INSTITUTE OF ACCOUNTANCY ARUSHA

MODULE NAME: FINANCIAL RISK MANAGEMENT

MODULE CODE: 09105

PROGRAMME: MSC FINANCE AND INVESTMENT

TOPIC: PARITY RELATIONSHIP

Introduction

Exchange rate has been defined as “a price of one currency expressed in terms of another currency”.
Like prices of other commodities exchange rate is not self-standing. It is at the possible influence of
other factors. These factors explain fluctuation or volatility of exchange rate. The main economic
variables which influence the exchange rate are inflation (price levels in different countries), interest
rate (opportunity cost of money across countries), relative changes in economic growth and
development, changes in international trade volumes and movements of balance of payments. The
description of relationship between exchange rate and most of the determinants of exchange rate is
provided by the international parity relationship, which are equilibrium conditions of exchange rate. The
relationship between exchange rate and their determinants are explained as follows :

(1) Supply and Demand Theory

According to this theory, the exchange rate is determined by the forces of demand and supply.
Therefore, the point of intersection of the two curves will be the equilibrium rate. If, for any reason, the
demand for a foreign currency increases, then the price will rise further, assuming the supply remains
the same. On the contrary, if the supply is increased by a shift of the supply curve downwards, the price
will decline from, provided the demand remains the same. Any excess demand, below the equilibrium
point or excess supply, above the equilibrium point decreases or increases the foreign currency reserves
of a country temporarily. This disequilibrium condition is rectified by market forces over time.

(2) Purchasing Power Parity (PPP)

Purchasing power parity (PPP) is an equilibrium theory which provides that exchange rates between
currencies are in equilibrium when their purchasing power is the same in each of the two countries.
This means that the exchange rate between two countries should equal the ratio of the two countries'
price level of a fixed basket of goods and services. When a country's domestic price level is increasing
(i.e. country experiences inflation), that country's exchange rate depreciates in order to return to PPP.
The process of equilibrium continues until prices of goods of two countries reach the same level. There
are two forms of Purchasing Power Parity (PPP), the absolute and relative version.

(i) The Absolute Version of PPP Theory

The absolute version of PPP theory is based on the law of one price. The theory states that in a free
market identical commodities will be priced similarly across borders, such that if the price in Tanzanian
shillings of a product is multiplied by the exchange rate, say, the US Dollar, it will yield the price of the
same product in US dollars. If we assume that the exchange rate between the TSHS and US $ is 1600: 1,
then a product that costs $1 in the United States should cost TSHS 1600 in Tanzania. Otherwise,
arbitrage profits will occur. Ultimately, however, the market, through the forces of demand and supply,
will bring about equilibrium between the Tanzanian shillings and US dollar prices. Thus, the law of one
price will be reinstated and as a result, the purchase power parity between the TSHS and the US $. The
differences in the rates of inflation between the countries will also be nullified because the PPP adjusts
to equal the ratio of their price levels. The implication of the theory is that the exchange will be
determined in some way by the relationship between prices of similar product in two countries.

Absolute version of PPP theory is based on following assumptions

• The law of one price assumes that there are no transportation costs and no differential taxes
applied between the two markets.
• There must be competitive markets for the goods and services in both countries.
• There law of one price only applies to tradable goods; immobile goods such as houses, and
many services that are local, are of course not traded between countries.
• The commodity is identical in both countries, no product differentiation so products are
homogeneous

The exchange rate implied by the Law of One Price is the equilibrium exchange rate and that any
deviation of market (actual) exchange rate from the rate implied in the law of one price, suggests the
existence of commodity arbitrage opportunity.

In practice it would take a long time to reach price equilibrium according to PPP. In the short run,
exchange rates are news driven i.e. announcements about interest rate changes, changes in perception
of the growth prospects of economies and the like are all factors that drive exchange rates in the short
run. The Purchasing Power Parity further suggests that the purchasing power of a consumer will be
similar when purchasing goods in a foreign country or in the home country. If inflation in the foreign
country differs from inflation in the home country, the exchange rate will adjust itself to maintain equal
purchasing power.

The Purchasing Power Parity model (absolute version) has shown some weaknesses and could be a poor
predictor of short-term changes in exchange rates because:

• It ignores the effects of capital movement on the exchange rate-trade and therefore exchange
rates will only reflect the prices of goods which enter into international trade and not the
general price level since this include non-tradable goods.
• It ignores the fact that government may manage exchange rates, e.g. through interest rate
policy such that the assumption of free market defeated.
• The transaction cost of trading the commodities such as shipping, insurance, storage cost do
exit.
• It assumes that identical commodities in the two countries (homogeneous) and that there is no
product differentiation which is unrealistic.

