Presentation on theme: "Multinational Financial Management Alan Shapiro 7th Edition J"— Presentation transcript:
1 Multinational 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
2 PARITY CONDITIONS AND CURRENCY FORECASTING CHAPTER 4PARITY CONDITIONS AND CURRENCY FORECASTING
3 CHAPTER 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
4 PART I. ARBITRAGE AND THE LAW OF ONE PRICE I. THE LAW OF ONE PRICEA. Law states:Identical goods sell for the same price worldwide.
5 ARBITRAGE 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.
6 ARBITRAGE 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)
7 ARBITRAGE AND THE LAW OF ONE PRICE D. Five Parity Conditions Linked by1. The adjustment of variousrates and prices to inflation.
8 ARBITRAGE 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).
9 ARBITRAGE 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.
10 ARBITRAGE AND THE LAW OF ONE PRICE F. THE LAW OF ONE PRICE- enforced by internationalarbitrage.
11 PART 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.
12 PURCHASING POWER PARITY II. ABSOLUTE PURCHASINGPOWER PARITYA. Price levels adjusted forexchange rates should beequal between countries
13 PURCHASING POWER PARITY II. ABSOLUTE PURCHASINGPOWER PARITYB. One unit of currency has same purchasing power globally.
14 PURCHASING 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.
15 PURCHASING POWER PARITY 1. In mathematical terms:where et = future spot ratee0 = spot rateih = home inflationif = foreign inflationt = the time period
16 PURCHASING POWER PARITY 2. If purchasing power parity isexpected to hold, then the bestprediction for the one-periodspot rate should be
17 PURCHASING POWER PARITY 3. A more simplified but less precise relationship isthat is, the percentage change should be approximately equal to the inflation rate differential.
18 PURCHASING 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.
19 PURCHASING POWER PARITY B. Real Exchange Rates:the quoted or nominal rate adjusted for a country’s inflation rate is
20 PURCHASING POWER PARITY C. Real exchange rates1. If exchange rates adjust to inflation differential, PPP states that real exchange rates stay the same.
21 PURCHASING POWER PARITY C. Real exchange rates2. Competitive positions:domestic and foreign firmsare unaffected.
22 PART 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
23 THE 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
24 THE FISHER EFFECT C. According to the Fisher Effect, countries with higher inflation rates have higher interest rates.
25 THE FISHER EFFECTD. Due to capital market integration globally, interest rate differentials are eroding.
26 PART IV. THE INTERNATIONAL FISHER EFFECT (IFE) I. IFE STATES:A. the spot rate adjusts to the interest rate differential between two countries.
28 THE INTERNATIONAL FISHER EFFECT B. Fisher postulated1. The nominal interest rate differential should reflect the inflation rate differential.
29 THE INTERNATIONAL FISHER EFFECT B. Fisher postulated2. Expected rates of return are equal in the absence of government intervention.
30 THE INTERNATIONAL FISHER EFFECT C. Simplified IFE equation:(if rf is relatively small)
31 THE INTERNATIONAL FISHER EFFECT D. Implications of IFE1. Currency with the lower interest rate expected to appreciate relative to onewith a higher rate.
32 THE INTERNATIONAL FISHER EFFECT D. Implications of IFE2. Financial market arbitrage:insures interest rate differential is an unbiased predictor of change in future spot rate.
33 PART 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.
34 INTEREST 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
35 INTEREST 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
36 INTEREST 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.
37 INTEREST 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.
38 INTEREST 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.
39 PART 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
40 PART 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
41 CURRENCY 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.
42 CURRENCY 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