THE ECONOMICS OF FOREIGN

EXCHANGE MARKET
OR PARITY RELATIONSHIPS
BY
Goodhope Mkaro
MBA(Finance), B.com-Acc(Hons),PGD
in Tax Mgt, CPB, CISI(UK),I.P, CPA(T)

Topic 6 1
 Theories of Foreign
Exchange Market
• The Theory of Purchasing Power
Parity
• The Fisher Effect
• The International Fisher Effect
• The Theory of Interest-Rate Parity
• The Forward Rate and the Future
Spot Rate Topic 6 2
There are Five Parity Relationships Thories
• 1.PURCHASING POWER PARITY(PPP)
• This is based on the Law of One Price (LOP)
• According to this law, if transportation costs
are relatively small, the price of an
internationally traded commodity must be
the same in all locations (Ceteris peribus)
• There are two types /versions of the PPP:
–Absolute Version (LOP)
–Relative Version
Topic 6 3
 The PPP Theory-Absolute Version
 The absolute version of the PPP theory
maintains that the equilibrium exchange
rate between domestic and foreign currencies
equals the ratio between domestic and
foreign prices.(PD(t)/PF(t)
i.e. Et =PD(t)/PF(t)
Where:-
PD(t)=Domestic price of a particular
commodity at time ‘t’
PF(t)=Foreign price of a particular commodity
at time ‘t’ Topic 6 4
 The PPP Theory-Absolute Version
E(t) = Expected exchange rate at time ‘t’
Hence according to the absolute version, the
currency has the same purchasing power
world-wide
Example:-
How many TZS equals to one US Dollar if,
 A basket of maize grain in Tanzania, costs
TZS 20,000 and 10 USD in the USA?
 If PPP holds Et =PD(t)/PF(t)

 Hence Et = TZS20,000/US$10

• = TZS2000/US$
Topic 6 5
 The PPP Theory-Absolute Version
Example
How many TZS equal one US Dollar if,
Price of a basket of grain in Tanzania

increases from TZS 20,000 to 23,000

while in the US the price is USD 10?
Et = PD(t)/PF(t)

 =TZS 23,000/USD 10

 = TZS 2,300/US$
Topic 6 6
 The PPP Theory-Absolute Version
 What is the Implication of the Absolute
Version?

 If the purchasing power of the foreign

currency is always the same at home and
abroad, then the exchange rate would be
constant.

 The nominal exchange rate between the

currencies of two countries must reflect the
different price levels in those countries and
the real exchange rate would be equal to 1.
Topic 6 7
PPP THEORY-RELATIVE VERSION
Relative inflation rate levels and
trends can predict relative
exchange rate movements
–PPP suggests that changes in
relative prices between countries
will lead to exchange rate
changes.
Topic 6 8
 PPP THEORY-RELATIVE VERSION
 In the long run, the currencies of countries that
experience significant inflation will tend to
devalue relative to the currency with lower inflation
rate and vice versa.
 Inflation: simply means, a general increase in price
levels.
 Et = (1 + ih)
E0 (1 + if)
 Note that, in forecasting for exchange rate, using the
Relative version, there are two sub-versions:-
Topic 6 9
 PPP THEORY-RELATIVE VERSION
1. The Mult-period version
2. The single-period version
• Application of the multi-period version is
recommended whenever inflation level forecasts are
constant. As such the formular will appear as
follows:-
 Et = (1 + ih)
t

E0 (1 + if)
• Where Et =Expected excange rate
• Eo =Spot exchange rate
Topic 6 10
 PPP THEORY-RELATIVE VERSION
• ih = Home inflation rate or inflation rate of a
quoted currency
• if = Foreign inflation rate or inflation rate of a
base currency
• Recall that, given an exchange rate, say of
TZS2200/US$, you should remember that
TZS is a quoted currency while US$ is a base
currency.
• It is therefore advised to get used of quoted
and base currency in order to avoid some
Topic 6 11
technical errors.
 Example 1: Suppose that the annual inflation rate
is expected to be 8% in the Eurozone and 2% in the
U.S. The current exchange rate is $1.20/€. What
would the expected spot exchange rate be in six
months for the euro?
 Answer: Et /E0 = (( 1 + iquoted) ÷ (1 + ibase))t
 Here, USD =Quoted currency, Euro=base currency
 E0.5 /E0 = (( 1 + ius$) ÷ (1 + ieuro))0.5
 = E0.5 ÷ $1.20 per euro = (1.02 ÷ 1.08)0.5
 Which implies S0.5 = (1.20) × 0.97 = 1.16
 So the expected spot exchange rate at the end of
six months would be $1.16 /EURO. 12
 Alternatively:-
 Et/Eo =(1 + 0.01) / (1 + 0.04)
 Et = 1.2 ((1 + 0.01) / (1 + 0.04))

