Multinational Financial

Management
Alan Shapiro
7th Edition
Power Points by
J.Wiley
&
Sons
Joseph F. Greco, Ph.D.
California State University, Fullerton
1

CHAPTER 4
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
3

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.
5

ARBITRAGE AND THE LAW OF ONE

PRICE
C. Five Parity Conditions Result
From These Arbitrage Activities
1. 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)
6

ARBITRAGE AND THE LAW OF ONE

PRICE
D. Five Parity Conditions Linked
by
1. The adjustment of
various
rates and prices to
inflation.

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).
8

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.
9

ARBITRAGE AND THE LAW OF ONE

PRICE
F. THE LAW OF ONE PRICE
- enforced by
international
arbitrage.
10

PART II. 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.
11

PURCHASING POWER PARITY

II.

ABSOLUTE PURCHASING
POWER PARITY

A. Price levels adjusted for

exchange rates should be
equal between countries
12

PURCHASING POWER PARITY

II.

ABSOLUTE PURCHASING
POWER PARITY

B. One unit of currency has

same purchasing power
globally.
13

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.
14

PURCHASING POWER PARITY

1.In mathematical terms:

et
e0
where
e0 =
ih =
if =
t =

ih

1 i f

t
t

et = future spot rate

spot rate
home inflation
foreign inflation
the time period
15

PURCHASING POWER PARITY

2. If purchasing power parity is
expected to hold, then the best
prediction for the one-period
spot rate should be
et e0

1 ih

1 i

t
t

16

PURCHASING POWER PARITY

3. A more simplified but less precise
relationship is

et
ih i f
e0

that is, the percentage change should be

approximately equal to the inflation rate
differential.

17

PURCHASING POWER PARITY

4.

PPP says

the currency with the higher

inflation rate is
expected to
depreciate
relative to the
currency
with the lower rate of inflation.
18

PURCHASING POWER PARITY

B. Real Exchange Rates:
the quoted or nominal rate
adjusted for a countrys
inflation rate is
et' et

(1 i f ) t
(1 ih ) t
19

PURCHASING POWER PARITY

C. Real exchange rates
1. If exchange rates adjust to
inflation differential, PPP
states that real exchange
rates stay the same.

20

PURCHASING POWER PARITY

C. Real exchange rates
2.

Competitive positions:
domestic and foreign

firms
are unaffected.
21

PART III.
THE FISHER EFFECT (FE)
I. THE FISHER EFFECT
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

22

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 inflation differential or
rh - r f = i h - i f
23

THE FISHER EFFECT

C. According to the Fisher
Effect,
countries with higher
inflation rates have higher
interest rates.

24

THE FISHER EFFECT

D. Due to capital market
integration globally, interest
rate differentials are
eroding.

25

PART IV. THE INTERNATIONAL

FISHER EFFECT (IFE)
I. IFE STATES:
A. the spot rate adjusts to the
interest
rate differential
between two
countries.
26

THE INTERNATIONAL FISHER

EFFECT
IFE = PPP + FE
et
(1 rh )

e0
(1 r f ) t
t

27

THE INTERNATIONAL FISHER

EFFECT
B. Fisher postulated
1. The nominal interest rate
differential should
reflect
the inflation
rate differential.
28

THE INTERNATIONAL FISHER

EFFECT
B. Fisher postulated
2. 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
1. 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
2. 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
2.

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
3.

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
1. Conditions required:
interest rate differential does
not equal the forward
discount.

premium or

2. Funds will move to a country

with a more attractive rate.
36

INTEREST RATE PARITY

THEORY
3.
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:
1. Higher interest rates on a
currency offset by
discounts.

forward

2. Lower interest rates are

by forward premiums.

offset
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:
1. Market-based
2. 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
1. Historical volume and price data
2. Charting and trend analysis
42