(ii) The relative form of purchasing power parity (PPP)

This version of PPP state that the exchange rate between the domestic currency and any foreign
currency will always adjust to reflect change in inflation/price level in the two countries. The relative
form of PPP is an alternative version that accounts for the possibility of market imperfections such as
transportation costs, tariffs and quotas. This version acknowledges that because of these market
imperfections, prices of similar products of different countries will not necessary be the same when
measured in a common currency.

Under this version of PPP ‘the exchange rate between the domestic currency and any foreign currency
will adjust to reflect changes in prices levels of the two countries. Subsequent to that, the currency of
the country experiencing a higher rate of inflation will depreciate against the other currency by
approximately the inflation differential. The higher the rate of inflation in one county relative to another
will signify that the purchasing power of that country’s currency is weak and accordingly its value
depreciates compared to the other country’s currency.

Given, the inflation levels for two countries, and the spot rate, the expected exchange rate can be
determined as follows by

using the purchasing power parity model:

Single period version (t = 1)

Where , This can be rewritten as is inflation rate differentials. inflation rate differentials in the short
run.

Multi period version (t>1) , this can be rearranged as The periodic domestic inflation rate The periodic
foreign inflation rate , whereas The domestic currency value of the foreign currency at time t The
domestic currency value of the foreign currency at time O is exchange rate differential, and This is to
say, generally that the

Therefore, according to Purchasing power parity, the exchange rate change during a given period should
be equal to the inflation rate differential in that same time period. According to PPP a currency with high
rate of inflation should devalue relative to the currency of the country with low rates of inflation. The
theory is however, likely to be more useful for predicting long run changes in exchange rates since these
are more likely to be determined by the underlying competitiveness of economies as measured by the
model. The clear prediction of the purchasing power parity model of exchange rate determination is
that, if a country experiences a faster rate of inflation than its trading partner it will experience,
depreciation.

(3)The Fisher effect [FE] theory

The Fisher Effect (FE) theory was initially developed by the US economist Irving Fisher. The theory
describes the relationship that exists between inflation rate and interest rate. It states that investors all
over the world expect the same real rate of return on their investments after the effects of inflation are
eliminated. Therefore, while nominal interest rates may differ between countries this is only because of
different inflation expectations. The FE holds that, in equilibrium, an increase (decrease) in the expected
rate of inflation in a country will cause a proportionate increase (decrease) in the interest rate in that
country. That is nominal interest rate in each country are equal to the required real rate of return plus
compensation for expected inflation. The theory states that the nominal interest rate (r) is made up of
two components: A real required rate of return “a” and inflation premium equal to the expected
amount of inflation “i”.

Hence, FE is given 1+ Nominal interest rate = (1+real required rate of return) (1+expcted inflation rate).
Where,

r = nominal rate;

a= real rate;

i = inflation rate

The expected inflation rate is the expected rate of inflation over the period of time for which funds are
to be lent.

The Fisher effect helps to explain the difference in the interest rates in two countries. This difference
can be correlated with the difference in the inflation rates in those countries. Accordingly, the
generalized version of Fisher theory insists that currencies with high rates of inflation should bear higher
interest rates than currencies with lower rates of inflation.

(4)The International Fisher effect [IFE]

This theory describes the precise relationship between the relative nominal interest rates of two
countries and exchange rates. It suggests that an investor who periodically invests in foreign interest-
bearing securities will on average achieve a return similar to what is possible domestically. The key point
of understanding the impact of relative changes in nominal interest rates among countries on the
foreign exchange value of a nation’s currency is to recall the implication of PPP and the generalized
Fisher Effect. PPP implies that exchange rates will move to offset changes in inflation rate differential.
Thus, a rise in the Tanzania inflation rate relative to those of other countries will be associated with a fall
in the Tanzanian Shillings (TSHS)’s value. It will also be associated with a rise in the Tanzanian interest
rate relative to foreign interest rates. This implies that the exchange rate of the country with higher
interest rates will depreciate to offset the interest rate advantage achieved by foreign investments.

