Dr Shamol Miah

In international finance, the Parity Theorem refers to several principles that govern the relationship between exchange rates, interest rates, and inflation rates. These principles are crucial for understanding the behavior of currency values and the implications for international trade and investment.

Covered Interest Rate Parity (CIP)

CIP is a concept in finance that essentially says that when you take into account both interest rates and exchange rates, there shouldn’t be an opportunity for risk-free profits by investing in different currencies. Let’s break it down with a simple example:

Imagine you have $1,000 and you want to invest it. In the US, you can invest it in a bank and earn 5% interest over a year. Alternatively, you could convert your $1,000 into euros and invest it in a European bank, where you can earn 4% interest over a year.

Now, let’s say the current exchange rate is such that 1 US dollar equals 0.90 euros. So, if you convert your $1,000 into euros, you’ll get 900 euros.

Here’s where Covered Interest Rate Parity comes into play. According to CIP, if you take into account both the interest rates and the expected exchange rate change, you shouldn’t be able to make a risk-free profit.

In this example, if CIP holds true, then the return you get from investing in the US (5% interest) should be the same as the return you get from investing in Europe (4% interest plus any expected change in the exchange rate). In other words, you shouldn’t be able to make more money by choosing one option over the other.

To ensure this equilibrium, you can use forward contracts. A forward contract is an agreement to exchange currencies at a predetermined rate at a future date.

So, let’s say you decide to convert your $1,000 into euros and invest it in Europe. At the same time, you enter into a forward contract to convert your euros back into dollars after one year at a predetermined exchange rate.

If CIP holds true, the forward exchange rate should be such that when you convert your euros back into dollars at the end of the year, you end up with the same amount of money as if you had invested in the US.

This is the essence of Covered Interest Rate Parity – ensuring that there are no risk-free profits to be made by exploiting differences in interest rates and exchange rates once you take into account forward contracts.

Uncovered Interest Rate Parity (UIP)

UIP is a concept in finance that helps us understand how interest rates and exchange rates are related. Let’s break it down in simple terms:

Imagine you have $1,000 and you’re thinking about what to do with it. In the US, you could invest it in a bank and earn 5% interest over a year. Alternatively, you could convert your $1,000 into euros and invest it in a European bank, where you can earn 4% interest over a year.

Now, here’s where Uncovered Interest Rate Parity comes into play. According to UIP, if you invest in a country with a higher interest rate, you should expect to earn a higher return to compensate for any expected change in the exchange rate between the two currencies.

So, in our example, if you decide to invest in Europe where the interest rate is lower (4%), UIP suggests that you should expect the euro to appreciate against the dollar over the year. Why? Because investors will be attracted to the higher interest rate in the US (5%), causing demand for dollars to increase, thus pushing up the value of the dollar relative to the euro.

Conversely, if you invest in the US where the interest rate is higher (5%), you should expect the dollar to depreciate against the euro over the year. This is because investors in Europe will be selling euros to buy dollars to take advantage of the higher interest rate in the US, thus increasing the supply of euros and decreasing their value relative to the dollar.

So, in summary, Uncovered Interest Rate Parity tells us that differences in interest rates between countries should be offset by expected changes in exchange rates, ensuring that investors don’t have an advantage by investing in one currency over another.

The Fisher Effect

The Fisher Effect is a simple yet powerful concept in economics that helps us understand the relationship between nominal interest rates, real interest rates, and inflation. Let’s break it down with a simple example:

Imagine you have $100 in your pocket, and you’re trying to decide whether to keep it there or put it in a savings account. If you put it in a savings account, you’ll earn some interest on it. Let’s say the nominal interest rate offered by the bank is 5% per year.

Now, here’s where the Fisher Effect comes in. The nominal interest rate is the rate the bank advertises, but what you really care about is how much your money will grow in terms of purchasing power after accounting for inflation. Inflation is the rate at which prices for goods and services are rising.

Let’s say the inflation rate is 2% per year. This means that, on average, prices are increasing by 2% each year.

