Multinational Financial Management
Alan Shapiro
10th Edition
John Wiley & Sons, Inc.
PowerPoints by
Joseph F. Greco, Ph.D.
California State University, Fullerton
1
CHAPTER 4
PARITY CONDITIONS AND
CURRENCY FORECASTING
ARBITRAGE AND THE LAW OF
ONE PRICE
I.
THE LAW OF ONE PRICE
A.
Law states:
Identical goods sell for the same price
worldwide.
3
ARBITRAGE AND THE LAW OF
ONE PRICE
B. Theoretical basis:
If the prices after exchange-rate
adjustment were not equal,
arbitrage for the goods worldwide ensures
that eventually they will.
4
ARBITRAGE AND THE LAW OF
ONE PRICE
C. Five Parity Conditions Result From These
Arbitrage Activities
1.
2.
3.
4.
5.
Purchasing Power Parity (PPP)
The Fisher Effect (FE)
The International Fisher Effect
(IFE)
Interest Rate Parity (IRP)
Unbiased Forward Rate (UFR)
5
ARBITRAGE AND THE LAW OF
ONE PRICE
D. Five Parity Conditions Linked by
1. The adjustment of various
rates and prices to inflation
2. The notion that money should have no
effect on real variables (since they
have been adjusted for price changes)
6
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 of
domestic money demand
7
ARBITRAGE AND THE LAW OF
ONE PRICE
F.
THE LAW OF ONE PRICE
- enforced by international
arbitrage.
8
PURCHASING POWER PARITY
I.
THE THEORY OF PURCHASING
POWER PARITY:
states that spot exchange rates between
currencies will change to the differential in
inflation rates between countries.
9
PURCHASING POWER PARITY
II. ABSOLUTE PURCHASING POWER PARITY
A.
Price levels adjusted for
exchange rates should be
equal between countries
10
PURCHASING POWER PARITY
II. ABSOLUTE PURCHASING POWER PARITY
B. One unit of currency has same purchasing power
globally.
11
PURCHASING POWER PARITY
III. RELATIVE PURCHASING POWER PARITY
A.
states that the exchange rate of one
currency against another will adjust to
reflect changes in the price levels of the
two countries
12
PURCHASING POWER PARITY
1.
In mathematical terms:
𝑒𝑡
𝑒0
=
1+ 𝑖ℎ 𝑡
1+ 𝑖𝑓
where et
e0
ih
if
t
𝑡
=
=
=
=
=
future spot rate
spot rate
home inflation
foreign inflation
the time period
13
PURCHASING POWER PARITY
2. If purchasing power parity is expected to hold, then
the best prediction for the one-period spot rate
should be written as:
𝑒𝑡 = 𝑒0
1+ 𝑖ℎ 𝑡
1+ 𝑖𝑓
𝑡
14
PURCHASING POWER PARITY
3.
A more simplified but less precise relationship is
written
et
 ih  i f
e0
that is, the percentage change should be
approximately equal to the inflation rate
differential.
15
PURCHASING POWER PARITY
4. PPP states:
the currency with the higher inflation rate is
expected to depreciate relative to the currency with
the lower rate of inflation.
16
PURCHASING POWER PARITY
B.
Real Exchange Rates:
the quoted or nominal rate adjusted for a
country’s inflation rate is
'
t
e
 et
(1  i f )
(1  ih )
t
t
17
PURCHASING POWER PARITY
C.
Real exchange rates
1. If exchange rates adjust to inflation differential,
PPP states that real exchange rates stay the
same.
18
PURCHASING POWER PARITY
C. Real exchange rates (con’t)
2.
Competitive positions:
domestic and foreign firms are unaffected
19
THE FISHER EFFECT (FE)
I.
THE FISHER EFFECT (FE)
A. Definition:
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
20
THE FISHER EFFECT
B.
Real Rates of Interest
1. Should tend toward equality
everywhere through arbitrage.
2. With no government interference
nominal rates vary by the inflation
differential or
rh - rf = ih - if
21
THE FISHER EFFECT
C.
According to the Fisher Effect:
countries with higher inflation rates have
higher interest rates
22
THE FISHER EFFECT
Due
to capital market integration globally, interest rate
differentials are eroding
23
THE INTERNATIONAL FISHER
EFFECT
I.
IFE STATES:
A.
the spot rate adjusts to the interest rate
differential between two countries
24
THE INTERNATIONAL FISHER
EFFECT
IFE = PPP + FE
et
(1  rh )

t
e0
(1  r f )
t
25
THE INTERNATIONAL FISHER
EFFECT
B.
Fisher postulated
1. The nominal interest rate differential should
reflect the inflation rate differential
26
THE INTERNATIONAL FISHER
EFFECT
B.
Fisher also postulated:
2. Expected rates of return are equal in
the absence of government intervention
27
THE INTERNATIONAL FISHER
EFFECT
C.
Simplified IFE equation:
(if rf is relatively small)
e1  e0
rh  rf 
e0
28
THE INTERNATIONAL FISHER
EFFECT
D.
Implications of IFE
1. Currency with the lower interest rate is
expected to appreciate relative to the one
with a higher rate
29
THE INTERNATIONAL FISHER
EFFECT
D.
Implications of IFE (con’t)
2. Financial market arbitrage:
insures interest rate differential is an
unbiased predictor of change in future spot
rate.
30
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 co.untries
31
INTEREST RATE PARITY
THEORY
1.
The forward premium or
discount equals the interest
rate differential.
𝐹−𝑆
𝑆
= 𝑟ℎ − 𝑟𝑓
where rh = the home interest rate
rf = the foreign interest rate
32
INTEREST RATE PARITY
THEORY
2.
In equilibrium, returns on currencies
will be the same
i. e. No profit will be realized and
interest parity exists which can be
written
F 1  rh 

S 1  rf 
33
INTEREST RATE PARITY
THEORY
B.
Covered Interest Arbitrage
1. Conditions required:
interest rate differential does not equal the
forward premium or discount
2.
Funds will move to a country
with a more attractive rate.
34
INTEREST RATE PARITY
THEORY
3.
Market pressures develop:
a.
As one currency is more demanded spot
and sold forward
b.
Inflow of funds depresses interest rates
c.
Parity eventually reached
35
INTEREST RATE PARITY
THEORY
C. Summary:
Interest Rate Parity states
1.
Higher interest rates on a currency are
offset by forward discounts
2.
Lower interest rates are offset by
forward premiums
36
THE FORWARD AND THE FUTURE
SPOT RATE
I.
THE UNBIASED FORWARD RATE
A.
States that, if the forward rate (ft ) is
unbiased, then it should reflect the
expected future spot rate (et)
B.
Stated as
ft = et
37
CURRENCY FORECASTING
I.
FORECASTING MODELS
A.
Created to forecast exchange rates in
addition to parity conditions
B.
Two types of forecast:
1. Market-based
2. Model-based
38
CURRENCY FORECASTING
1. 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
39
CURRENCY FORECASTING
2.
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
1.) Historical volume and price data
2.) Charting and trend analysis
40
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