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Chapter04LectureSlides.pdf
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Multinational Financial Management Alan Shapiro 10th Edition
John Wiley & Sons, Inc.
PowerPoints by
Joseph F. Greco, Ph.D.
California State University, Fullerton
CHAPTER 4
PARITY CONDITIONS AND
CURRENCY FORECASTING
ARBITRAGE AND THE LAW OF
ONE PRICE
I. THE LAW OF ONE PRICE
A. Law states:
Identical goods sell for the same price
worldwide.
3
ARBITRAGE AND THE LAW OF
ONE PRICE
B. Theoretical basis:
If the prices after exchange-rate
adjustment were not equal,
arbitrage for the goods worldwide ensures
that eventually they will.
4
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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D. Five Parity Conditions Linked by
1. The adjustment of various rates and prices to inflation
2. The notion that money should have no
effect on real variables (since they
have been adjusted for price changes)
ARBITRAGE AND THE LAW OF
ONE PRICE
6
Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-1
Five Key Theoretical Relationships Among Spot Rates, Five Key Theoretical Relationships Among Spot Rates, Five Key Theoretical Relationships Among Spot Rates, Five Key Theoretical Relationships Among Spot Rates,
Forward Rates, Inflation Rates, and Interest RatesForward Rates, Inflation Rates, and Interest RatesForward Rates, Inflation Rates, and Interest RatesForward Rates, Inflation Rates, and Interest Rates
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
8
Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-2
Bolivia Ends its Hyperinflation in 1985 by Shutting Down Bolivia Ends its Hyperinflation in 1985 by Shutting Down Bolivia Ends its Hyperinflation in 1985 by Shutting Down Bolivia Ends its Hyperinflation in 1985 by Shutting Down
tttthe Printing Presseshe Printing Presseshe Printing Presseshe Printing Presses
ARBITRAGE AND THE LAW OF
ONE PRICE
F. THE LAW OF ONE PRICE
- enforced by international
arbitrage.
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PURCHASING POWER PARITY
I. THE THEORY OF PURCHASING
POWER PARITY:
states that spot exchange rates between
currencies will change to the differential in
inflation rates between countries.
11
Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-3
The Big Mac Hamburger Standard as of January 11. 2012The Big Mac Hamburger Standard as of January 11. 2012The Big Mac Hamburger Standard as of January 11. 2012The Big Mac Hamburger Standard as of January 11. 2012
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.
14
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
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PURCHASING POWER PARITY
2. If purchasing power parity is expected to hold, then the best prediction for the one-period spot rate should be written as:
� = � �� ��
�
�� � �
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PURCHASING POWER PARITY
3. A more simplified but less precise relationship is
written
that is, the percentage change should be approximately equal to the inflation rate differential.
fh t ii
e
e −=
0
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Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-4
Purchasing Power ParityPurchasing Power ParityPurchasing Power ParityPurchasing Power Parity
PURCHASING POWER PARITY
4. PPP states:
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
t
h
t
f
tt i
i ee
)1(
)1( '
+
+ =
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PURCHASING POWER PARITY
C. Real exchange rates
1. 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 (con’t)
2. Competitive positions:
domestic and foreign firms are unaffected
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Exhibit_4-5
Retail Prices Around the World for Oakley’s Monster Dog Retail Prices Around the World for Oakley’s Monster Dog Retail Prices Around the World for Oakley’s Monster Dog Retail Prices Around the World for Oakley’s Monster Dog
SunglassesSunglassesSunglassesSunglasses
Exhibit_4-6
Purchasing Power Parity Empirical Data 1993 Purchasing Power Parity Empirical Data 1993 Purchasing Power Parity Empirical Data 1993 Purchasing Power Parity Empirical Data 1993 ---- 2006200620062006
Exhibit_4-7
Purchasing Power Parity and Actual Exchange RatesPurchasing Power Parity and Actual Exchange RatesPurchasing Power Parity and Actual Exchange RatesPurchasing Power Parity and Actual Exchange Rates
I. THE FISHER EFFECT (FE)
A. Definition:
states that nominal interest rates (r) are a
function of the real interest rate (a) and a
premium (i) for inflation expectations.
R = a + i
THE FISHER EFFECT (FE)
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THE FISHER EFFECT
B. Real Rates of Interest 1. Should tend toward equality
everywhere through arbitrage.
