International Finance INTERNATIONAL PARITY CONDITIONS

What are the determinants of exchange rate? Are changes in exchange rates predictable? The economic theory that link exchange rates, price levels, and interest rates together are called International Parity conditions.

Price & exchange rates If the identical product or service can be sold in the different markets, the product’s price should be the same in both markets. If two markets situated in two different countries comparing price would require only a conversion from one currency to the other. p$ * s = p¥ Exchange rate could be deduced from the local product prices. s =p¥ / p$

Purchasing power parity PPP – absolute or the law of one price Exchange rate between currencies of two countries should be equal to the ratio of the countries price level. Absolute PPP states that the spot exchange rate is determined by the relative price of the similar basket of goods. A Big Mac Switzerland costs SFr 6.30 which the same Big Mac in the USA is $ 2.49. Calculate the PPP exchange rate. How ever on the date of survey, the actual exchange rate was SFr1.66/$. Calculate the percentage of over or under value of SFr.

Relative PPP If the spot exchange rate between two countries starts in equilibrium, any change in the expected differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate.

Empirical test of PPP Two general conclusions can be made from these tests PPP holds up well over the very long run but poorly for shorter time periods. The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets.

Effective Exchange Rate On any given day, a currency may appreciate in value relative to some currencies while depreciating in value against others. An effective exchange rate is a measure of the weighted-average value of a currency relative to a select group of currencies. Thus, it is a guide to the general value of the currency.

Weighted Average Value To construct an EER, we must first pick a set of currencies we are most interested in. Next, we must assign relative weights. In the following example, we weight the currency according to the country’s importance as a trading partner.

Weights Suppose that of all the trade of the US with Canada, Mexico, and the UK, Canada accounts for 50 percent, Mexico for 30 percent, and the UK for 20 percent. These constitute our weights (0.50, 0.30, and 0.20). Now consider the following exchange rate data.

Exchange Rate Data

Calculating the EER The EER is calculating by summing the weighted values of the current period rate relative to the base year rate. The weighted-average value is calculated as: (weight i)(current exchange value i)/(base exchange value i) where i represents each individual country included in the weighted average.

Calculating the EER Commonly this sum is multiplied by 100 to express the EER on a 100 basis. Hence, an EER is an index. As we shall see next, the base-year value of the index is 100. The index, therefore, is useful is showing changes in the weighted average value from one period to another.

Example Let last year be the base year. The effective exchange rate last year was: [(1.52/1.52)*0.50 + (10.19/10.19)*0.30 + (0.61/.61)*0.20]*100 = 100. As with any index measure, the base year value is 100.

Example Today’s value of the EER is: or (0.958) 95.8 (1.44/1.52)*0.50 + (9.56/10.19)*0.30 + (0.62/0.61)*0.20 or (0.958) 95.8 The dollar, therefore, has experienced a 4.2 percent depreciation in weighted value.

Effective Exchange Measures There are a number of effective exchange measures available in the popular press. Some common measures are: Bank of England Index: The Economist. J.P. Morgan: The Wall Street Journal and the Financial Times.

Exchange rate pass-through Pass-through is the measure of response of imported and exported prices to exchange rate changes. BMW produces an automobile in Germany and pays all production expenses in Euros. The price of BMW in U.S market should simply be; P$BMW = P€BMW * S = €35000 * $1.000/€ = $35000 If € appreciate 20% versus the USD, from $1.00/€ to $1.200/ €, calculate the theoretical price of BMW in U.S market.

Interest rates & exchange rates Fisher effect The fisher effect holds that an increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest tare in the country. i = r + E(л) Eg. Real interest rate 2% per year. Expected inflation rate is 4%, the nominal interest rate set at 6% then. The lender will be fully compensated for the expected erosion of the purchasing power of money while still expecting to realize a 2% real return.

The forward parity The forward rate is calculated for any specific maturity by adjusting the current spot exchange rate by the ratio of Euro currency interest rates of the same maturity for the two subject currencies. Eg. 90-day forward rate for the Swiss franc/USD exchange rate is; FSF/$90 = SSF/$ * [1+(iSF * 90/360)] / [1+ (i$ * 90/360)] Spot rate of SF 1.4800/$, 90-day Euro Swiss franc deposit rate 4% per annum, 90-day Euro dollar deposit rate of 8% per annum. Calculate the 90-day forward rate of SF/$

Currency yield curves and the forward premium

Interest rate parity - IRP Linkage between the foreign exchange markets and the international money markets.

Covered Interest Arbitrage – CIA Uncovered Interest Arbitrage –UIA

Equilibrium between interest rates and exchange rates

Forecasting exchange rates Efficient market approach Fundamental approach Technical approach