Multinational Financial Management Alan Shapiro 7th Edition Power Points by J.Wiley & Sons Joseph F Greco, Ph.D California State University, Fullerton CHAPTER PARITY CONDITIONS AND CURRENCY FORECASTING CHAPTER OVERVIEW I ARBITRAGE AND THE LAW OF ONE PRICE II PURCHASING POWER PARITY III THE FISHER EFFECT IV THE INTERNATIONAL FISHER EFFECT V INTEREST RATE PARITY THEORY VI THE RELATIONSHIP BETWEEN THE FORWARD AND FUTURE SPOT RATE VII CURRENCY FORECASTING PART I ARBITRAGE AND THE LAW OF ONE PRICE I THE LAW OF ONE PRICE A Law states: Identical goods sell for the same price worldwide ARBITRAGE AND THE LAW OF ONE PRICE B Theoretical basis: If the price after exchange-rate adjustment were not equal, arbitrage in the goods worldwide ensures eventually it will ARBITRAGE AND THE LAW OF ONE PRICE C Five Parity Conditions Result From These Arbitrage Activities Purchasing Power Parity (PPP) The Fisher Effect (FE) The International Fisher Effect (IFE) Interest Rate Parity (IRP) Unbiased Forward Rate (UFR) ARBITRAGE AND THE LAW OF ONE PRICE D Five Parity Conditions Linked by The adjustment of various rates and prices to inflation ARBITRAGE AND THE LAW OF ONE PRICE The notion that money should have no effect on real variables (since they have been adjusted for price changes) ARBITRAGE AND THE LAW OF ONE PRICE E Inflation and home currency depreciation: jointly determined by the growth of domestic money supply; Relative to the growth of domestic money demand ARBITRAGE AND THE LAW OF ONE PRICE F THE LAW OF ONE PRICE - enforced by international arbitrage 10 THE INTERNATIONAL FISHER EFFECT B Fisher postulated The nominal interest rate differential should reflect the inflation rate differential 28 THE INTERNATIONAL FISHER EFFECT B Fisher postulated Expected rates of return are equal in the absence of government intervention 29 THE INTERNATIONAL FISHER EFFECT C Simplified IFE equation: (if rf is relatively small) e1 − e0 rh − rf = e0 30 THE INTERNATIONAL FISHER EFFECT D Implications of IFE Currency with the lower interest rate expected to appreciate relative to one with a higher rate 31 THE INTERNATIONAL FISHER EFFECT D Implications of IFE Financial market arbitrage: insures interest rate differential is an unbiased predictor of change in future spot rate 32 PART VI INTEREST RATE PARITY THEORY I INTRODUCTION A 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 33 INTEREST RATE PARITY THEORY The forward premium or discount equals the interest rate differential (F - S)/S = (rh - rf) where rh = the home rate rf = the foreign rate 34 INTEREST RATE PARITY THEORY In equilibrium, returns on currencies will be the same i e No profit will be realized and interest parity exists which can be written (1 + rh) = F (1 + rf) S 35 INTEREST RATE PARITY THEORY B Covered Interest Arbitrage Conditions required: interest rate differential does not equal the forward premium or discount Funds will move to a country with a more attractive rate 36 INTEREST RATE PARITY THEORY Market pressures develop: a As one currency is more demanded spot and sold forward b rates Inflow of fund depresses interest c Parity eventually reached 37 INTEREST RATE PARITY THEORY C Summary: Interest Rate Parity states: Higher interest rates on a currency offset by discounts forward Lower interest rates are offset by forward premiums 38 PART VI THE RELATIONSHIP BETWEEN THE FORWARD AND THE FUTURE SPOT RATE I THE UNBIASED FORWARD RATE A States that if the forward rate is unbiased, then it should reflect the expected future spot rate B Stated as ft = e t 39 PART VI CURRENCYFORECASTING I FORECASTING MODELS A Created to forecast exchange rates in addition to parity conditions B Two types of forecast: Market-based Model-based 40 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 41 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 of Historical volume and price data Charting and trend analysis 42