2. With no government interference
nominal rates vary by the 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
�Due to capital market integration globally, interest rate
differentials are eroding
30
Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-8
The Fisher EffectThe Fisher EffectThe Fisher EffectThe Fisher Effect
Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-9
Fisher Effect: Nominal Interest Rate versus Inflation Rate Fisher Effect: Nominal Interest Rate versus Inflation Rate Fisher Effect: Nominal Interest Rate versus Inflation Rate Fisher Effect: Nominal Interest Rate versus Inflation Rate
28 Developed and Developing Countries as of 28 Developed and Developing Countries as of 28 Developed and Developing Countries as of 28 Developed and Developing Countries as of
November 2007November 2007November 2007November 2007
Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-10
The Distinction Between Capital Market Integration and The Distinction Between Capital Market Integration and The Distinction Between Capital Market Integration and The Distinction Between Capital Market Integration and
Capital Market SegmentationCapital Market SegmentationCapital Market SegmentationCapital Market Segmentation
Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-11
Real Interest Rate Versus Nominal Interest Rate for 28 Real Interest Rate Versus Nominal Interest Rate for 28 Real Interest Rate Versus Nominal Interest Rate for 28 Real Interest Rate Versus Nominal Interest Rate for 28
Developed and Developing Countries as of May 2007Developed and Developing Countries as of May 2007Developed and Developing Countries as of May 2007Developed and Developing Countries as of May 2007
Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-12
France Segments its Money Market to Defend the FrancFrance Segments its Money Market to Defend the FrancFrance Segments its Money Market to Defend the FrancFrance Segments its Money Market to Defend the Franc
Copyright © 2014 John Wiley & Sons, Inc. All rights reserved.
I. IFE STATES:
A. the spot rate adjusts to the interest rate differential
between two countries
THE INTERNATIONAL FISHER EFFECT
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THE INTERNATIONAL FISHER
EFFECT
IFE = PPP + FE
t
f
t
ht
r
r
e
e
)1(
)1(
0 +
+ =
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THE INTERNATIONAL FISHER
EFFECT
B. Fisher postulated
1. The nominal interest rate differential should
reflect the inflation rate differential
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THE INTERNATIONAL FISHER
EFFECT
B. Fisher also 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
0
h f
e e r r
e
− − =
40
THE INTERNATIONAL FISHER
EFFECT
D. Implications of IFE
1. Currency with the lower interest rate is expected to appreciate relative to the one with a higher rate
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THE INTERNATIONAL FISHER
EFFECT
D. Implications of IFE (con’t)
2. Financial market arbitrage:
insures interest rate differential is an
unbiased predictor of change in future spot
rate.
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Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-13
International Fisher EffectInternational Fisher EffectInternational Fisher EffectInternational Fisher Effect
INTEREST RATE PARITY
THEORY
I. INTRODUCTION
A. 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 co.untries
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INTEREST RATE PARITY
THEORY
1. The forward premium or
discount equals the interest
rate differential.
��
� = �� − ��
where rh = the home interest rate
rf = the foreign interest rate
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INTEREST RATE PARITY
THEORY
2. In equilibrium, returns on currencies will be the same
i. e. No profit will be realized and interest parity exists which can be written
( )
( )
1
1
h
f
rF
S r
+ =
+
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Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-14
An example of Interest Rate ParityAn example of Interest Rate ParityAn example of Interest Rate ParityAn example of Interest Rate Parity
INTEREST RATE PARITY
THEORY
B. 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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Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-15
An example of Covered Interest ArbitrageAn example of Covered Interest ArbitrageAn example of Covered Interest ArbitrageAn example of Covered Interest Arbitrage
INTEREST RATE PARITY
THEORY
3. Market pressures develop:
a. As one currency is more demanded spot
and sold forward
b. Inflow of funds depresses interest rates
c. Parity eventually reached
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Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-16
Interest Rate Parity TheoryInterest Rate Parity TheoryInterest Rate Parity TheoryInterest Rate Parity Theory
INTEREST RATE PARITY
THEORY
C. Summary:
Interest Rate Parity states
1. Higher interest rates on a currency are
offset by forward discounts
2. Lower interest rates are offset by
forward premiums
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Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-17
Uncovered and Covered Interest Rate Differentials (U.S. $ Versus Other Currencies)
THE FORWARD AND THE FUTURE
SPOT RATE
I. THE UNBIASED FORWARD RATE
A. States that, if the forward rate (ft ) is
unbiased, then it should reflect the
expected future spot rate (et)
B. Stated as
ft = et
54
Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-18
Relationship between the Forward Rate and the Future Relationship between the Forward Rate and the Future Relationship between the Forward Rate and the Future Relationship between the Forward Rate and the Future
Spot RateSpot RateSpot RateSpot Rate
CURRENCY FORECASTING
I. FORECASTING MODELS
A. 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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Copyright © 2014 John Wiley & Sons, Inc. All rights reserved. Exhibit_4-19
Forecasting in a FixedForecasting in a FixedForecasting in a FixedForecasting in a Fixed----Rate SystemRate SystemRate SystemRate System
CURRENCY FORECASTING
1. 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 FORECASTING
2. MODEL-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 data
2.) Charting and trend analysis
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