IRP FOT n IFE_

8/3/2019 IRP FOT n IFE_

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Fundamental Equilibrium

Relationships


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Interest Rate Parity Determinants of international interest rates

Domestic and foreign credit conditions

Forward-exchange rates and exchange rateexpectations

Arbitrage

Factors that inhibit arbitrage

Capital controls

Risk factors

Transaction costs


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Term structure of interest rate

Relationship between interest rates and time to

maturity Expectation of future short term rates is vital

determining the level of longer term rates


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Covered interest arbitrage equalizes the return

(adjusted for cost of eliminating exchange risk

by means of a forward contract) in differentcurrencies

Ex: interest rate on a dollar deposit must equal the

interest rate on Swiss Franc deposit covered in

the forward market

Results from arbitrage between the spot and

forward markets


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Covered interest arbitrage

Movement of funds

Between securities denominated in differentcurrencies

To profit from effective rates of interest in

different curremcies.


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Deviations from interest rate parity May not always hold true

Capital controls can divide credit markets

Financial instruments are not always alike

Tax treatments

Liquidity

Day count

Pricing conventions

Institutional arrangements


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Fisher Open Theorem Irving Fischer

Identifies relationship between changes in

interest rates and changes in price levels.

Compensation for lending present funds

Increase in purchasing power

Increase in price levels

Risk of default


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Components of interest rate Nominal Rate

Real rate of return

Inflation premium


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Fisher Effect :

1+ Nominal Rate =

(1+ real rate)*(1+Increase in Inflation rate)

r = a + i + ai

r = nominal rate

a= real rate of interest

i = inflation premium


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Ex-post, the price change will not equal the

expected value

But if the market utilizes all the informationavailable r should include the best possible

estimate of inflation rate.

Then the change in interest rate will be equalto change in the expected price levels


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1+Rh = 1+Ih

1+Rf =1+If

Rh, Rf : rate of interest in home and foreign

country respectively

Ih, If : rate of inflation in home and foreign

country.


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Generalized version of Fisher effect says:

Currencies with higher inflation rates should

bear higher interest rate and viceversa


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Example The real interest rate is 5%

Inflation rate premium 1%

Calculate nominal interest rate

r = a + i + ai

= .05+.01+.05*.01

= .0605

=6.05%


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International Fisher Effect Describes relationship between the interest

rate and the expected exchange rate changes.

Expected rate of change in exc.rate = interestrate differential

IFE = E(S1) S0 = Ih-If

S0

E(S1) = Expected spot rate

S0 = spot rate


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Difference between IRP and IFE IRP substitutes a know forward rate but IFE

takes into account the expected rate of change

in the exchange rate.


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Foreign Exchange Exposure Foreign exchange risk

Foreign exchange exposure

ARE THEY SAME ?


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Foreign exchange exposure is the extent to

which transactions, assets and liabilities of an

enterprise are denominated in currencies otherthan reporting currency of the enterprise.

Foreign exchange risk is the net potential

gains or losses which can arise from exchangerate changes.


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Types of exposures Transaction Exposure

Translation Exposure

Economic Exposure


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Transaction Exposure/Conversion

Exposure Arises due to:

time difference between the date of the

conclusion of the contract and the dischargeof the obligations.

The transaction is required to be denominated

in foreign currency for the transactionexposure to occur.


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Transactions resulting in

Transaction Exposure Accounts payable in foreign currencies

Accounts receivable in foreign currency

Debt payments to be made in foreign currency

Commitments to accept loan repayments in

foreign currency

Anticipated payments from foreign

subsidiaries


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Entities which face transaction

exposure1. Traders (importers and exporters)

2. Multinational corporations


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Instruments of Hedging Forward Contracts

Money Market Hedge

Future Contracts Option Contracts

Currency Invoicing

Exposure Netting

Foreign Currency Accounts Leading and Lagging

Hedging with proxy currencies (when the forwardmarket for the currency does not exist)


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Translation Exposure/Accounting

Exposure Translation exposure of a corporation is

simply the difference between the exposed

assets and liabilities. The gains and losses due to translation

exposure are accounting in nature, there is no

cash implication.


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Methods of Translation Current and Non-current Method

Monetary and Non-monetary Method

Temporal Method

Current Rate Method


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Current/Non-Current Method Current Assets and Liabilities current rate

Non-current assets and liabilities historical

rates


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Monetary/Non-monetary method

Monetary assets and liabilities Current rates

Non-Monetary assets and liabilities

Historical rates


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Difference between the two methods In Monetary and non-monetary method

inventory is valued at historic rates unlike in

current and non current method it is valued atcurrent rate.

Term Liabilities are valued at current rate in

monetary and non-monetary method unlike incurrent and non-current method they are

valued at historic rates


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Temporal Method:

Inventories and Investments translated at

current rate (if they are valued at market pricein the B/S)

Current Rate Method:

All the assets and liabilities are valued atcurrent rate


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Managing Translation Exposure Fund Adjustments

Forward Contract Hedge


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Economic ExposureAlso Called as

Operating Exposure

Competitive Exposure

Strategic Exposure


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Economic Exposure Effect of unexpected exchange rates on the

future operating cash flows of the company.

Change in economic net worth of a companydue to change in exchange rates.

Ambiguous but has wider ramification with

far reaching effects. Involves not only the action of the company

but also of competitors and consumers.


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Impact of economic exposure Cash inflows

Cash outflows


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Impact on cash outflows Factors :

Sources of inputs - domestic and foreign

Supplier reaction

Government reaction


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Managing Economic Exposure Marketing Strategies

Market Selection

Pricing (to retain market share or profit margin,frequency of price change)

Product Decisions

Production Strategies Financial Strategies (Cheap Borrowing)

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