Multinational business finance course 723g33

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Multinational business financecourse 723g33

Chap 7 International Parity Conditions

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International Parity Conditions

Q: What are the determinants of exchange rates? Are changes in exchange rates predictable?

The economic theories that link exchange rates, price levels, and interest rates together are called international parity conditions.

These international parity conditions form the core of the financial theory.

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The Law of one price: Prices and Exchange Rates

If the identical product or service can be: sold in two different markets; and no restrictions exist on the sale; and transportation costs of moving the product

between markets are equal, then the products price should be the same in

both markets. This is called the law of one price.

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Prices and Exchange RatesA primary principle of competitive

markets is that prices will equalize across markets if frictions (transportation costs) do not exist.

Comparing prices would require only a conversion from one currency to the other:

P$ x S = P¥

Where the product price in US dollars is (P$), the spot exchange rate is (S) and the price in Yen is (P¥). 7-4

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Exhibit 7.1 The McCurrency Menu—the Hamburger Standard

Under or over value? It changes all the time!


Prices and Exchange Rates If the law of one price were true for all goods and

services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices.

By comparing the prices of identical products denominated in different currencies, we could determine the “real” or PPP exchange rate that should exist if markets were efficient.

This is the absolute version of the PPP theory.

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Prices and Exchange Rates If the assumptions of the absolute

version of the PPP theory are relaxed, we observe what is termed relative purchasing power parity (RPPP).

the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period. This is RPPP.

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Prices and Exchange Rates More specifically, with regard to RPPP:

“If the spot exchange rate between two countries starts in equilibrium, any change in the 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.”

Q2: Why?

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Exhibit 7.2 Relative Purchasing Power Parity (PPP)

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%∆S

%∆P


Prices and Exchange Rates Empirical testing of PPP and the law of

one price has been done, but has not proved PPP to be accurate in predicting future exchange rates.

Two general conclusions can be made from these tests: PPP holds up well over the very long run but

poorly for shorter time periods; and, the theory holds better for countries with

relatively high rates of inflation and underdeveloped capital markets.

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Prices and Exchange Rates Individual national currencies often need to

be evaluated against other currency values to determine relative purchasing power.

The objective is to discover whether a nation’s exchange rate is “overvalued” or “undervalued” in terms of PPP.

This problem is often dealt with through the calculation of exchange rate indices such as the nominal effective exchange rate index.

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Exhibit 7.3 IMF’s Real Effective Exchange Rate Indexes for the United States, Japan, and the Euro Area (2000 = 100)

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Prices and Exchange Rates Incomplete exchange rate pass-through is one

reason that a country’s real effective exchange rate index can deviate from the exchange rate

The degree to which the prices of imported and exported goods change as a result of exchange rate changes is termed pass-through.

For example, a car manufacturer may or may not adjust pricing of its cars sold in a foreign country if exchange rates alter the manufacturer’s cost structure in comparison to the foreign market.

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Prices and Exchange Rates Pass-through can also be partial as there are

many mechanisms by which companies can absorb the impact of exchange rate changes.

Price elasticity of demand is an important factor when determining pass-through levels.

The price elasticity of demand for any good is the percentage change in quantity of the good demanded as a result of the percentage change in the goods price.

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Interest Rates and Exchange Rates The Fisher Effect states that nominal interest rates in

each country are equal to the required real rate of return plus compensation for expected inflation.

This equation reduces to (in approximate form):i = r +

Where i = nominal interest rate, r = real interest rate and = expected inflation.

Empirical tests (using ex-post) national inflation rates have shown the Fisher effect usually exists for short-maturity government securities (treasury bills and notes).

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Interest Rates and Exchange Rates The relationship between the percentage

change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the international Fisher effect.

“Fisher-open” states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries.

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Interest Rates and Exchange Rates formally:

Where i$ and i¥ are the respective national interest rates and S1 is the spot exchange rate (¥/$) at t=1, S2 is the expected future spot rate at t=2.

Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates.

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S2 = i$ - i¥

S1 – S2


Interest Rates and Exchange RatesA forward rate is an exchange rate

quoted for settlement at some future date.

A forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought forward or sold forward at a specific date in the future.

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Interest Rates and Exchange Rates The forward rate is calculated for any specific

maturity by adjusting the current spot exchange rate by the ratio of Eurocurrency interest rates of the same maturity for the two subject currencies.

For example, the 90-day forward rate for the Swiss franc/US dollar exchange rate

(FSF/$90) =the current spot rate (SSF/$) times the ratio of the 90-day euro-Swiss franc deposit rate (iSF) over the 90-day Eurodollar deposit rate (i$).