In specific terms, the IFE suggests that currencies with low interest rates are expected to appreciate
relative to currencies with high interest rates. Essentially what the international fisher effect says is that
arbitrage between financial markets in the form of international capital flows should ensure that the
interest differential between any two countries is an Unbiased Predictor of the future change in the spot
rate of exchange. This condition does not mean, however, that the interest differential is an especially
accurate predictor; it just means that prediction errors tend to cancel out over time. Give the interest
rates of two countries and spot rate of one country IFE can be applied to determine the expected
(future) exchange rate as follows. ,

(5) The interest rate parity [IRP] theory

Interest rates can be used as a tool for demand management in monetary policy therefore interest rates
in different countries will vary depending on the economic condition of the economy. Another factor
influencing exchange rates is the interest rates. If interest rates are high in one country compared to
another, this will have the effect of attracting capital inflows as investors try to take advantage of the
higher rate of interest. Consequently, the demand for domestic currency increases, pushing up its price.
The ultimate effect is a depreciation of the domestic country’s currency as it becomes more expensive.

The Interest Rate Parity (IRP) theorem examines the impact of nominal interest rate differentials
between two countries on the future/forward rate of the foreign currency. This theory states that
premium or discount of one currency against another should reflect the interest rate differential
between the two currencies. The theory specifically, offers that in a perfect market situation and where
there are no restrictions on the flow of money one should be able to gain the same real value on one
monetary asset irrespective of country where they are held.

The theory states that: The difference in the national interest rates for securities of similar risks and
maturity should be equal to, but opposite sign to the forward rate discount or premium for the foreign
currency, except for transaction costs. IRP is an equilibrium condition – a ‘parity relationship’ and holds
that exchange rates are determined by interest rate differentials. It states that the premium or discount
of one currency in relation to the other should reflect the interest rate differentials between the two
currencies. Thus, interest rates play an important role in determining exchange rates. The IRP equation
is

[(FR-SR)/SR]×12/n×100%=rd-rf

The IRP holds where forward premium or discount (the difference between the spot and forward rates)
equals interest rate differential between the two countries. It follows that, the IRP is an equilibrium
condition that should hold in the absence of barriers to international capital flows i.e. it assumes that
money is internationally mobile.

If IRP do not hold then it would be possible for arbitrageurs to make unlimited amounts of money
exploiting the arbitrage opportunity. Since we do not typically observe persistent arbitrage conditions,
we can safely assume that IRP holds on the whole. But in some cases the inconsistency or disparity in
the interest rate theory can be observed which suggest the existence of interest arbitrage opportunity.

In case of disparity in the IRP the investor may take advantages for the interest rates differences by
doing the following

(i) Say choose to invest at foreign currency money market instrument of identical risk and
maturity for the same period.
(ii) This would require that the investor exchange the home currency for foreign currency at the
spot rate of exchange,
(iii) invests foreign currency in a money market instrument,

(iv) Sell the foreign currency forward (in order to avoid any risk that the exchange rate would
change), and
 (v) at the end of the period convert the resulting proceeds back to home currency. The different
between the amount invested in chosen currency and the final proceeds will be the investor’s
interest arbitrage profit.

6. The rational expectations theory

According to this theory forward rate is regarded as unbiased predictor of the future spot rate. It
suggests that, when the current level of risk is ignored, the equilibrium is achieved when the forward
differential equals the expected changes in the exchange 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, such that the forward rate agreed today for future
use will be approximately equal the spot rate at that date. A formal statement of the unbiased forward
rate (UFR) condition is that the forward rate should reflect the expected future spot rate on the date of
settlement of the forward contract such that incentives to buy or sell the currency forward.

Unbiased predictor simply means that the forward rate will, on average, overestimate and
underestimate the actual future spot rate in equal frequency and degree. It therefore “misses the mark”
in a regular and orderly manner and sum of the errors equals to zero. The fact that it is unbiased
predictor, however, does not mean that the future spot rate will actually be equal to what the forward
rate predicts. Forward rate speculations Speculation is the process of seeking to profit from anticipated
exchange rate fluctuations.

Forward speculation on the other hand is the process which involves purchasing the underlying currency
expected to appreciate forward and selling it on the date of settlement of the forward contract

Determination of opportunity for commodity and interest rate arbitrage profit

The Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) like the rest of the theories are
equilibrium conditions. It follows that when these theories hold (i.e. they are operating at equilibrium)
there is no opportunity for arbitrage profit. Contrary, any disequilibrium (disparities) would entail that
the opportunity for arbitrage profit exist and one can benefit from such exchange rate disparity. While,
disequilibrium in interest rate parity theory amounts to interest rate arbitrage, similar condition under
purchasing power parity leads to commodity arbitrage opportunity under law of one price

Purchasing power parity disequilibrium and commodity arbitrage opportunity The PPP absolute version
the LOP is formally represented by the equation: Et= pd (t)/pf (t), it provides that the exchange rate
between two countries is simply the ratio of prices of a particular product in the countries. Commodity
arbitrage exists if the Law of Price does not hold. It occurs when the exchange rate implied by
Purchasing Power Parity is different from the actual/ given exchange rate.

