathrm{f/d}}\left(\mathrm{1+}{\mathrm{i}}_{\mathrm{f}}\left[\frac{\mathrm{Actual}}{\mathrm{360}}\right]\right)\mathrm{/}\left(\mathrm{1+}{\mathrm{i}}_{\mathrm{d}}\left[\frac{\mathrm{Actual}}{\mathrm{360}}\right]\right

 

Uncovered interest rate parity states that the expected return on an un-hedged foreign currency position should equal the return on a similar domestic currency investment.

\mathrm{\%}\mathrm{\Delta }{\mathrm{S}}^{\mathrm{e}}_{\mathrm{f/d}}\mathrm{=}{\mathrm{i_f-i_d}}

Forward rate parity states that the forward exchange rate will be an unbiased predictor of the future spot exchange rate if covered interest rate parity and uncovered interest rate parity hold.

\mathrm{Expected\ Spot\ rate=\ }{\mathrm{F}}_{\mathrm{f/d}}\mathrm{=}{\mathrm{S}}_{\mathrm{f/d}}\left(\mathrm{1+}{\mathrm{i}}_{\mathrm{f}}\left[\frac{\mathrm{Actual}}{\mathrm{360}}\right]\right)\mathrm{/}\left(\mathrm{1+}{\mathrm{i}}_{\mathrm{d}}\left[\frac{\mathrm{Actual}}{\mathrm{360}}\right]\right)

 

The ex-ante version of PPP states that ‘expected’ changes in spot exchange rates are driven by ‘expected’ inflation differentials:

\mathrm{\%}\mathrm{\Delta }{\mathrm{S}}^{\mathrm{e}}_{\mathrm{f/d}}\mathrm{=}{\mathrm{\pi }}^{\mathrm{e}}_{\mathrm{f}}\mathrm{-}{\mathrm{\pi }}^{\mathrm{e}}_{\mathrm{d}}

The international Fisher effect states that if uncovered interest rate parity and ex ante PPP hold, the foreign-domestic nominal yield spread is determined solely by the foreign-domestic expected inflation differential.

{\mathrm{i}}_{\mathrm{f}}\mathrm{-}{\mathrm{i}}_{\mathrm{d}}\mathrm{=}{\mathrm{\pi }}^{\mathrm{e}}_{\mathrm{f}}\mathrm{-}{\mathrm{\pi }}^{\mathrm{e}}_{\mathrm{d}

If all the key international parity conditions held at all times, then the expected percentage change in the spot exchange rate would equal

  • The forward premium or discount (expressed in %)
  • The nominal yield spread between countries
  • The difference between expected national inflation rates