 E6 months =1.2 X 0.97 = $1.16 /EURO

 Example 2: Suppose that the annual inflation rate

is expected to be 10% in Tanzania and 4% in the
U.S for the next three years. The current exchange
rate is TZS2200/US$. What would the expected
spot exchange rates be for the next three years?
 Recall that, if PPP holds:-
 Et = (1 + ih)
t
E0 (1 + if) Topic 6 13
 Multi-Period Version cont……
 Hence Et = Eo((1 + ih) / (1 + if))t
 Year one: E1 =2200 X ((1 + 0.1)/(1 + 0.04))1
E1 = TZS 2,327/US$

 Year two:E2 = 2200 X ((1 + 0.1)/(1 + 0.04))2

E2 = TZS 2,461/US$

 Year 3: E3 = 2200 X ((1 + 0.1)/(1 + 0.04))3

E1 = TZS 2,603/US$
14
 Single-Period Version cont: This version is
applied whenever inflation rates are not constant
hence the formula should suitably be adjusted to
read:-
 Et = (1 + ih)
Et-1 (1 + ih)
 Example 3: Suppose that the annual inflation rates
are expected to be 10% in Tanzania and 4% in the
U.S for year 1, and 12% and 5% in year two, and
14% and 6% in year three for TZ and US
respectively. The current exchange rate is
TZS2200/US$. What would the expected spot
exchange rates be for the next three years? 15
 Hence the approximation formula of the
Relative version of PPP states that:-
 Et – EO = ih - if
EO
• The above equation implies that, if PPP holds;
exchange rate differences should be equal to
inflation rate differences between two countries.
 Example. Given the spot rate of TZS 20/KES
and the expected exchange rate in one year is
TZ30/KES. Required:If the inflation rate in TZ
is 10%, what is the expected inflation rate in
Kenya? 16
 Solution:If PPP holds:-
 Et = (1 + ih)
Et-1 (1 + if)
 Note that ih = iQuoted currency & if = iBase currency
 Hence Et = Et-1(1 + ih) / (1 + if)
 Year one:E1 = E0(1 + ih) / (1 + if)
 E1 =2,200 (1+0.1)/(1+ 0.04) =TZS2,327
 Year two:E2 = E1(1 + ih) / (1 + if)
 E2 =2,327 (1+0.12)/(1+ 0.05) =TZS2,482
 Year three:E3 = E2(1 + ih) / (1 + if)
 E3 =2,482 (1+0.14)/(1+ 0.06) =TZS2,669
17
 Relative PPP Theory Cont…
• All in all the relative version of the
purchasing power parity
concludes that, currencies bearing
high inflation rate will devalue
relative with currencies bearing
lower inflation and vice versa.

18
 Food for Thought

Find out the empirical

tests of the Relative PPP
theory.