The Fisher Effect tells us that the nominal interest rate is composed of two parts: the real interest rate and the expected inflation rate. In our example:

Nominal Interest Rate = Real Interest Rate + Inflation Rate

So, if the nominal interest rate is 5% and the inflation rate is 2%, then the real interest rate must be:

Real Interest Rate = Nominal Interest Rate – Inflation Rate = 5% – 2% = 3%

This means that after accounting for inflation, your money is actually growing at a rate of 3% per year in terms of purchasing power.

Now, let’s say you decide to put your $100 in the savings account for one year. After one year, your money will have grown by 5%, so you’ll have:

$100 + (5% of $100) = $100 + $5 = $105

However, because prices have gone up by 2% due to inflation, your purchasing power has actually only increased by 3%. So, in terms of what you can buy with your money, it’s as if you have $103 at the end of the year.

This example illustrates how the Fisher Effect helps us understand the relationship between nominal interest rates, real interest rates, and inflation, and why it’s important to consider inflation when making financial decisions.

The International Fisher Effect (IFE)

IFE is an economic concept that extends the Fisher Effect to international markets, taking into account exchange rates between currencies. Let’s break it down with a simple example:

Imagine two countries, Country A and Country B, each with their own currency, let’s say the dollar for Country A and the euro for Country B.

Now, let’s say Country A’s nominal interest rate is 5% per year, and Country B’s nominal interest rate is 4% per year.

At first glance, it might seem like you’d want to invest your money in Country A because it offers a higher nominal interest rate. However, the International Fisher Effect tells us that we need to consider not just the nominal interest rates, but also the expected changes in exchange rates between the two currencies.

Let’s say that investors expect the dollar to depreciate relative to the euro by 2% over the next year. This means that if you were to convert dollars into euros today, you’d get fewer euros in a year’s time due to the expected depreciation of the dollar.

Now, let’s apply the International Fisher Effect:

In Country A (with the dollar), the real interest rate would be:

Real Interest Rate (Country A) = Nominal Interest Rate (Country A) – Expected Inflation Rate (Country A) = 5% – 2% = 3%

In Country B (with the euro), the real interest rate would be:

Real Interest Rate (Country B) = Nominal Interest Rate (Country B) – Expected Inflation Rate (Country B) = 4% – 0% (let’s assume there’s no expected inflation in Country B) = 4%

According to the International Fisher Effect, investors should expect to earn the same real return regardless of where they invest their money after accounting for expected changes in exchange rates.

So, even though the nominal interest rate in Country A is higher, the expected depreciation of the dollar reduces the real return. Therefore, investors would expect to earn the same real return whether they invest in Country A or Country B.

This example illustrates how the International Fisher Effect helps investors understand how nominal interest rates and expected exchange rate changes interact to determine real returns in international investments.

Purchasing Power Parity (PPP)

PPP is a concept in economics that helps us understand how exchange rates between currencies should adjust to equalize the purchasing power of different currencies. Let’s explain it with a simple example:

Imagine you’re traveling from the United States to Europe, and you want to buy a bottle of water. In the US, the price of a bottle of water is $1. Now, let’s say the exchange rate between the US dollar and the euro is such that 1 dollar equals 0.90 euros.

So, if you were to convert your $1 into euros and buy a bottle of water in Europe, you’d get 0.90 euros. Now, according to Purchasing Power Parity, if markets are efficient and there are no barriers to trade, the price of a similar bottle of water in Europe should also be 0.90 euros.

However, let’s say you find out that the actual price of a bottle of water in Europe is 1 euro. This means that the euro is overvalued relative to the dollar because it’s more expensive to buy the same good in Europe compared to the US.

According to PPP, this situation should not persist in the long run. Arbitrageurs, who are people who buy and sell goods to take advantage of price differences, will notice that they can buy bottles of water cheaply in the US and sell them at a higher price in Europe. This buying pressure on US goods will increase demand for dollars, causing the dollar to appreciate relative to the euro.

As the dollar appreciates, it will take fewer dollars to buy 1 euro. Eventually, the exchange rate will adjust such that 1 dollar equals 1 euro, and the price of a bottle of water will be the same in both countries when measured in the same currency.

