F9 Financial Management

2 Designed to give you the knowledge and application of: Section H: Risk Management H1. The nature and type of risk and approaches to risk management H2. Courses of exchange rate differences and interest rate fluctuations H3. Hedging techniques for foreign currency risk H4. Hedging techniques for interest rate risk

3 Learning Outcomes H3: Hedging techniques for foreign currency risk  Causes of exchange rate fluctuations, including: i.balance of payments [1] ii.purchasing power parity theory [2] iii.interest rate parity theory [2] iv.four-way equivalence [2]  Forecast exchange rates using: [2] i.purchasing power parity ii.interest rate parity  Causes of interest rate fluctuations, including: [2] i.structure of interest rates and yield curves ii.expectations theory iii.liquidity preference theory iv.market segmentation

4 Balance of payments A country’s balance of payments is commonly defined as the record of transactions of its imports and export over a specified period. If the level of imports exceeds the level of exports, there is said to be a deficit on the balance of payments. This equates to a net payment in a foreign currency. Example Deterioration of an exchange rate. Exchange rate 1: INR 40 = $ 1 Exchange rate 2: INR 45 = $ 1 The above illustrates a appreciation of the $ to the INR. Under exchange rate 1, one $ would have cost INR 40. However, under exchange rate 2, $1 now costs INR 45. This may have been due to a deficit in the balance of payments for the country that uses INR. The demand for $ would have increased causing its price to inflate. Causes of exchange rate fluctuation

5 PPP assumptions  No transport costs  No differential taxes  Competitive markets must exist  Only applies to tradable goods PPP formula I f – I h = E f I f = Inflation rate in the foreign country I h = Inflation rate in the home country E f = % change in spot rate of foreign currency Purchasing power parity (PPP) theory  States that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries.  This means that the exchange rate between currencies of two countries must change to adjust to the change in prices of goods in these two countries  The process of equilibrium continues until prices of goods of two countries reach the same level. The exchange rates between currencies of two countries will adjust to reflect changes in inflation rates in the two countries.

6 (1+ h c ) S 1 = S 0 x (1 + h b ) Where S 1 = expected spot rate S 0 = current spot rate h c = inflation rate in country c h b = inflation rate in country b Example In Year 1 the spot rate between the Indian Rupee and the US Dollar is Rs 45, while the price index stands at 100. In year 2, the expected inflation rate in India is 6% while that of the US is 2%. The expected exchange rate using the PPP theory can be determined, as under: Current spot rate (S0) = Rs 45 Inflation rate in India (c) = 6% Inflation rate in US (b) = 2% Expected spot rate = Rs per US $ This indicates in countries that witness high inflation rates, currency values decline more, compared to the currencies of countries with lower inflation rates. Forecast exchange rates using purchasing power parity (PPP)

7 International Fisher effect  Investors all over the world expect the same real rate of return on their investments after the effects of inflation are eliminated  the nominal rate of return is equal to the real rate of return plus the effect of inflation. Example Assume that the nominal interest rate in Germany is 5% and the rate of inflation is 3% and the expected rate of inflation in the US is 4%. In this case, the nominal interest rate in the US can be calculated using the Fisher theory as follows: Using the Fisher theory we have Therefore the nominal rate of interest in the US is 0.06 or 6%. It can be observed that the real rate of return after eliminating the rate of inflation is the same in both Germany and the US, i.e. 2%, (5% - 3%) in Germany and (6% - 4%) in the US.

8 Example If interest rates are high in one country relative to another, this will have the effect of attracting capital inflows as investors try to take advantage of the higher rate of interest. As a result, the demand for domestic currency increases, pushing up its price. The ultimate effect is a depreciation of the domestic county’s currency as it becomes more expensive. Interest Rate Parity (IRP) theory  States that the premium or discount of one currency in relation to other should reflect the interest rate differentials between the two currencies.  Examines the impact of nominal interest rate differentials between two countries on the future/forward rate of the foreign currency.  Interest rates can be used as a tool for demand management in monetary policy therefore interest rates in different countries will vary depending on economic condition of the economy. Interest rates are another factor influencing exchange rates. IRP equation is: I h – I f = p I h = Home interest rate I f = Foreign interest rate p = Forward premium / discount of the foreign currency

9 Example Current/ Spot rate: Rs 47 per US$ Interest rate in India (c): 5% p.a. Interest rate in USA (b): 2% p.a. (1 + i c ) F 0 = S 0 x (1 + i b ) Expected spot rate = 47 x (1+.05)/(1+.02) = Rs per US$ Forecasting exchange rate using Interest Rate Parity (1 + i c ) F 0 = S 0 x (1 + i b ) Where i c = interest rate in country c i b = interest rate in country b S 0 = current spot rate F 0 = expected spot rate

10 Causes of interest rate fluctuations Causes of interest rate fluctuation Demand & Supply Inflation Government policy increase in the demand for credit will raise interest rates, and vice versa the higher the rate of inflation, the more interest rates are likely to rise long term interest rates are influenced by monetary policy declared and reviewed by the government Refer to Self Examination Question 1 and 2 (page 481)

11 Recap  Causes of exchange rate fluctuations, including: i.balance of payments [1] ii.purchasing power parity theory [2] iii.interest rate parity theory [2] iv.four-way equivalence [2]  Forecast exchange rates using: [2] i.purchasing power parity ii.interest rate parity  Causes of interest rate fluctuations, including: [2] i.structure of interest rates and yield curves ii.expectations theory iii.liquidity preference theory iv.market segmentation