Lecture 14

March 22, 2004

Exchange Rate - Amount of one currency needed to purchase one unit of another. Spot Rate of Exchange - Exchange rate for an immediate transaction. Forward Exchange Rate - Exchange rate for a forward transaction.

Forward Premiums and Forward Discounts Example - The Peso spot price is peso per dollar and the 1 year forward rate is Peso per dollar, what is the premium and discount relationship?

Forward Premiums and Forward Discounts Example - The Peso spot price is peso per dollar and the 1 year forward rate is Peso per dollar, what is the premium and discount relationship?

Forward Premiums and Forward Discounts Example - The Peso spot price is peso per dollar and the 1 year forward rate is Peso per dollar, what is the premium and discount relationship? Answer - The dollar is selling at a 5.15% premium, relative to the peso. The peso is selling at a 5.15% discount, relative to the dollar.

 Basic Relationships equals

1) Interest Rate Parity Theory  The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates.

Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in 6.7 % or a 1 year US bond (in 1.22%. The spot rate is peso:$1 The 1 year forward rate is peso:$1 Which bond will you prefer and why? Ignore transaction costs

Value of US bond = $1,000,000 x = $1,012,200 Value of Mexican bond = $1,000,000 x = 10,981,500 peso exchange 10,981,500 peso x = 11,717,261 peso bond pmt 11,717,261 peso / = $1,012,072 exchange Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Mexican bond (in 6.7 % or a 1 year US bond (in 1.22%. The spot rate is peso:$1 The 1 year forward rate is peso:$1 Which bond will you prefer and why? Ignore transaction costs

2) Expectations Theory of Exchange Rates Theory that the expected spot exchange rate equals the forward rate.

3) Purchasing Power Parity The expected change in the spot rate equals the expected difference in inflation between the two countries.

solve for Es Es = Example - If inflation in the US is forecasted at 1.5% this year and Mexico is forecasted at 6.5%, what do we know about the expected spot rate? Given a spot rate of peso:$1

4) International Fisher effect The expected difference in inflation rates equals the difference in current interest rates. Also called common real interest rates

Exchange Rate Relationships 4) International Fisher effect The expected difference in inflation rates equals the difference in current interest rates. Also called common real interest rates

Example - The real interest rate in each country is about the same

Percent error in the one month forward rate for Swiss Franc per US $ compared to actual spot rate

The Big Mac Index – The price of a Big Mac in different countries (May 29, 2004)

Relative change in purchasing power, percent Relative change in exchange rate, percent

Nominal versus Real Exchange Rates U.S. Dollar / British Pound (in log scale)

Countries with the highest interest rates generally have the highest inflation rates. In this diagram each of the 129 points represents a different country. Average inflation rate, percent, latest 5 years to 2003 Average money market rate, percent, latest 5 years to 2003

Example - Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of Y:$1 the car sells for $14,209 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 134Y:$1, what will be the price of the car? 1,715,000 = $12, Conversely, if the yen is trading at a forward discount, Japan will experience a decrease in purchasing power.

Example - Harley Davidson builds a motorcycle for a cost plus profit of $12,000. At an exchange rate of Y:$1, the motorcycle sells for 1,448,400 yen in Japan. If the dollar rises in value and the exchange rate is 134Y:$1, what will the motorcycle cost in Japan? $12,000 x 134 = 1,608,000 yen

 Currency Risk can be reduced by using various financial instruments  Currency forward contracts, futures contracts, and even options on these contracts are available to control the risk