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Interest Rates and Exchange RatesFormal representation of the forward

rate:FSF/$

90 = SSF/$ x [1 + (iSF x 90/360)]

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[1 + (i$ x 90/360)]


Interest Rates and Exchange RatesThe forward premium or discount is

the percentage difference between forward exchange rate and spot rate, stated in annual percentage terms.

f SF = Spot – Forward

Note that here SF/$ is used. If use $/SF, then it is (F-S)/S instead. Use common sense.

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Forward

360days

100 x x


Interest Rates and Exchange RatesThe theory of Interest Rate Parity (IRP) provides the linkage between the foreign exchange markets and the international money markets. The theory states: The difference in the national

interest rates for securities of similar risk and maturity (i$ -i€) should be equal to, but with an opposite sign, the forward rate discount or premium for the foreign currency (F-S)/S. we use the quotation $/€ here. (i$ -i€) = (F-S)/S

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Exhibit 7.5 Currency Yield Curves and the Forward Premium

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i$

isf


Exhibit 7.6 Interest Rate Parity (IRP)

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Exchange market

Exchange market


Arbitrage opportunities The spot and forward exchange rates are not

constantly in the state of equilibrium described by interest rate parity.

When the market is not in equilibrium, the potential for risk-free arbitrage profit exists.

The arbitrager will exploit the imbalance by investing in the currency that offers higher return and sell forward and realize a risk free arbitrage profit.

This is known as covered interest arbitrage (CIA).

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Exhibit 7.7 Covered Interest Arbitrage (CIA)

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Uncovered interest arbitrage

Uncovered interest arbitrage (UIA) is a deviation from covered interest arbitrage .In UIA, investors borrow in currencies that have relatively low interest rates and convert the proceed into currencies that offer higher interest rates.The transaction is “uncovered” because the investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the exchange rate risk at the end of the period.

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Exhibit 7.8 Uncovered Interest Arbitrage (UIA): The Yen Carry Trade

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In the yen carry trade, the investor borrows Japanese yen at relatively low interest rates, converts the proceeds to another currency such as the U.S. dollar where the funds are invested at a higher interest rate for a term period. At the end of the period, the investor exchanges the dollars back to yen to repay the loan, pocketing the difference as arbitrage profit. If the spot rate at the end of the period is roughly the same as at the start, or the yen has fallen in value against the dollar, the investor profits. If, however, the yen were to appreciate versus the dollar over the period, the investment may result in significant loss.


Interest Rates and Exchange Rates The following exhibit (7,9) illustrates the

equilibrium conditions between interest rates and exchange rates.

The disequilibrium situation, denoted by point U, is located off the interest rate parity line.

However, the situation represented by point U is unstable because all investors have an incentive to execute the same covered interest arbitrage, which will close this gap in no time.

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Exhibit 7.9 Interest Rate Parity (IRP) and Equilibrium


Interest Rates and Exchange RatesForward exchange rates are

unbiased predictors of future spot exchange rates.

Intuitively this means that the distribution of possible actual spot rates in the future is centered on the forward rate.

Unbiased prediction simply means that the forward rate will, on average, overestimate and underestimate the actual future spot rate in equal frequency and degree.

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Exhibit 7.10 Forward Rate as an Unbiased Predictor for Future Spot Rate

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Ex: International Parity ConditionsFundamental parity conditions (using dollar and yen). The forcasted inflation for Japan and US are 1% and 5% respectively. A 4% differential. The US interest rate is 8%, Japan 4%. The spot rate S1 is 104￥ /$. The one-year forward is S1 100￥ /$. The Spot rate one year from now is S2

a) Purchasing Power Parity (PPP)S2 /S1= (1+∏ ￥ )/(1+∏$)

S2=104*1,01/1,05=100￥ /$7-33


International Parity Conditions b) the Fisher EffectThe nominal interest rate differential =difference in

expected rate of inflation8%-4%=-(1%-5%)

c) International Fisher EffectThe forcasted change in spot rate =the differential

between nominal interest rates(S1-S2 ) /S2 =i$ -i ￥

d) Interest Rate Parity (S1-F ) /F=i$ -i ￥

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International Parity Conditions e) Forward rate as an unbiased predictor

. This is also called expectations theory. Combining d) and c), we have F=S2

where S2 is expected spot rate in the future.

See exhibit 7.11 for the 5 parity conditions in the exchange market.

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Exhibit 7.11 International Parity Conditions in Equilibrium (Approximate Form)

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Exchange Rate Pass-Through


Mini-Case Questions: Currency Pass-Through at Porsche Which do you believe is most important for

sustaining the sale of the new Carrera model, maintaining a profit margin or maintaining the U.S. dollar price?

Given the change in exchange rates and the strategy employed by Porsche, would you say that the purchasing power of the U.S. dollar customer has grown stronger or weaker?

In the long run, what do most automobile manufacturers do to avoid these large exchange rate squeezes?

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Exhibit 1 Pass-Through Analysis for the 911 Carrera 4S Cabriolet, 2003

Multinational business finance course 723g33

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