1. International Financial Markets: Exchange Rates, Interest Rates and Inflation Rates

2. Exchange Rates Price of a unit of one currency in terms of another; e.g. £/$, €/$ People care about what a currency can bring in terms of goods & services or a rate of return How one currency trades against another depends on how each trades against goods and services or financial instruments

3. Parity Relationships In equilibrium, the same product or financial instrument should cost the same (in terms of a given currency) in any country Otherwise, there is an incentive to trade How strong are the barriers to trade?

4. Purchasing Power Parity (PPP) S 0, the spot exchange rate, is measured as €/$ If the same good sells for P $ in the U.S. and P euro in Europe, then in equilibrium:

6. Checking PPP for the Big Mac Suppose the spot exchange rate is.7569 €/$ In Paris, you can buy a Big Mac for €2.84, the equivalent of $3.75 However, a Big Mac in NYC costs $3.00 Let’s take a trip The secret to arbitrage: do it big

7. Paris To-Do List 1.Borrow €1 billion (@2.08375% annualized rate per day) 2.Convert to €1bil/.7569 = $1,321,178,491 3.Board plane to NYC

8. NYC To-Do List 1.Rent fleet of 18- wheelers 2.Buy $1,321,178,491/3.00 = 440,392,830 Big Macs 3.Return to airport and board cargo planes to Paris

9. Paris Return To-Do List 1.Sell 440,392,830 Big Macs @ €2.84: €1,250,715,637 2.Pay bank €1,000,114,181 (principal plus int.) 3.End day, tired but happy with €250,601,456 (=$331,089.253.50)

10. Relative PPP If transaction costs prevent $ prices for every single good from being equated across countries, maybe the average $ price of a general market basket of goods will be equated

11. Relative PPP and Expected Exchange Rates Expected depreciation of ¥ relative to $ is related to amount by which Japanese inflation rate exceed that in U.S.

12. General Relative PPP Over Time

13. Interest Rate Parity (IRP) F 1 is the one-period forward exchange rate (say, £/$) If IRP doesn’t hold there is a relatively easy and low- cost arbitrage opportunity

14. Arbitrage Opportunity Ability to buy and sell perfect substitutes at different prices in 2 markets Earn profit with no risk and without putting up any of your own money Arbitrage opportunities will be driven out in an efficient capital market

15. General IRP Over Time Suppose F t = E(S t ); e.g., assume forward rates are unbiased predictors of future spot rates Combine IRP with PPP

16. IRP + Relative PPP Relation between nominal interest rates in different countries and their relative inflation rates Cross-multiply (1+R US ) t and (1+h UK ) t

17. International Fisher Effect In equilibrium, real interest rates tend to be equated across countries

18. International Capital Budgeting: Home Currency Approach Translate all foreign cash flows into $ using spot and expected future exchange rates; discount at $ discount rate S 0 and E(S t ) measured as for. curr./$

19. International Capital Budgeting: Foreign Currency Approach Discount foreign currency (FC) cash flows at FC discount rate to find FC in FC terms Translate the result into $ using the spot exchange rate

20. The Role of Interest Rate Parity If IRP holds, the relationship between R FC and R $ is given by:

21. Equivalence of the Two Approaches