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Multinational Financial Management Alan Shapiro

7th Edition J.Wiley & SonsPower Points byJoseph F. Greco, Ph.D.California State University, Fullerton

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CHAPTER 4

PARITY CONDITIONS AND CURRENCY FORECASTING

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CHAPTER OVERVIEW

I. ARBITRAGE AND THE LAW OFONE PRICE

II. PURCHASING POWER PARITYIII. THE FISHER EFFECTIV. THE INTERNATIONAL FISHER EFFECTV. INTEREST RATE PARITY THEORYVI. THE RELATIONSHIP BETWEEN

THE FORWARD AND FUTURE SPOT RATE

VII. CURRENCY FORECASTING

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PART I. ARBITRAGE AND THE LAW OF ONE PRICE

I. THE LAW OF ONE PRICEA. Law states:

Identical goods sell for the same price worldwide.

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ARBITRAGE AND THE LAW OF ONE PRICE

B. Theoretical basis:

If the price after exchange-rate

adjustment were not equal,

arbitrage in the goods

worldwide ensures eventually it will.

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ARBITRAGE AND THE LAW OF ONE PRICE

C. Five Parity Conditions Result From These Arbitrage Activities

1. Purchasing Power Parity (PPP)2. The Fisher Effect (FE)3. The International Fisher Effect(IFE)4. Interest Rate Parity (IRP)5. Unbiased Forward Rate (UFR)

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ARBITRAGE AND THE LAW OF ONE PRICE

D. Five Parity Conditions Linked by

1. The adjustment of various

rates and prices to inflation.

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ARBITRAGE AND THE LAW OF ONE PRICE

2. The notion that money should have no effect

on real variables (since they have been adjusted for price changes).

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ARBITRAGE AND THE LAW OF ONE PRICE

E. Inflation and home currency depreciation:

1. jointly determined by the growth of domestic

money supply;2. Relative to the growth of

domestic money demand.

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ARBITRAGE AND THE LAW OF ONE PRICE

F. THE LAW OF ONE PRICE- enforced by

international arbitrage.

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PART II. PURCHASING POWER PARITY

I. THE THEORY OF PURCHASINGPOWER PARITY: states that spot exchange rates between currencies will change to the differential in inflation rates between countries.

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PURCHASING POWER PARITY

II. ABSOLUTE PURCHASING POWER PARITY

A. Price levels adjusted for

exchange rates should be

equal between countries

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PURCHASING POWER PARITY

II. ABSOLUTE PURCHASING POWER PARITY

B. One unit of currency has

same purchasing

power globally.

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PURCHASING POWER PARITY

III. RELATIVE PURCHASING POWER PARITY

A. states that the exchange rate of one currency

against another will adjust to reflect changes in the price levels of the two countries.

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PURCHASING POWER PARITY

1. In mathematical terms:

where et = future spot rate

e0 = spot rate

ih = home inflation

if = foreign inflation t = the time period

tf

tht

i

i

e

e

1

1

0

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PURCHASING POWER PARITY

2. If purchasing power parity is expected to hold, then the

bestprediction for the one-periodspot rate should be

tf

th

ti

iee

1

10

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PURCHASING POWER PARITY

3. A more simplified but less precise relationship is

that is, the percentage change should be approximately equal to the inflation rate differential.

fht ii

e

e

0

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PURCHASING POWER PARITY

4. PPP says

the currency with the higher inflation rate is

expected to depreciate relative to the currency with the lower rate of inflation.

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PURCHASING POWER PARITY

B. Real Exchange Rates:the quoted or nominal rate

adjusted for a country’s inflation rate is

th

tf

tt i

iee

)1(

)1('

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PURCHASING POWER PARITY

C. Real exchange rates1. If exchange rates adjust to

inflation differential, PPP states that real exchange rates stay the same.

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PURCHASING POWER PARITY

C. Real exchange rates

2. Competitive positions:

domestic and foreign firms

are unaffected.