Topic 6 19
Some Asumptions and Challenges of PPP
• The PPP assumes that goods are easily
traded. But this is not the case for such
goods as housing and medical services.
• PP assumes that, theere is no transaction
cost the thing which is not true.
• The PPP theory assumes that tradable
goods are identical across countries.
However, some goods are of superior
quality and taste than others.
20
 Some Asumptions and Challenges of PPP
 It is not possible to compare a similar
basket of goods in each country with its
trading partners in order to test the PPP
theory.
 Many other factors influence exchange
rates besides relative prices, the core factor
being the forces of demand and supply.
 Difficult to establish which one comes first,
price change or exchange rate change? (egg
and chicken parable) 21
 The Fisher Effect
• The Fisher Effect assumes that the real
interest rate is the same across all countries
as such nominal interest rate in a respective
country is equal to a real interest rate plus an
expected rate of inflation such that:-
1+r =(1+a) (1+i)
r= ((1+a) (1+i)) -1
Where; r = nominal interest rate
a = real interest rate
i = inflation rate 22
 The Fisher Effect
• Hence the approximaion formula states
that:- Nominal Interest Rate = Real
Interest Rate + Inflation
• i.e. r = a + i
• The nominal interest rate embodies an
inflation premium sufficient to compensate
lenders or investors for an expected loss of
purchasing power. Consequently, nominal
interest rates are higher when people
expect higher rates of inflation and vice
versa. 23
 The Fisher Effect Cont…
 The real interest rate in one country is
thought to be relatively stable over time.
Hence currency bearing high inflation rate
will bear higher interest rate and vice
versa.
 Hence: rh - rh = ih - ih
Food for Thought
What are the implications and
Challenges of the Fisher Effect Theory?
 The Fisher Effect
• Example:Given the spot exchange rate
between Tanzania and Kenya is Tsh 20 to
Ksh and respective annual rates of inflation
are 15% and 10%. Required:-
• (i) If the rate of interest in Tanzania is 20%
what is the rate of interest in Kenya?
• (ii) Given i and ii above demonstrate the
Fisher Effect must hold calculate the
approximate real rates of interests in each
country 25
 THE INTERNATIONAL FISHER EFFECT (IFE)
• In the long run a future spot rate of a
currency with a higher interest rate
should depreciate relative to the
currency with a lower interest rate and
vice vesa.
• The International Fisher Effect states
that the future spot rate should move in
an amount equal to, but in a different
direction from, the difference in interest
rates between two countries. 26
 The International Fisher Effect Cont…
 The International Fisher Effect holds that the
interest differentials between two countries should
be equal to the future change in the spot rate.
 In the same stance as for the case of the relative
version of PPP, there are two versions,:-
 1. The multi-period version: Applied if interest
rates are estimated to be constant through out. Such
that:-
• Et = (1 + r )
t
h
E0 (1 + rf)
 Note that, rh= rQuoted while rf = rBase
27
 The International Fisher Effect Cont…
• 2. The single period version is applied
whenever interest rates are not constant suh
that:-
• Et = (1 + rh)
Et-1 (1 + rf)
• Note that; rh = rQuoted while rf = rBase
• The IFE combines both the PPP and the
Fisher effect, as it explains the relationship
between real interest rate, nominal interest
rate (inflation rate inclusive) and exchange
rate. 28
 The International Fisher Effect Cont…
• Hence the approximation formula of
the IFE states that:-
• Et – EO = rh - rf
EO
• The above equation implies that, if IFE
holds; exchange rate differences will be
equal to interest rate differences
between two countries.
29
• Example 1: If annual interest rates are expected to
be 20% in Tanzania and 10% in the U.S. The current
spot rate is TZS2200/US$. What would the expected
spot exchange rates be for the next three years?
• Hints: Use similar approach as for the case of PPP
• Example 2: Suppose that the annual interes rates
are expected to be 20% in Tanzania and 10% in the
U.S for year 1, and 22% and 12% in year two, and
25% and 14% in year three for TZ and US
respectively. The current exchange rate is
TZS2200/US$. What would the expected spot
exchange rates be for the next three years?
• Hints: Use similar approach as for the case of PPP30
 THE THEORY OF INTEREST-RATE PARITY
• According to the interest parity theory, the
spread between a forward rate and a spot
rate should be equal but opposite in sign to
the difference in interest rates between two
countries.
• In other words, the interest-rate parity theory
holds that the difference between a forward
rate and a spot rate equals the difference
between a domestic interest rate and a
foreign interest rate.
31
 THE THEORY OF INTEREST-RATE PARITY
• 2. The single period version applies
whenever interest rates are not constant
suh that:-
• Ft = (1 + rh)
Et-1 (1 + rf)
• Note that; rh = rQuoted while rf = rBase

32
 THE THEORY OF INTEREST-RATE PARITY
 In the same stance as for the case of the
relative version of PPP, there are two
versions of the IRP:-
 1. The multi-period version: Applies if
inerest rates are estimated to be constant
through out. Such that:-
• Ft = (1 + rh) t
E0 (1 + rf)
 Note that, Ft =Forward rate, and, rh=
rQuoted while rf = rBase 33
 THE THEORY OF INTEREST-RATE PARITY
• Hence the approximation formula of the
IRP states that:-
• Ft – EO X 12/N or 360/N days = rh - rf
EO
• The above equation implies that, if IRP
holds; Forward PM or Discout will be
equal to interest rate differences
between two currencies.
• Hints: Similar approach as for PPP & IFE
34
 THE THEORY OF INTEREST-RATE PARITY
• One of the uses of the Interest Rate
Parity is to establish as to whether
covered interest rate arbitrage exists or
not.
• To do so, one needs to compare the fwd
PM or Disc against interest rate
differences.
• Should there be differences between the
two, then it is possible to make arbitrage
profit. 35
 THE THEORY OF INTEREST-RATE PARITY
• The phrase Covered interest rate
arbitrage implies that the interest
rate transactions are covered
through a forwad contract in order to
avoid exchange rate loss at the end
of the arbitrage process.
• Qn. Differentiate between the
covered and uncovered interest
36
 THE THEORY OF INTEREST-RATE PARITY
• Example: Given the spot rate TZS 2000/US$
and 2 months fwd rate of TZS 2200/US$.
Given also that the TZS interest rate is 10%
while on US$ is 4%. Required.
• (i) Compute the two months forward pm or
discount on USD relative to TZS.
• Solution (i): Annualized Fwd PM or Disc
• ((Ft-Eo)/Eo) X 360/n or 12/n X 100
• ((2200-2000) /2000) X 12/2 X100 =60%
37
 THE THEORY OF INTEREST-RATE PARITY
• Hence US$ is trading at a forward premium of
60% relative to TZS.
• (QN iii)-Home work: What is the PM or Disc
on TZS?
• Hints: Convert TZS into a base currency then
proceed using the same formula.
• (QN iv): If Interest Rate Parity holds; is it true
that, the currency with a higher interest rate
trades at a forward discount relative to the
one bearing lower interest rate? 38
 THE FORWARD RATE AND THE FUTURE SPOT RATE
• According to this theory, Forward rate is
regarded as unbiased predictor of future
spot rate.
• i.e. Ft = Et
• If speculators think that a forward rate is
higher than their prediction of a future
spot rate, they will sell the foreign
currency forward.
39
 THE FORWARD RATE AND THE FUTURE SPOT RATE
• This speculative transaction will bid down the
forward rate until it equals the expected
future spot rate.
• By the same token, if speculators believe that
a forward rate is lower than an expected
future spot rate, they will buy a foreign
currency forward.
• This speculative transaction will bid up the
forward rate until it reaches the expected
future spot rate.
40
 Arbitrages
• Geographic Arbitrage
• Triangular Arbitrage

