International Financial Management: INBU 4200 Fall Semester 2004 Lecture 4: Part 4 International Parity Relationships: The International Fisher Effect (Chapter 5)

Recall: Two Long Run Parity Models Purchasing Power Parity Exchange rate between two countries should be equal to the ratio of the two countries price level. The change in the exchange rate will be equal to, but opposite in sign to, the difference in inflation. International Fisher Effect The change in the exchange rate will be equal to, but opposite in sign to, the difference in the nominal interest rate between two countries. Both of these models are regarded as longer term forecasting models. Not concerned with where spot rates will be in a couple of minutes, hours, days or weeks.

International Fisher Effect The last major foreign exchange parity model is the International Fisher Effect. This model begins with the Fisher interest rate model: Attributed to the economist Irving Fisher (see next slide) Explanation of the market (nominal) interest rate. Market interest rate is made up of two critical components: Real rate requirement; relates to the real growth rate in the economy. Inflationary expectations premium; the markets expectations regarding future rates of inflation

Irving Fisher 1867-1947. One of the earliest American neo-classical economists Noted for: The Quantity Theory of Money (MV = PT) Theory of Interest Just days before the October 1929 Wall Street crash, he was quoted as saying that stock prices were not over inflated but, rather, had achieved a “new, permanent plateau.”

Fisher Interest Rate Model The Fisher model assumes: Real rate requirement relatively stable over time. Inflationary expectations subject to wide swings over time. Thus, the inflationary expectations premium is subject to large changes over time. Thus, changes in market interest rates occur primarily because of changes in expected inflation!

The Fisher Effect The Fisher Effect is best stated as: A change in the expected rate of inflation will result in a direct and proportionate change in the market rate of interest. Assume the following: real rate requirement is 3.0% Expected rate of inflation is 1.0% Under these conditions, the market interest rate would be 4% If the expected rate of inflation increases to 2.0%, the market interest rate would rise to 5%.

Fisher Effect Data Country 2004 2005 Bond Rate CPI Forecast 2 Year Gov’t Country 2004 2005 Bond Rate Australia +2.2% +2.5% 5.27% U.S. +1.9% +1.8% 2.45% Switzerland +0.7% +0.4% 1.13% Japan -0.1% nil 0.14% Forecast: The Economist Poll, May 29, 2004 Conclusion: Higher expected rate of inflation counties are associated with higher market interest rates.

Fisher Effect Cross Border Assumptions Model assumes that the real rate requirement is the same across major industrial countries. Thus observed market interest rate differences between counties is accounted for on the basis of differences in inflation expectations. Example: If the United States 1 year interest rate is 5% in the United Kingdom 1 year interest rate is 7%, then: The expected rate of inflation is 2% higher in the U.K. over the next 12 months.

International Fisher Effect International Fisher effect parity model suggests that: Changes in exchange rates will be driven by differences in market interest rates between countries. Relationship to Exchange Rates The currencies of high interest rate countries will weaken (depreciate). The currencies of low interest rate countries will strengthen (appreciate) Why? Because differences in interest rates capture (incorporate) differences in expected inflation.

Summary: Exchange Rate – Interest Rate Relationship Relatively high interest rate countries have high inflationary “expectations” conditions. Relatively high inflation causes a currency to weaken (depreciate): see PPP model. Relatively low interest rate countries have low inflationary “expectations” conditions. Relatively low inflation causes a currency to strengthen (appreciate): see PPP model

Forecasting With the International Fisher Effect Assumptions: The exchange rate will change by a percentage amount equal to the observed market interest rate difference. Exchange rate will move opposite to the observed interest rate difference. Data to be used: Use (National) Government securities Use yields to maturities (not coupon yields) Match maturity of securities with forecasted time period Very Important

Japanese Yen Example Using interest rate data from Bloomberg’s web site (rates and bonds): http://www.bloomberg.com/markets/index.html 2 year U.S. Government rate: 2.65% 2 year Japanese Government rate: 0.14% Higher U.S. interest rate is accounted for on the basis of higher expected U.S. inflation: = 2.65% – 0.14% = 2.51% Forecast: Yen over the next two years.

Yen Exchange Rate Change Given the expected inflation differences, the yen will appreciate 2.51% per year. Current spot rate JPY110.44/USD. Spot rate 1 year from now: 107.67 = 110.44 - (110.44 x .0251) = 110.44 – 2.77 = 107.67\ Spot rate 2 years from now: 104.97 = 107.67 – (107.67 x .0251) = 107.67 – 2.70 = 104.97 Note: Yen is quoted in European terms, hence the minus sign in the above calculation. The minus sign represents an appreciation of the yen.

Australian Dollar Example Using interest rate data from Bloomberg’s web site (rates and bonds): http://www.bloomberg.com/markets/index.html 2 year U.S. Government rate: 2.65% 2 year Australian Government rate: 5.13% Higher Australian interest rate is accounted for on the basis of higher expected inflation in Australia: = 2.65% – 5.13% = -2.48% Forecast: Australian dollar over the next two years.

Exchange Rate Change Given the expected inflation differences, the Australian dollar will depreciate 2.48% per year. Current spot rate USD.7262/AUD. Spot rate 1 year from now: .7569 = .7762 - (.7762 x .0248) = .7762 - .0193 = .7569 Spot rate 2 years from now: 3.09 = .7569 - (.7569 x .0248) = .7569 - .0188 = .7381 Note: The Australian dollar is quoted in American terms; hence the minus sign in the above calculation The minus sign represents a depreciation of the Australian dollar.