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PART III.THE FISHER EFFECT (FE)

I. THE FISHER EFFECTstates that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations.

R = a + i

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THE FISHER EFFECT

B. Real Rates of Interest1. Should tend toward equality

everywhere through arbitrage.2. With no government

interference nominal rates vary by inflation differential or

rh - rf = ih - if

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THE FISHER EFFECT

C. According to the Fisher Effect,

countries with higher inflation rates have higher interest rates.

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THE FISHER EFFECT

D. Due to capital market

integration globally,

interest rate

differentials are eroding.

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PART IV. THE INTERNATIONAL FISHER EFFECT (IFE)

I. IFE STATES:A. the spot rate adjusts to the

interest rate differential between two

countries.

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THE INTERNATIONAL FISHER EFFECT

IFE = PPP + FE

tf

tht

r

r

e

e

)1(

)1(

0

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THE INTERNATIONAL FISHER EFFECT

B. Fisher postulated1. The nominal interest rate

differential should reflect the inflation rate differential.

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THE INTERNATIONAL FISHER EFFECT

B. Fisher postulated

2. Expected rates of return are equal in the absence of government intervention.

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THE INTERNATIONAL FISHER EFFECT

C. Simplified IFE equation:

(if rf is relatively small)

1 0

0h f

e er r

e

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THE INTERNATIONAL FISHER EFFECT

D. Implications of IFE1. Currency with the

lower interest rate expected to appreciate relative to one

with a higher rate.

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THE INTERNATIONAL FISHER EFFECT

D. Implications of IFE

2. Financial market arbitrage:

insures interest rate differential is an unbiased predictor of change in future spot rate.

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PART VI. INTEREST RATE PARITY THEORY

I. INTRODUCTIONA. The Theory states:

the forward rate (F) differs from the spot rate (S) at

equilibrium by an amount equal to the interest

differential (rh - rf) between two countries.

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INTEREST RATE PARITY THEORY2. The forward premium or

discount equals the interestrate differential.

(F - S)/S = (rh - rf)

where rh = the home rate

rf = the foreign rate

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INTEREST RATE PARITY THEORY3. In equilibrium, returns on

currencies will be the samei. e. No profit will be realizedand interest parity existswhich can be written

(1 + rh) = F

(1 + rf) S

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INTEREST RATE PARITY THEORYB. Covered Interest Arbitrage

1. Conditions required:

interest rate differential does

not equal the forward premium or discount.

2. Funds will move to a country

with a more attractive rate.

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INTEREST RATE PARITY THEORY3. Market pressures develop:

a. As one currency is more demanded spot and sold forward.

b. Inflow of fund depresses interest rates.

c. Parity eventually reached.

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INTEREST RATE PARITY THEORYC. Summary:

Interest Rate Parity states:

1. Higher interest rates on a

currency offset by forward discounts.

2. Lower interest rates are offset by forward

premiums.

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PART VI. THE RELATIONSHIP BETWEEN THE

FORWARD AND THE FUTURE SPOT RATE

I. THE UNBIASED FORWARD RATEA. States that if the forward rate is unbiased, then it should reflect the expected future spot rate.B. Stated as

ft = et

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PART VI. CURRENCYFORECASTING

I. FORECASTING MODELSA. Created to forecast exchange rates in addition to parity conditions.B. Two types of forecast:

1. Market-based 2. Model-based

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CURRENCY FORECASTING

MARKET-BASED FORECASTS:

derived from market indicators.

A. The current forward rate contains implicit information about exchange rate changes for one year.

B. Interest rate differentials may be used to predict exchange rates beyond one year.

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CURRENCY FORECASTINGMODEL-BASED FORECASTS:

include fundamental and technical analysis.A. Fundamental relies on key

macroeconomic variables and policies which most like affect exchange rates.B. Technical relies on use of

1. Historical volume and price data2. Charting and trend analysis