FOREX

Converting €1 million at an exchange rate of €.70 to $1.00 would mean that you had $1,430,000.00:
If 1.0 dollars = .70 euros, then 1 euro= 1.43 dollars:
1 ÷ .70 = 1.42857 or 1.43 $/€
€ 1million * 1.43 $/€ = $1,430,000.00
If you left the €1 million in an Irish bank for one year at 2% you would make €20,000.00:
€1 million * .02 = € 20,000.00, so you would have €1,020,000.00
If you put the $1,430,000.00 in a U.S. bank at 4% you would make $57,200.00:
$1,430,000.00 * .04 = $57,200.00, so you would have $1,487,000.00
If in one year you took the €1,020,000.00 and cashed it in at a rate of €.65 to $1.00 you would have $1,570,800.00. If 1.0 dollars = .65 euros, then 1 euro= 1.54 dollars:
1 ÷ .65 = 1.53846 or 1.54 $/€
€1,020,000.00 * .1.54 $/€ = $1,570,800.00

Due to the foreign exchange rate you would have been better off leaving the money in euros even though the interest rate was half that of the U.S. interest rate.

Going backwards, if you have 1.43 $/€ then you have .70 €/$, and if you have 1.54 $/€ you have .65 €/$, you have you therefore have more dollars per euro at this exchange rate. You are only receiving 65 euros for every American dollar, as opposed to one year ago when you were receiving 70 euros for every American dollar. According to the theory of purchasing power parity, this would mean that the inflation rate was 7.69% higher in the U.S. than in Europe over this period of time and you would be better off leaving your money in euros:
Inflation rate = 100 * (.70 – .65)/.65 = 7.69%

Banks, corporations, and individuals use covered interest arbitrage as a hedging technique to protect themselves against the fluctuations in the foreign currency exchange market. An investor buys a financial instrument in a specified foreign currency and then at the same time buys a forward foreign exchange contract to convert this currency to another currency. The forward exchange contract would be due at the time of the maturity of the financial instrument and would allow him to convert the principle and interest back to a specified denomination. If at the time of maturity the foreign exchange market isn’t conducive to exchanging the currency, then the investor can choose not to exercise the forward exchange option and can allow the funds to remain in the foreign currency. This allows individuals to repatriate investment currency to their native economies when the exchange rates are optimal. Interestingly, 2009 was the final phase out year for repatriation of dividends under the American Jobs Creation Tax Act of 2004 at a preferred tax rate of 6% of their qualified production activities income; (it had previously been at 3% for the tax years 2005 and 2006), the subsequent repatriation tax rate for dividends from 2010 onward is 9%, (BNA, 2010). This left corporations in the difficult position last year of deciding either to repatriate foreign dividends when the dollar was strong against foreign currency in virtually every market, causing them to lose in the foreign exchange market in order to gain a preferred tax rate, or to leave these investments in foreign currencies with the prospect of obtaining a better foreign exchange rate, and to face a more extreme repatriation tax rate in the future.

Absolute purchasing power parity, (PPP), or the law of one price, is the idea that the pricing for a specific good or service should be the same in every country at the same given time, (Appleyard, Field, & Cobb, p.485). Absolute PPP disregards tariffs and other trade restrictions, transportation costs, and the fact that good and services are not comparable from one country to another, therefore economists often use a scaled down version called relative purchasing power parity that accounts for these discrepancies. As seen in the example above regarding the euro exchange, purchasing power parity is used to compare inflation rates across different countries by comparing the changes in their currencies values to one another.

References:

Appleyard, D., Field, A., & Cobb, S. (2010). International economics (7th ed.). New York: McGraw-Hill Irwin.

BNA Tax Management Inc. (2010). Summary of H.R. 4520, American Jobs Creation Act of 2004. Tax Management Summary online. Retrieved from www.bna.com/tm/eti_tm_summary.htm.