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  1 International Parity Relationships and Forecasting FX Rates Chapter Objective:   ã This chapter examines several key international parity relationships, such as interest rate parity and  purchasing power parity. Chapter Outline  Interest Rate Parity  Purchasing Power Parity  The Fisher Effects  Forecasting Exchange Rates 5 Chapter five  2 Interest Rate Parity  IRP: Relationship between nominal interest rates and forward/spot exchange rates or forward premiums  IRP is an zero arbitrage condition.    Arbitrage = the act of buying and selling simultaneously the same or equivalent assets to make a guaranteed (riskless) profit.  If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity.  Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds.  3 Interest Rate Parity Suppose you have $100,000 to invest for one year. 1)invest in Canada at i $  :  Future value = $100,000(1 +  i $ ), or 2)trade your dollars for pound at the spot rate, invest in UK at i £ and hedge your exchange rate risk by selling the future value of the British investment forward. Future value = $100,000(  F  / S  )(1 + i £  ) Since  both investments have the same risk , they must have the same future value  —  otherwise an arbitrage would exist. Therefore, $100,000( F  / S  )(1 + i   £  ) = $100,000(1 +  i  $  ) ( F  / S  )(1 + i   £  ) = (1 +  i  $  ) ( F  / S  ) = (1 +  i  $  ) / (1 + i   £  )  4 Interest Rate Parity Formally, (  F  / S  )(1 + i £  ) = (1 +  i $ ) or if you prefer, IRP is sometimes approximated   as 1  + i £ 1  + i $ = S     F    i $  –    i  £ = S     F  –   S    If i $  >  i  £ then F>S
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