So, in summary, Purchasing Power Parity tells us that exchange rates between currencies should adjust to ensure that identical goods cost the same when expressed in the same currency, taking into account exchange rate movements.

Absolute Purchasing Power Parity (APPP)

APPP is a theory in economics that suggests that the exchange rate between two currencies should equal the ratio of the price levels in the two countries. Let’s break it down with a simple example:

Imagine there are two countries, Country A and Country B, and they each have their own currency. Let’s call the currency of Country A “A-dollars” and the currency of Country B “B-euros.”

According to Absolute Purchasing Power Parity, if the exchange rate between A-dollars and B-euros is 2 (meaning 1 A-dollar equals 2 B-euros), then the price level of goods and services in Country A should be twice as high as the price level in Country B.

For example, let’s say in Country A, the price of a loaf of bread is 2 A-dollars. According to Absolute PPP, the price of the same loaf of bread in Country B should be 1 B-euro (half of the price in Country A) for the exchange rate to be in line with Absolute PPP.

Here’s how it works:

• If the price of the loaf of bread in Country A is higher than 1 B-euro (the equivalent price in Country B), it means that goods are relatively more expensive in Country A compared to Country B. In this case, according to Absolute PPP, the exchange rate should decrease (meaning 1 A-dollar would be worth less than 2 B-euros) to bring the prices in line with each other.
• Conversely, if the price of the loaf of bread in Country A is lower than 1 B-euro (the equivalent price in Country B), it means that goods are relatively cheaper in Country A compared to Country B. In this case, according to Absolute PPP, the exchange rate should increase (meaning 1 A-dollar would be worth more than 2 B-euros) to bring the prices in line with each other.

In essence, Absolute Purchasing Power Parity suggests that exchange rates should adjust to make the purchasing power of different currencies equal. However, it’s worth noting that in reality, various factors such as transaction costs, tariffs, and non-tradable goods can cause deviations from Absolute PPP.

Relative Purchasing Power Parity (RPPP)

RPPP is a theory in economics that suggests that changes in exchange rates between two currencies should reflect changes in the price levels of those two countries. Let’s break it down with a simple example:

Imagine there are two countries, Country A and Country B, and they each have their own currency. Let’s call the currency of Country A “A-dollars” and the currency of Country B “B-euros.”

According to Relative Purchasing Power Parity, if the exchange rate between A-dollars and B-euros changes over time, it should reflect changes in the price levels between the two countries.

For example, let’s say initially, 1 A-dollar equals 2 B-euros. Now, let’s suppose prices in Country A start to rise faster than prices in Country B. This means that goods and services in Country A become relatively more expensive compared to Country B.

According to Relative PPP, in order to maintain parity, the exchange rate should adjust so that 1 A-dollar is worth fewer B-euros. This would make goods and services in Country A relatively more expensive for people holding B-euros, reflecting the increase in prices in Country A.

Conversely, if prices in Country A start to rise more slowly than prices in Country B, goods and services in Country A become relatively cheaper compared to Country B. In this case, according to Relative PPP, the exchange rate should adjust so that 1 A-dollar is worth more B-euros. This would make goods and services in Country A relatively more attractive for people holding B-euros, reflecting the slower increase in prices in Country A.

In summary, Relative Purchasing Power Parity suggests that changes in exchange rates should reflect changes in the relative price levels between countries over time. However, like Absolute PPP, it’s important to note that various factors can cause deviations from Relative PPP in real-world situations.

Summary

Overall, the Parity Theorem provides a framework for understanding the interplay between exchange rates, interest rates, and inflation rates in international finance. It helps economists, policymakers, and investors analyze and predict movements in currency values and make informed decisions in the global financial markets.

References

Levi, M. D. (2009). International finance. 5th ed. New York, NY: Routledge.

Moffett, M. H., Stonehill, A. I., & Eiteman, D. K. (2020). Fundamentals of Multinational Finance, Global Edition. Pearson Higher Education.

Pılbeam, K. (2013). International Finance. https://doi.org/10.1007/978-1-137-11637-6.

Shapiro, A. C., and Hanouna, P. (2019). Multinational Financial Management. John Wiley & Sons.