Topic 6 41
 Arbitrages
• Generally, Arbitration is the purchase of
something in one market and its sale in
another market to take advantage of a
price differential.
• In as far as forex is concerned,
professional arbitragers quickly transfer
funds from one currency to another in
order to profit from discrepancies
between exchange rates in different
markets. 42
 Types of Arbitrage
• 1. Geographic arbitrage: This could
arise when local demand-and-supply
conditions might create temporary
discrepancies among various
markets.
• Arbitrage specialists would buy the
currency in a market where its price
is lower and then sell the currency
where its price is higher. 43
 2. Triangular Arbitrage
• A three-point arbitrage, commonly
known as a triangle arbitrage, is the
arbitrage transaction among three
currencies.
• This type of arbitrage can occur if any of
the three cross rates is out of line.
• You will only be able to make arbitrage
profit if the underlying currency of
ivestment is undervalued by the market.
44
 2. Triangular Arbitrage
• Eg.Consider the following quotations:-
-TZS2,000/US$
-KES 100/US$
-TZS 25/KES
Required:-
(i) Are there arbitrage opportunities?
(ii) Suppose an investor has TZS 1,000,000,000
to invest in the forex market. Show the
arbitrage process and compute the
arbitrage profit. 45
• Solution
• Since the investor has got TZS
1,000,000,000 to invest, we need to test
the cross rate only to make sure that TZS
is undervalued.
• Recall that, you will only be able to make
arbitrge profit if the underlying currency
is undervalued by the market.
• This type of arbitrage can occur if any of
the three cross rates is out of line.
Topic 6 46
• Step 1: Cross rate between TZS and KES
• Given TZS 2000/US$ and KES 100/ US$
• TZS/KES??
• TZS2000/US$ ÷ KES100/US$
• TZS2000/US$ X US$/KES100
• Hence the cross rate is TZS20/KES
• Comparison:-
• Cross rate TZS20/KES
• Actual market rate TZS25/KES
• Which currency is undervalued by the mkt?
47
• Conclusion: Since the cross rate is not
equal to the actual market rate, then
arbitrage opportunity exists.
• We also observe that TZS is undervalued
by the market while KES is overvalued as
such it is worthwhile investing in TZS.
• Solution(ii)
• Step 1: Sell TZS 1bil in order to obtain the
common currency (USD). i.e. the common
currency between the above two
exchange rates.(TZS and KES) 48
• Given: TZS 2000=US$
TZS 1bil =?
• (TZS 1,000,000,000 X US$) ÷ TZS2,000
=USD 500,000
• Step two: Sell the above USD 500,000 in
order to obtain the second currency
(KES).
• Given KES 100 = US$
? = US$ 500,000
49
• (US$500,000 X KES100) ÷ US$=KES 50M
• Step 3: Sell the above KES 50m in order
to obtain back the first currency (i.e.
the currency of investment, TZS)
• Given: TZS 25=KES
? = KES 50 M
• (TZS25 X KES50M) ÷ KES
= TZS 1,250,000,000
50
• Hence: Arbitrage profit =Proceeds at
end – Amount invested.
• TZS 1,250,000,000 –TZS1,000,000,000
=TZS 250,000,000
• Thanks for listening. May GOD Bless you.

51