Page 1 International Finance Lecture 3

Page 2 Foundations of International Financial Management Globalization and the Multinational Firm International Monetary System Balance of Payments The Market for Foreign Exchange International Parity Relationships

Page 3 International Parity Relations Interest rate __________ Purchasing __________ parity __________ effect Using the parity relations in forecasting exchange rates

Page 4 Interest Rate Parity F – forward rate, FC/DC S – spot rate, FC/DC r FC – interest rate of foreign currency __________ r DC – interest rate of domestic currency __________

Page 5 Interest Rate Parity You observe that spot EUR/USD=1.05, one-year interest rates are: r USD =1.76%, r EUR =3.39%, what is the 1-year forward EUR/USD rate?

Page 6 Interest Rate Parity IRP is an __________ condition. If IRP did not hold, then it would be possible for a trader to make __________ amounts of money without risk exploiting the arbitrage opportunity. Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds. If it does not hold for long time, it is due to __________ costs and government-imposed capital ________ that make arbitrage impossible

Page 7 Interest Rate Parity

Page 8 Interest Rate Parity and Expected Exchange Rates Forward rate can be viewed as the best guess about the future spot rate, given today’s information. F t = E[S t+1 |Information t ] –Recall S t = E[S t+1 |Information t ]*(1+r DC )/ (1+r FC ) –Today’s __________ exchange rate depends on the today’s interest rates and an expectation about the future exchange rate FC/DC

Page 9 Interest Rate Parity You observe that spot EUR/USD=1.05, interest rates are: r USD =1.76%, r EUR =3.39% per annum, what is the 3- months forward EUR/USD rate?

Page 10 IRP and Covered Interest Arbitrage If IRP failed to hold, an arbitrage would exist. It’s easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates. Spot exchange rateS($/£)=$ day forward rateF 360 ($/£)=$1.20 Canadian interest ratei$i$ =7.10% British interest rate i £ =11.56%

Page 11 IRP and Covered Interest Arbitrage Alternative 1. Invest $1,000 in 7.1%, in one year investment will be worth $1,071 = $1,000  (1+ i $ ) = $ __________ Alternative 2. –Exchange $1,000 for £800 at the going spot rate, (note that £800 = $1,000÷$1.25/£), –invest £800 in the UK at i £ = 11.56% for one year, receive £ __________ –Translate £ back into dollars at F 360 ($/£) = $1.20/£, the £ will be exactly $1,071. Note that _______ alternatives 1 and 2 are the same.

Page 12 IRP and Covered Interest Arbitrage According to IRP it must be the case that F 360 ($/£) = $ __________ If F 360 ($/£)  $1.20/£, riskless arbitrage is possible –As usual, __________

Page 13 Arbitrage Strategy I If F 360 ($/£) > $1.20/£, let’s say $1.30. Forward GBP overpriced (CAD is underpriced). Sell forward GBP and buy spot GBP to make it riskless. i.__________ $1,000 at t = 0 at i $ = 7.1%. ii.__________ $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800 at 11.56% (i £ ) for one year to achieve £ iii.__________ £ back into dollars, if F 360 ($/£) > $1.20/£, £ will be more than enough to repay your dollar obligation of $1,071. £ * $1.3 = $ , profit = $ __________

Page 14 Arbitrage Strategy II If F 360 ($/£) < $1.20/£, let’s say $1.10. Forward GBP underpriced (CAD overpriced). Buy forward GBP (sell forward CAD), sell spot GBP, get CAD to make it riskless. i.__________ £800 at t = 0 at i £ = 11.56%. ii.__________ £800 for $1,000 at the prevailing spot rate, invest $1,000 at 7.1% for one year to achieve $1,071. iii.__________ $1,071 back into pounds, if F 360 ($/£) < $1.20/£, $1,071 will be more than enough to repay your £ obligation of £ $1,071/$1.10= £973.64, profit = £ __________

Page 15 IRP and Covered Interest Arbitrage You observe the following. Spot CHF/USD=1.6627, 6- months forward CHF/USD= Interest rates are 3.5% in the USA and 3.0% p.a. in Switzerland (compounded semiannually). Ignore transaction costs. Are there any arbitrage opportunities? If yes, what are they?

Page 16 IRP and Covered Interest Arbitrage

Page 17 IRP and Covered Interest Arbitrage You observe the following. Spot JPY/USD=108, 3- months forward JPY/USD= Interest rates are 5.20% in the USA and 1.2% p.a. in Switzerland (compounded quarterly). Ignore transaction costs. Are there any arbitrage opportunities? If yes, what are they?