It involves the purchase of a particular product/ commodity in the country where

• it is Cheaper (undervalued currency) and

• sell in the country where it is expensive and make arbitrage profit.

Interest rate parity disequilibrium and interest arbitrage opportunity

Interest rate arbitrage exists if the IRP is not holding, that is the interest rate differentials are
inconsistent with the forward premium or discount at a given period of time. The process will involve
borrowing and lending currencies. The arbitrageur will borrow from the country whose currency is
undervalued and invest in the country whose currency is overvalued and convert the investment
proceeds into the first currency borrowed and repay the loan, the difference is arbitrage profit.

(a) Covered interest arbitrage (CIA)

The spot and forward exchange markets are not, however constantly in the state of equilibrium
described by interest rate parity. When the market is not in equilibrium, the potential for “riskless”
arbitrage profit exists. The arbitrager who recognizes such an imbalance will move to take advantage of
the disequilibrium by investing in whichever currency offers the higher return on a covered basis. The
process whereby an investor earns a risk-free profit by

(1) borrowing funds in one currency,

(2) exchanging those funds in the spot market for a foreign currency,

(3) investing the foreign currency at interest rates in a foreign country,

(4) selling forward, at the time of original investment, the investment proceeds to be received at
maturity,

(5) using the proceeds of the forward sale to repay the original loan, and

(6) having a remaining profit balance.

(b) Uncovered interest arbitrage

Investors borrow in countries and currencies exhibiting relatively low interest rates and convert the
proceeds into currencies that offer much higher interest rates. The transaction is “uncovered” because
the investor does not sell the higher yielding currency proceeds forward.

REVIEW QUESTIONS

QUESTION ONE

Given that spot exchange rate between Tanzania and Kenya is TZS 20 to KES 1 and respective annual
rates of inflation are 15% and 10%.

i. Assume the PPP and expectation theory hold, Calculate the rate of foreign exchange expected in
12 months and 12 months forward rate.
ii. If the rate of interest in Tanzania is 20%, what is rate of interest in Kenya?
iii. Given i and ii above demonstrate the Fisher Effect must hold. Calculate the approximate real
rates of interest in each country
QUESTION TWO

Two countries Tanzania and Kenya produce only one good wheat. Suppose the price of wheat in
Tanzania is TZS 2000 and in Kenya is KES 200.

• According to law of one Price what should be the TZS/KES spot rate
• Suppose the prices of wheat over the next year is expected to rise to TZS 2,500 and KES 200.
What will be one year TZS/KES forward rate?
QUESTION THREE

A basket of goods sold at SFr 2,000 in Switzerland when the same basket of goods sold for £ 1,000 in UK.
The current exchange rate is SFr 2.0/£. Over the forthcoming year inflation is estimated to 2% in
Switzerland and 4% in UK.

Required:

i. if the Purchasing Power Parity theory holds what will exchange rate be at the end of the year?

ii. The rate of interest available on a one year government bond in Canada is 5%. A similar bond in
Australia yields 7%. The current spot rate is C$ 1.02/A$

Required

What will be the one year forward rate of the market obeys the Interest Rate Parity?

QUESTION FOUR

In July the one year interest rate is 4% on Swiss Franc and 13% on USD.

Required

a) If the current exchange rate is SF 1=USD 0.63 what is expected future exchange rate in one year.
b) If a change in expectation regarding future US inflation causes the expectation future spot rate
to rise to USD 0.70. What would happen to the USD interest rate according to IFE.
QUESTION FIVE

Suppose the interest rate on the Pound is 15% in London and the interest rate on the comparable
Tanzania Shillings in investment in DSM is 10%. The pound spot rate is TZS 3,300 and the one year
forward rate is TZS 3,100.

Required

a. Are there covered interest arbitrage? Show relevant computation

b. Is the covered interest differential in favourable for investment in London or DSM. (For
calculations assume 1 million units currency can be borrowed and invested)
iii. An investor wishes to invest USD 1,000,000. He do so in the US at 7.5% per annum or in Canada
at 6% per annum. The spot rate is Canadian dollar 1.5311 per US dollar and 90 days forward
rate is Canadian dollar 1.5236 per US dollar. What would you advise the investor?
QUESTION SIX

It is now the beginning of the year 2000. The spot rate for the USD is TZS 2,240 while spot bid-ask
spread is TZS 15. A forecaster provides the following forecasts for the bid-ask spread and inflation rate
for the Tanzania and United States in the next four years

YEAR 2001 2002 2003 2004

BID-ASK SPREAD (TZS) 23 27 30 45

FORECAST RATE OF INFLATION

TANZANIA 6% 5% 4% 3.5%

UNITED STATES 3.5% 3% 3% 2.5%

Required:

On the basis of the bid-ask spread forecasts and the theory of PPP determine the expected exchange
rates and the percentage bid-ask spread for the years 2000-2004.

