Presentation on theme: "Multinational Financial Management Alan Shapiro 7th Edition J"— Presentation transcript:
1Multinational Financial Management Alan Shapiro 7th Edition J Multinational Financial Management Alan Shapiro 7th Edition J.Wiley & SonsPower Points byJoseph F. Greco, Ph.D.California State University, Fullerton
2PARITY CONDITIONS AND CURRENCY FORECASTING CHAPTER 4PARITY CONDITIONS AND CURRENCY FORECASTING
3CHAPTER OVERVIEW I. ARBITRAGE AND THE LAW OF ONE PRICE II. PURCHASING POWER PARITYIII. THE FISHER EFFECTIV. THE INTERNATIONAL FISHER EFFECTV. INTEREST RATE PARITY THEORYVI. THE RELATIONSHIP BETWEEN THE FORWARD AND FUTURE SPOT RATEVII. CURRENCY FORECASTING
4PART I. ARBITRAGE AND THE LAW OF ONE PRICE I. THE LAW OF ONE PRICEA. Law states:Identical goods sell for the same price worldwide.
5ARBITRAGE AND THE LAW OF ONE PRICE B. Theoretical basis:If the price after exchange-rateadjustment were not equal, arbitrage in the goods worldwide ensures eventually it will.
6ARBITRAGE AND THE LAW OF ONE PRICE C. Five Parity Conditions Result From These Arbitrage Activities1. 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)
7ARBITRAGE AND THE LAW OF ONE PRICE D. Five Parity Conditions Linked by1. The adjustment of variousrates and prices to inflation.
8ARBITRAGE AND THE LAW OF ONE PRICE 2. The notion that money should have no effect on real variables (since they have been adjusted for price changes).
9ARBITRAGE 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 ofdomestic money demand.
10ARBITRAGE AND THE LAW OF ONE PRICE F. THE LAW OF ONE PRICE- enforced by internationalarbitrage.
11PART II. PURCHASING POWER PARITY I. THE THEORY OF PURCHASINGPOWER PARITY:states that spot exchange rates between currencies will change to the differential in inflation rates between countries.
12PURCHASING POWER PARITY II. ABSOLUTE PURCHASINGPOWER PARITYA. Price levels adjusted forexchange rates should beequal between countries
13PURCHASING POWER PARITY II. ABSOLUTE PURCHASINGPOWER PARITYB. One unit of currency has same purchasing power globally.
14PURCHASING POWER PARITY III. RELATIVE PURCHASING POWER PARITYA. states that the exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries.
15PURCHASING POWER PARITY 1. In mathematical terms:where et = future spot ratee0 = spot rateih = home inflationif = foreign inflationt = the time period
16PURCHASING POWER PARITY 2. If purchasing power parity isexpected to hold, then the bestprediction for the one-periodspot rate should be
17PURCHASING POWER PARITY 3. A more simplified but less precise relationship isthat is, the percentage change should be approximately equal to the inflation rate differential.
18PURCHASING POWER PARITY 4. PPP saysthe currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation.
19PURCHASING POWER PARITY B. Real Exchange Rates:the quoted or nominal rate adjusted for a country’s inflation rate is
20PURCHASING POWER PARITY C. Real exchange rates1. If exchange rates adjust to inflation differential, PPP states that real exchange rates stay the same.
21PURCHASING POWER PARITY C. Real exchange rates2. Competitive positions:domestic and foreign firmsare unaffected.
22PART III. THE FISHER EFFECT (FE) 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
23THE FISHER EFFECT B. Real Rates of Interest 1. Should tend toward equalityeverywhere through arbitrage.2. With no government interference nominal rates vary by inflation differential orrh rf = ih - if
24THE FISHER EFFECT C. According to the Fisher Effect, countries with higher inflation rates have higher interest rates.
25THE FISHER EFFECTD. Due to capital market integration globally, interest rate differentials are eroding.
26PART IV. THE INTERNATIONAL FISHER EFFECT (IFE) I. IFE STATES:A. the spot rate adjusts to the interest rate differential between two countries.
28THE INTERNATIONAL FISHER EFFECT B. Fisher postulated1. The nominal interest rate differential should reflect the inflation rate differential.
29THE INTERNATIONAL FISHER EFFECT B. Fisher postulated2. Expected rates of return are equal in the absence of government intervention.
30THE INTERNATIONAL FISHER EFFECT C. Simplified IFE equation:(if rf is relatively small)
31THE INTERNATIONAL FISHER EFFECT D. Implications of IFE1. Currency with the lower interest rate expected to appreciate relative to onewith a higher rate.
32THE INTERNATIONAL FISHER EFFECT D. Implications of IFE2. Financial market arbitrage:insures interest rate differential is an unbiased predictor of change in future spot rate.
33PART VI. INTEREST RATE PARITY THEORY I. INTRODUCTIONA. The Theory states:the forward rate (F) differs from the spot rate (S) at equilibrium by an amount equal to the interest differential (rh - rf) between two countries.
34INTEREST RATE PARITY THEORY 2. The forward premium ordiscount equals the interestrate differential.(F - S)/S = (rh - rf)where rh = the home raterf = the foreign rate
35INTEREST RATE PARITY THEORY 3. In equilibrium, returns oncurrencies will be the samei. e. No profit will be realizedand interest parity existswhich can be written(1 + rh) = F(1 + rf) S
36INTEREST RATE PARITY THEORY B. Covered Interest Arbitrage1. Conditions required:interest rate differential doesnot equal the forward premium or discount.2. Funds will move to a countrywith a more attractive rate.
37INTEREST RATE PARITY THEORY 3. Market pressures develop:a. As one currency is more demanded spot and sold forward.b. Inflow of fund depresses interest rates.c. Parity eventually reached.
38INTEREST RATE PARITY THEORY C. Summary:Interest Rate Parity states:1. Higher interest rates on acurrency offset by forward discounts.2. Lower interest rates are offset by forward premiums.
39PART VI. THE RELATIONSHIP BETWEEN THE FORWARD AND THE FUTURE SPOT RATE I. THE UNBIASED FORWARD RATEA. States that if the forward rate is unbiased, then it should reflect the expected future spot rate.B. Stated asft = et
40PART VI. CURRENCYFORECASTING I. FORECASTING MODELSA. Created to forecast exchange rates in addition to parity conditions.B. Two types of forecast:1. Market-based2. Model-based
41CURRENCY FORECASTING MARKET-BASED FORECASTS: derived from market indicators.A. The current forward rate contains implicit information about exchange rate changes for one year.B. Interest rate differentials may be used to predict exchange rates beyond one year.
42CURRENCY FORECASTING 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 of1. Historical volume and price data2. Charting and trend analysis