1 Multinational Financial Management Alan Shapiro 10 th 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) 5

ARBITRAGE AND THE LAW OF ONE PRICE 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) 6

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 7

ARBITRAGE AND THE LAW OF ONE PRICE F.THE LAW OF ONE PRICE - enforced by international arbitrage. 8

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. 9

PURCHASING POWER PARITY II. ABSOLUTE PURCHASING POWER PARITY A. Price levels adjusted for exchange rates should be equal between countries 10

PURCHASING POWER PARITY II. ABSOLUTE PURCHASING POWER PARITY B. One unit of currency has same purchasing power globally. 11

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 12

PURCHASING POWER PARITY 13

PURCHASING POWER PARITY 14

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. 15

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. 16

PURCHASING POWER PARITY B.Real Exchange Rates: the quoted or nominal rate adjusted for a country’s inflation rate is 17

PURCHASING POWER PARITY C.Real exchange rates 1.If exchange rates adjust to inflation differential, PPP states that real exchange rates stay the same. 18

PURCHASING POWER PARITY C. Real exchange rates (con’t) 2. Competitive positions: domestic and foreign firms are unaffected 19

THE FISHER EFFECT (FE) 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 20

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 r h - r f = i h - i f 21

THE FISHER EFFECT C.According to the Fisher Effect: countries with higher inflation rates have higher interest rates 22

THE FISHER EFFECT  Due to capital market integration globally, interest rate differentials are eroding 23

THE INTERNATIONAL FISHER EFFECT I.IFE STATES: A.the spot rate adjusts to the interest rate differential between two countries 24

THE INTERNATIONAL FISHER EFFECT IFE = PPP + FE 25

THE INTERNATIONAL FISHER EFFECT B.Fisher postulated 1. The nominal interest rate differential should reflect the inflation rate differential 26

THE INTERNATIONAL FISHER EFFECT B. Fisher also postulated: 2. Expected rates of return are equal in the absence of government intervention 27

THE INTERNATIONAL FISHER EFFECT C.Simplified IFE equation: (if r f is relatively small) 28

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 29

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. 30

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 (r h - r f ) between two co.untries 31

INTEREST RATE PARITY THEORY 32

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 33

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. 34

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 35

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 36

THE FORWARD AND THE FUTURE SPOT RATE I.THE UNBIASED FORWARD RATE A.States that, if the forward rate (f t ) is unbiased, then it should reflect the expected future spot rate (e t ) B. Stated as f t = e t 37

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 38

CURRENCY FORECASTING 1. MARKET-BASED FORECASTS: - derived from market indicators a.The current forward rate contains implicit information about exchange rate changesfor one year b.Interest rate differentials may be used to predict exchange rates beyond one year 39

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 40

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