Page 18 IRP and Covered Interest Arbitrage

Page 19 Hedging Currency Risk Hedging – a part of risk management Taking a position, with the purpose of reducing risk, based on the view that an unfavorable event will occur in the market. –Hedging never __________ all risk, should be viewed as risk reducing, not risk eliminating strategy. –Reduces loss __________, but also reduces the gain potential.

Page 20 IRP and Hedging Currency Risk You are a Canadian importer of British woolens and have just ordered next year’s inventory. Payment of £100M is due in one year. Spot exchange rateS($/£)=$1.25/£ 360-day forward rateF 360 ($/£)=$1.20/£ Canadian interest ratei$i$ =7.10% British interest rate i £ =11.56% IRP implies that there are two ways that you fix the cash outflow to a certain Canadian dollar amount: a)Enter ________________________ contract on the pound. You will pay (£100M)(1.2/£) = $ __________ today. b)Form a forward market __________ as shown below.

Page 21 IRP and Hedging Currency Risk To form a forward market hedge: –__________ $ million in Canada (in one year you will owe $120 million). –__________ $ million into pounds at the spot rate S($/£) = $1.25/£ to receive £89.64 million. –__________ £89.64 million in the UK at i£ = 11.56% for one year. –In one year your investment will have grown to £100 million—exactly enough to pay your supplier.

Page 22 IRP and Forward Bid-Ask Spread Profit in FC per unit DC: S bid * (1+r bid,FC ) -F ask *(1+r ask,DC ) ≤ 0 F bid *(1+r bid,DC ) - S ask * (1+r ask,FC )≤0 –F – forward exchange rate, _________ –S – spot exchange rate, _________ –r bid,FC, r ask,FC interest rates on lending (i.e. on your savings account) and _________(i.e. if you want to get a loan) in the foreign country –r bid,DC, r ask,DC lending and borrowing interest rates in the home country (country of the currency that is in the denominator in the _________ exchange rate)

Page 23 IRP and Bid-Ask Spread You see the following rates. Spot USD/EUR= , JPY/USD= Short-term annualized interest rates are: r $ =5-5.25, r EUR = , r JPY = What should be the spot JPY/EUR rate and 3-month forward JPY/EUR, EUR/USD and JPY/USD rates?

Page 24 IRP and Bid-Ask Spread Solution (2) 3-month forward JPY/EUR rate

Page 25 IRP and Bid-Ask Spread Solution (3) 3-month forward EUR/USD rate

Page 26 IRP and Bid-Ask Spread Solution (4) 3-month forward JPY/USD rate

Page 27 Interest Rate Parity

Page 28 Interest Rate Parity

Page 29 Purchasing Power Parity The exchange rate between two currencies should equal the ratio of the countries’ price levels: For example, if an ounce of gold costs $300 in the U.S. and £150 in the U.K., then the price of one pound in terms of dollars should be:

Page 30 Purchasing Power Parity If the law of one price were true for all goods and services, the purchasing power parity exchange rate can be found from any set of prices. This is __________ purchasing power parity. Hamburger standard compares Big Mac prices with the exchange rates to determine whether or not overvaluation or undervaluation exist.Big Mac prices Index introduced by The Economist, shortly after the Big Mac they introduced the Tall Latte index. Subscription required. They offer free online subscription, try and see the articles.The Economist

Page 31 Absolute PPP indices

Page 32 Purchasing Power Parity Absolute PPP never works for most goods/commodities – Less Strict version uses a basket of goods instead of individual items. Relative Purchasing Power Parity: –If the spot exchange rate between two countries starts in __________, any change in differential rate of inflation between them tends to be offset over in the long run by an equal but opposite change in the spot exchange rate.

Page 33 Purchasing Power Parity S 0 – spot rate at the start of the period, FC/DC S 1 – expected spot rate at the start of the period, FC/DC  FC – expected inflation rate of foreign country (FC)  DC – expected inflation rate of domestic country (DC)

Page 34 Purchasing Power Parity and Exchange Rate Determination Relative PPP states that the rate of change in the exchange rate is equal to the differences in the rates of inflation: e = (1 +  DC ) (  FC –  DC ) ≈  FC –  DC

Page 35 Purchasing Power Parity Spot CAD/GBP =$2.235, inflation in Canada is 1.3% and in the UK 2.1%. What is the expected spot exchange rate one year from now, according to the PPP?

