1. Interest Rate Parity &
Purchasing power parity
Presented by
Danish Hasan
Ramiz
Junaid Zamir

2. Interest Rate Parity (IRP)

3. Interest Rate Parity
• The Interest Rate Parity states that the
interest rate difference between two
countries is equal to the percentage
difference between the forward
exchange rate and the spot exchange
rate.

4. • It plays essential role in foreign
exchange markets.
• The difference between the interest
rates in any two countries is the same
as the difference between the forward
and the spot rates of their respective
currencies.

5. • Interest rate parity A currency is worth
what it can earn.
• The return on a currency is the interest rate
on that currency plus the expected rate of
appreciation over a given period.
• When the returns on two currencies are
equal, interest rate parity prevails.

6. Explanation
The relationship can be seen when you follow the
two methods an investor may take to convert
foreign currency into U.S. dollars.
• Option A would be to invest the foreign currency
locally at the risk-free rate for a specific time
period. Then convert the proceeds from the
investment into U.S. dollars at the maturity.
• Option B would be to invest the same dollars in the
(U.S.) market for the same time period. When no
arbitrage opportunities exist, the cash flows from
both options are equal.

7. Mathematically
Rate of return in local Rate of return in foreign
=
currency currency

8. In equilibrium, returns on currencies will be the
same i. e. No profit will be realized
and interest rate parity
exits which can be written
(1 + rh) = F
(1 + rf) S

9. Violation of IRP
If interest rate parity is violated, then an arbitrage
opportunity exists. The simplest example of this is what
would happen if the forward rate was the same as the spot
rate but the interest rates were different, then investors
would:
• borrow in the currency with the lower rate
• convert the cash at spot rates
• enter into a forward contract to convert the cash plus the
expected interest at the same rate
• invest the money at the higher rate
• convert back through the forward contract
• repay the principal and the interest, knowing the latter will be
less than the interest received.

10. Implications of IRP
• If domestic interest rates are less than
foreign interest rates, you will invest
in foreign country at higher interest
rates.
• Domestic investors can benefit by
investing in the foreign market

11. Implications of IRP
• If domestic interest rates are more
than foreign interest rates, you will
invest in domestic market at higher
interest rates
• Foreign investors can benefit by
investing in the domestic market

12. Purchasing power parity (PPP)

13. Purchasing power parity (PPP)
The purchasing power of a country’s
currency. The number of units of
currency required to purchase a
basket of goods in Pakistan and the
same basket of goods and services
that a USD would buy in United states.

14. Need for PPP
• Because the exchange rates only
reflects when goods are traded. Also,
currencies are traded for purposes
other than trade in goods and
services, e.g., to buy capital assets.
Also, different interest rates,
speculation or interventions by central
banks can influence the foreign-
exchange market.

15. Purpose
• Differences in living standards
between nations because PPP takes
into account the relative cost of living
and the inflation rates of the
countries,

16. Assumption
• In the absence of transportation and
other transaction costs, competitive
markets will equalize the price of an
identical good in two countries when
the prices are expressed in the same
currency.

17. Example
• For example, a TV set that sells for 750 Canadian
Dollars [CAD] in Vancouver should cost 500 US
Dollars [USD] in Seattle when the exchange rate
between Canada and the US is 1.50 CAD/USD. If
the price of the TV in Vancouver was only 700 CAD,
consumers in Seattle would prefer buying the TV
set in Vancouver due to which the US consumers
buying Canadian goods will bid up the value of the
Canadian Dollar, thus making Canadian goods
more costly to them. This process continues until
the goods have again the same price.

18. Fluctuations
• PPP rate fluctuations are mostly due to
different rates of inflation in the two
economies which would result in the
difference in prices at home and
abroad

19. Reasons for different measures
The main reasons why different measures
do not perfectly reflect standards of living
are:
• PPP numbers can vary with the specific
basket of goods used, making it a rough
estimate.
• Differences in quality of goods are hard to
measure and thereby reflect in PPP.

20. Range and quality of goods
• Local, non-tradable goods and services (like
electric power) that are produced and sold
domestically.
• Tradable goods such as non-perishable
commodities that can be sold on the
international market

21. Rank Country GDP (PPP) $M
1 United States 14,264,600
2 China 7,916,429
3 Japan 4,354,368
4 India 3,288,345
5 Germany 2,910,490
6 Russia 2,260,907
27 Pakistan 439,558
List by the International Monetary Fund (2008)

22. Factors effecting
IRP and PPP

23. Factors of PPP
• Technology
• Luxury goods
• Raw materials
• Energy prices

24. Factors for IRP
Factors that influence the level of market
interest rates include:
- Expected levels of inflation
- General economic conditions
- Monetary policy
- Foreign exchange market activity
- Foreign investor
- Levels of sovereign debt outstanding
- Financial and political stability

25. Formulas
Fo = forward rate
} IRP
So = current spot rate
ic = interest rate in country c
ib = interest rate in country b
S1 = expected spot rate
} PPP
So = current spot rate
ic = expected inflation rate in country c
ib = expected inflation rate in country b

26. Question
IRP
A Canadian company is expected to receive
Kuwaiti dinars in 1 years time. The spot rate
is CAD/Dinar 5.4670. The company could
borrow in dinars at 9% or in Canadian
dollars at 14%. There is no forward rate for
one year’s time. Predict what the exchange
rate is likely to be in one year

27. Solution
So = 5.4670
ic = 14% or 0.14
ib = 9% or 0.09
F = 5.4670 x (1 + 0.14)
(1 + 0.09)
F = 5.7178

28. Question
PPP
The spot exchange rate between UK sterling
and Danish kroner is £1 = 8 kroners.
Assuming that there is now purchasing
parity an amount of commodity costing
£110 in UK will cost 880 kroners in
Denmark. Over the next year price inflation
in denmark is expected to be 5% while in UK
it is expected to be 8%. What is the
expected spot exchange rate at the end of
the year?

29. Solution
So = 8
ic = 5% or 0.05
ib = 8% or 0.08
S1 = 8 x (1 + 0.05)
(1 + 0.08)
S = 7.78
1

30. UK price = £110 x 1.08= £118.80
Danish price = 880 x 1.05= 924 Kroner
= 924 = 7.78
118.80

31. Thank you