QUESTION SEVEN

Bing Ltd a UK based company is due to pay 80 Million Lira to Google Ltd. The spot rate is Lira 2,400/£.
Interest rates for the next year are expected to be 8% in the UK and 20% in Italy.

Required:

Assume the International Fisher Effect is valid, evaluate the effect on the sterling cost of this transaction
if Bing Ltd delay payments by one year

QUESTION EIGHT

Hilton a US based Multinational Comp6will receive 2,000,000 Euros in one year time from items it
exported. It did not hedge this transaction, Hilton believes that the future value of the Euro will be
determined by Purchasing Power Parity (PPP). It expects that inflation in countries using Euro will be
12% next year, while inflation in the US will be 7% next year.

The spot rate of Euro is $ 1.46 and the one-year forward rate is $1.50

Required:

a) Estimate the amount of US dollars that Hilton will receive in the one year when converting its
Euro receivables into US dollar
b) The spot rate of the Australian dollar is pegged at $ 0.13. Hilton believes that the Australian
dollar will remain pegged to the US dollar for the next year. If Hilton decides to convert its 2
million Euros into Australian dollar instead of US dollars at the end of one year, estimate the
amount of Australian dollars that Hilton will receive in one year when converting its Euro
receivables into Australian dollars.
QUESTION NINE

a) Using the Exchange rate between the Tanzania Shillings (TZS) and the US dollar (USD) as a case,
discuss any four fundamental causes of exchange rate fluctuations.
b) Explain the meaning of outward covered interest arbitrage and inwards covered interest
arbitrage. Point out a key difference between the two (

QUESTION TEN

Kisukuru Int. Company limited an international firm based in Tanzania has recently observed that a
product called magadi is also obtained in Kenya. A ton of magadi is sold for TSHS 2,000,000 in Meru
Tanzania while the same ton is sold for KZS 125,000 in Nakuru Kenya. Given that the current average
market rate between TSHS/KZS is 17 and that transportation costs between Meru and Nakuru is TSHS
500,000 or (KZS 55,000) per trip; and that the exchange rates are expected to be stable for the
foreseeable future.

REQUIRED :

a. Is commodity arbitrage viable given the above information? Why? (Support your answer with
necessary computations).

b. Calculate total arbitrage profit and profit per tonne (if any) that Kisukuru Int. Company can make, if it
can purchase 100 tons of magadi at any given period from either country.

QUESTION ELEVEN

Currently, the spot exchange rate is TSHS 1500/$ and the three-month forward exchange rate is TSHS
1520/$. The three-month interest rate is 8.0% per annum in the Tanzania and 5.8% per annum in the US.
Assume that you can borrow as much as TSHS 3,000,000 or $ 2,000,000

REQUIRED :

(i) Determine whether the interest rate parity is currently holding

(ii) If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the
steps and determine the arbitrage profit.
iii) Explain how the IRP will be restored as a result of covered arbitrage activities.

QUESTION TWELVE

(a) “Parity theories link exchange rate and other economic variables. Indeed, these variables
influence the value of currency in question”
REQUIRED:

Discuss four factors that cause nation’s currency to appreciate or depreciate.

(b) Kasri Ltd, a Tanzanian import-export firm, learned that a particular type of rice grown in Tanzania,
commonly known as “Super Rice” is also grown in Songaland. A ton of super rice is sold for Songaland
Wan 50,000 while the same ton of rice is sold for TSHS 1,200,000 in Tanzania. Shipping costs (Dar es
Salaam to Songaland and vice versa) amount to US$ 90 per ton. Current exchange rates (mid-rates)
among the three currencies are as follows: TSHS/US$: TSH 1560/$

TSHS/Wan: TSH 52/Wan

Wan/US$: Wan 45/US $

The exchange rates are expected to be stable for the foreseeable future and the firm can import or
export 100 tons of super rice at any given time.

REQUIRED:

(i) With supporting computations, show if the given information presents Kasri Ltd with
arbitrage opportunity.
(ii) If there is a commodity arbitrage opportunity show how Kasri Ltd can exploit it and the profit
that it will make.