Page 36 Evidence on PPP PPP probably __________ precisely in the real world for a variety of reasons. –Haircuts cost 10 times as much in the developed world as in the developing world. –Film, on the other hand, is a highly __________ commodity that is actively traded across borders. –Shipping costs, as well as tariffs and quotas can lead to __________ from PPP. PPP-determined exchange rates still provide a valuable benchmark.

Page 37 The Fisher Effects (Long Run) An increase (decrease) in the expected rate of inflation will cause a proportionate increase (decrease) in the interest rate in the country. For Canada, the Fisher effect is written as: 1 + i $ = (1+  $ )(1 + E[  $ ]) approximation:  $ is the equilibrium expected “real” Canadian interest rate E[  $ ] is the expected rate of Canadian inflation i $ is the equilibrium expected nominal Canadian interest rate

Page 38 Expected Inflation The Fisher effect implies that the expected inflation rate is approximated as the difference between the nominal and real interest rates in each country, i.e. i $ =  $ + (1 +  $ )E[  $ ] ≈  $ + E[  $ ]

Page 39 International Fisher Effect If the Fisher effect (FE) holds in Canada 1 + i$ = and the Fisher effect holds in Japan, 1 + i¥ = and if the real rates are the same in each country  $ = then we get the International Fisher Effect (IFE): 1 + i $ 1 + i ¥ =

Page 40 International Fisher Effect If the expected inflation is 8.91% in the US and 12.87% in Eurozone, and the US riskless rate is 10%, what is the nominal riskless rate in the Eurozone? Assume the International Fisher Effect is true.

Page 41 International Fisher Effect If the International Fisher Effect (IFE) holds, then forward rate PPP (FPPP) holds: and if IRP also holds

Page 42 PPP FRPP FE FEP IFE Exact Equilibrium Exchange Rate Relationships IRP E(1 +  ¥ ) E(1 +  $ ) 1 + i $ 1 + i ¥

Page 43 Exchange rate expectation The spot USD/EUR=1.25, US riskless rate is 10% and the Eurozone riskless rate is 14%. What is the expected spot rate one year from now?

Page 44 Forecasting Exchange Rates Efficient __________ Approach __________ Approach Technical Approach Performance of the Forecasters

Page 45 Efficient Markets Approach Financial Markets are efficient if prices reflect all available and relevant information. If this is so, exchange rates will only change when new information arrives, thus: S t = E[S t+1 ] and Predicting exchange rates using the efficient markets approach is affordable and is hard to beat.

Page 46 Fundamental Approach Based on theoretical general or partial equilibrium models –__________ macroeconomics –Model production, balance of payments, etc and solve for exchange rates Based on asset market values –Another group of theoretical __________, solve for long-run __________ exchange rates, –Infer current spot rates, and see if there is a potential for exchange rate movement towards the long-run values

Page 47 Technical Approach Infer future movements of the exchange rates based on historical rates “Technical analysis” –Assumes markets are __________

Page 48 Example Canadian and Euro deposit rates are 5% and 6%, respectively. Current exchange rate S 0 = CAD1.3/€. Bank of Canada announces a permanent increase in the money supply of 10%. On this news Canadian interest rate drops to 4%. What’s the effect on S 0 in SR? Two effects: –____________________________________________. This alone would lead to S 0 =E[S]*(1+R €)/(1+R$) = 1.288*1.06/1.04 = (pre-event E[S] is computed from uncovered interest parity). –_____________________: Ms up by 10% => E[S] up by approximately 10% now (t=0). –Finally, ___________________________________

Page 49 Example Cont’d What is S 0 in the LR? –P _______ until R is _________ –S 0 = _________________________

Page 50 Exchange Rate Overshooting The exchange rate is said to _________ when its immediate response to a change is greater than its long run response. –We assume that changes in the money supply have immediate effects on interest rates and exchange rates. –We assume that people change their expectations about inflation immediately after a change in the money supply. Overshooting helps explain why exchange rates are so ____________. Overshooting occurs in the model because prices ________________, but expectations about prices ______.

Page 51 Exchange Rate Volatility Changes in price levels are less volatile, suggesting that price levels change slowly. Exchange rates are influenced by interest rates and expectations, which may change rapidly, making exchange rates volatile.