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MULTINATIONAL BUSINESS FINANCE COURSE 723G33 International Parity Conditions ESM chapter 7 PhD in Finance 7-1.

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Presentation on theme: "MULTINATIONAL BUSINESS FINANCE COURSE 723G33 International Parity Conditions ESM chapter 7 PhD in Finance 7-1."— Presentation transcript:

1 MULTINATIONAL BUSINESS FINANCE COURSE 723G33 International Parity Conditions ESM chapter 7 PhD in Finance 7-1

2 International Parity Conditions Managers of multinational firms, international investors, importers and exporters, and government officials must deal with these fundamental issues: What are the relationship between exchange rate, interest rate and inflation? Are changes in exchange rates predictable? PhD in Finance 7-2

3 International Parity Conditions 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. PhD in Finance7-3

4 4 International Parity Conditions  The derivation of these conditions requires the assumption of Perfect Capital Markets (PCM).  no transaction costs  no taxes  complete certainty  NOTE – Parity Conditions are expected to hold in the long-run, but not always in the short run.

5 The Law of one price: 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 do not exist, then the product’s price should be the same in both markets. This is called the law of one price.

6  A primary principle of competitive markets is that prices will equalize across markets if frictions (transportation costs) do not exist. That is: P $ x S = P ¥ or S= P ¥ / P $ Where the product price in US dollars is (P $ ), the spot exchange rate is (S) and the price in Yen is (P ¥ ). 7-6 PhD in Finance

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8  Law of one price should hold for a basket of identical goods and services in different currencies.  By comparing the prices of identical products denominated in different currencies, we could determine the PPP exchange rate that should exist if markets were efficient.  S ¥/$ = ∑P ¥ / ∑P $  Note that Big Mac index is potentially misleading but fun to know. 7-8 PhD in Finance

9  If the exchange rate between two currencies starts in equilibrium, then, we have 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. 7-9 PhD in Finance

10  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.” 7-10 PhD in Finance

11 7-11 %∆S %∆P PhD in Finance

12  RPPP is not accurate in predicting future exchange rates.  Two general conclusions can be made from empirical tests:  RPPP 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 PhD in Finance

13  The objective is to discover whether a nation’s exchange rate is “overvalued” or “undervalued” in terms of RPPP.  This problem is often dealt with through the calculation of exchange rate indices such as the nominal effective exchange rate index PhD in Finance

14 Relative PPP Example  Given inflation rates of 5% and 10% in Australia and the UK respectively, what is the prediction of PPP with regards to $A/£ exchange rate? = (0.05 – 0.10)/( ) = = - 4.5% The general implication of relative PPP is that countries with high rates of inflation will see their currencies depreciate against those with low rates of inflation. 14 Relative PPP

15 15 Forecasting Future Spot Rates  Suppose the spot exchange rate and expected inflation rates are:  What is the expected ¥/$ exchange rate if relative PPP holds? Answer:

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17  Incomplete exchange rate pass-through is one of the reasons that a country’s Real effective exchange rate index can deviate from the exchange rate  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 PhD in Finance

18  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 PhD in Finance

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20  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: i = r + Where i is nominal interest rate, r is real interest rate and is expected inflation PhD in Finance

21 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.  Also called “Fisher-open”. The spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries PhD in Finance

22  approximately:  Where i $ and i ¥ are the respective national interest rates and S 1 is the spot exchange rate (¥/$) at t=1, S 2 is the expected future spot rate at t=2.  Justification for the International Fisher effect is that investors must offset the expected change in exchange rates S2S2 = i $ - i ¥ S 1 – S 2 PhD in Finance

23  A forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought or sold forward at a specific date in the future.  A forward rate is an exchange rate quoted for settlement at some future date. For 1, 2, 3, 6, 12 month.  Forward rate over 2 years is called swap rate PhD in Finance

24  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 (F SF/$ 90) = the current spot rate (S SF /$) times the ratio of the 90- day euro-Swiss franc deposit rate (i SF ) over the 90-day Eurodollar deposit rate (i $ ) PhD in Finance

25  Formal representation of the forward rate: F SF/$ 90 = S SF/$ x [1 + (i SF x 90/360)] 7-25 [1 + (i $ x 90/360)] PhD in Finance

26  The forward premium or discount (of SF) 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 Forward 360 days 100 x x PhD in Finance

27 The 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 7-27 PhD in Finance

28 7-28 i$i$ i sf PhD in Finance

29 7-29 Exchange market PhD in Finance

30  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) PhD in Finance

31 7-31 PhD in Finance

32 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 PhD in Finance

33 7-33 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. PhD in Finance

34  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 PhD in Finance

35 7-35 Exhibit 7.9 Interest Rate Parity (IRP) and Equilibrium PhD in Finance

36  Forward 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 PhD in Finance

37 7-37 PhD in Finance

38 Fundamental 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 S 1 is 104 ¥ /$. The one-year forward is S ¥ /$. The Spot rate one year from now is S 2  a) Purchasing Power Parity (PPP) S 2 /S 1 = (1+ ∏ ¥ )/(1+ ∏ $ ) S 2 =104*1,01/1,05=100 ¥ /$ 7-38 PhD in Finance

39  b) the Fisher Effect The nominal interest rate differential =difference in expected rate of inflation 8%-4%=-(1%-5%) c) International Fisher Effect The forcasted change in spot rate =the differential between nominal interest rates (S 1 -S 2 ) /S 2 =i $ -i ¥ d) Interest Rate Parity (S 1 -F ) /F=i $ -i ¥ 7-39 PhD in Finance

40  e) Forward rate as an unbiased predictor. This is also called expectations theory. Combining d) and c), we have F=S 2 where S 2 is expected spot rate in the future. See exhibit 7.11 for the 5 parity conditions in the exchange market PhD in Finance

41 7-41 PhD in Finance

42 7-42 Exchange Rate Pass-Through PhD in Finance

43  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? 7-43 PhD in Finance

44 7-44 Exhibit 1 Pass-Through Analysis for the 911 Carrera 4S Cabriolet, 2003 PhD in Finance


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