Multinational Finance : Foreign Exchange By Sandun Fernando

Notations LKR/USD = 145 Or USD: LKR = 145

Quotation Direct quote – exchange rate in terms of local investor’s currency. Eg LKR/USD Indirect quote – USD/LKR

Bid Price and Ask Price Bid price – buying rate, listed first Ask price – selling rate LKR/USD =

If a bank offered a rate of AUD:MXN – , calculate arbitrage profit.

Forward Premium and discount

International Parity Relationships There are the following four international parity relationships: Interest rate parity (IRP) Purchasing power parity (PPP) Forward rates and future spot rates parity International Fisher effect (IFE). 8

Interest Rate Parity It states that the exchange rate of two countries will be affected by their interest rate differential. In other words, the currency of a high-interest-rate-country will be at a forward discount relative to the currency of a low-interest- rate-country, and vice versa. This implies that the exchange rate (forward and spot) differential will be equal to the interest rate differential between the two countries. That is: Interest differential = Exchange rate (forward and spot) differential F 0 =S 0 (1+Rd)/(1+Rf) 9

Purchasing Power Parity In absolute terms, purchasing power parity states that the exchange rate between the currencies of two countries equals the ratio between the prices of goods in these countries. Further, the exchange rate must change to adjust to the change in the prices of goods in the two countries. In relative terms, purchasing power states that the exchange rate between the currencies of the two countries will adjust to reflect changes in the inflation rates of the two countries. In formal terms, it implies that the expected inflation differential equals to the current spot rate and the expected spot rate differential. Thus: Inflation rate differential = Current spot rate and expected spot rate differential 10

Example Thailand and South Korea are running annual inflation rates of 5 per cent and 7 per cent, respectively. The current spot exchange rate is Won 18.50/Baht. What should be the value of the Thai Baht in one year? If purchasing power parity holds, then the expected spot rate after one year will be: Won18.85/Baht. 11

Expectation Theory of Forward Rates The expectation theory of forward exchange rates states that the forward rate provides the best and unbiased forecast of the expected future spot rate. In formal terms, it means that the forward rate and the current rate differential must be equal to the expected spot rate and the current spot rate differential. Thus: Forward and current spot rate differential = Expected and current spot rate differential 13

International Fisher Effect In formal terms, the international Fisher effect states that the nominal interest rate differential must equal to the expected inflation rate differential in two countries. And which is the expected change in exchange rate. Nominal interest rate differential = Expected inflation rate differential 14

Foreign Exchange Risk Foreign exchange risk is the risk that the domestic currency value of cash flows, denominated in foreign currency, may change because of the variation in the foreign exchange rate. There would not be any foreign exchange risk if the exchange rates were fixed. We can distinguish between three types of foreign exchange exposure: Economic exposure – Transaction and operating exposure Transaction exposure – due to existing transaction Translation exposure – translation gain or loss 15

What Maters Exchange Rate?