Chapter 6 Relationships among inflation, interest rates
and exchange rates
Lecture outline
Purchasing power parity (PPP)
Interpretations of purchasing power parity
Rationale behind relative PPP theory
Derivation of purchasing power parity
Using PPP to estimate exchange rate effects
Graphic analysis of purchasing power parity
Testing the purchasing power parity theory
Why purchasing power parity does not hold
International Fisher effect (IFE)
Fisher effect
Using the IFE to predict exchange rate movements
Implications of the international Fisher effect
Derivation of the international Fisher effect
Graphical analysis of the international Fisher effect
Tests of the international Fisher effect
Limitations of the IFE
IFE theory versus reality
Chapter theme
This chapter discusses the relationship between inflation and exchange rates according to the
purchasing power parity (PPP) theory. Since this is one of the most popular subjects in international
finance, it is covered thoroughly. While PPP is a relevant theory, it should be emphasised that PPP will
not always hold in reality. However, it provides a foundation in understanding how inflation can affect
exchange rates. The international Fisher effect (IFE) is one of the important theories in the
international finance which is also discussed in this chapter. Yet, it should again be emphasised that
this theory does not always hold. If the PPP and IFE theories held consistently, decision making by
MNCs would be much easier. Because these theories do not hold consistently, an MNC’s decisionmaking is very challenging.
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Chapter 6: Relationships among inflation, interest rates and exchange rates
Topics to stimulate class discussion
1. Provide reasoning for why highly inflated countries tend to have weak home currencies.
2. Identify the inflation rate of your home country and some well-known foreign country. Then
identify the percentage change of your home currency with respect to that foreign country. Did the
currency change in the direction and by the magnitude that you would have expected according to
PPP? If not, what is your conclusion for (1) inflation of home country is higher than that of foreign
country, (2) inflation of foreign country is higher than that of home country.
3. Identify the quoted one-year interest rates in your home country and in a well-known foreign
country as of one year ago. Also determine how your home currency changed relative to this foreign
currency over the last year. Did the currency change according to the IFE theory? If not, does this
information disprove IFE? Elaborate.
Point counter-point
Does PPP eliminate concerns about long-term exchange rate risk?
WHO IS CORRECT? Use the internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
POINT: Yes. Studies have shown that exchange rate movements are related to inflation differentials in
the long run. Based on PPP, the currency of a high-inflation country will depreciate against the
Australian dollar. A subsidiary in that country should generate inflated revenue from the inflation,
which will help offset the adverse exchange effects when its earnings are remitted to the parent. If a
company is focused on long-term performance, the deviations from PPP will offset over time. In some
years, the exchange rate effects may exceed the inflation effects, and in other years the inflation effects
will exceed the exchange rate effects.
COUNTER-POINT: No. Even if the relationship between inflation and exchange rate effects is
consistent, this does not guarantee that the effects on the company will be offsetting. A subsidiary in a
high-inflation country will not necessarily be able to adjust its price level to keep up with the increased
costs of doing business there. The effects vary with each MNC’s situation. Even if the subsidiary can
raise its prices to match the rising costs, there are short-term deviations from PPP. The investors who
invest in an MNC’s stock may be concerned about short-term deviations from PPP because they will
not necessarily hold the stock for the long term. Thus, investors may prefer that companies manage in
a manner that reduces the volatility in their performance in short-run and long-run periods.
ANSWER: It is possible that inflation and exchange rate effects will offset over the long run. However,
many investors will not be satisfied because they may invest in the company for just a few years or even
a shorter term. Thus, they will prefer that MNCs assess their exposure to exchange rate risk and attempt
to limit the risk.
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Chapter 6: Relationships among inflation, interest rates and exchange rates
Answers to end-of-chapter questions
1. PPP Explain the theory of purchasing power parity (PPP). Based on this theory, what is a general
forecast of the values of currencies in countries with high inflation?
ANSWER: PPP suggests that the purchasing power of a consumer will be similar when purchasing
goods in a foreign country or in the home country. If inflation in a foreign country differs from
inflation in the home country, the exchange rate will adjust to maintain equal purchasing power.
Currencies in countries with high inflation will be weak according to PPP, causing the purchasing
power of goods in the home country versus these countries to be similar.
2. Rationale of PPP Explain the rationale of the PPP theory.
ANSWER: When inflation is high in a particular country, foreign demand for goods in that country
will decrease. In addition, that country’s demand for foreign goods should increase. Thus, the home
currency of that country will weaken; this tendency should continue until the currency has
weakened to the extent that a foreign country’s goods are no more attractive than the home
country’s goods.
Inflation differentials are offset by exchange rate changes.
3. Testing PPP Explain how you could determine whether PPP exists. Describe a limitation in testing
whether PPP holds.
ANSWER: One method is to choose two countries and compare the inflation differential to the
exchange rate change for several different periods. Then, determine whether the exchange
rate changes were similar to what would have been expected under PPP theory.
A second method is to choose a variety of countries and compare the inflation differential of each
foreign country relative to the home country for a given period. Then, determine whether the
exchange rate changes of each foreign currency were what would have been expected based on
the inflation differentials under PPP theory.
A limitation in testing PPP is that the results will vary with the base period chosen. The base period
should reflect an equilibrium position, but it is difficult to determine when such a period exists.
4. Testing PPP Inflation differentials between the Australia and other industrialised countries have
typically been a few percentage points in any given year. Yet, in many years annual exchange
rates between the corresponding currencies have changed by 10 per cent or more. What does
this information suggest about PPP?
ANSWER: The information suggests that there are other factors besides inflation differentials that
influence exchange rate movements. Thus, the exchange rate movements will not necessarily
conform to inflation differentials, and therefore PPP will not necessarily hold.
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Chapter 6: Relationships among inflation, interest rates and exchange rates
5. Limitations of PPP Explain why PPP does not hold.
ANSWER: PPP does not consistently hold because there are other factors besides inflation that
influences exchange rates. Thus, exchange rates will not move in perfect tandem with inflation
differentials. In addition, there may not be substitutes for traded goods. Therefore, even when a
country’s inflation increases, the foreign demand for its products will not necessarily decrease (in the
manner suggested by PPP) if substitutes are not available.
6. Implications of IFE Explain the international Fisher effect. What is the rationale for the existence of
the IFE? What are the implications of the IFE for companies with excess cash that consistently invest
in foreign Treasury bills? Explain why the IFE may not hold.
ANSWER: The IFE suggests that a currency’s value will adjust in accordance with the differential in
interest rates between two countries.
The rationale is that if a particular currency exhibits a high nominal interest rate, this may reflect a
high anticipated inflation. Thus, the inflation will place downward pressure on the currency’s value if
it occurs.
The implications are that a company that consistently purchases foreign Treasury bills will on
average earn a similar return as on domestic Treasury bills.
The IFE may not hold because exchange rate movements react to other factors in addition to
interest rate differentials. Therefore, an exchange rate will not necessarily adjust in accordance
with the nominal interest rate differentials, so that IFE may not hold.
7. Implications of IFE Assume Australian interest rates are generally above foreign interest rates.
What does this suggest about the future strength or weakness of the Australian dollar based on
the IFE? Should Australian investors invest in foreign securities if they believe in the IFE? Should
foreign investors invest in Australian securities if they believe in the IFE?
ANSWER: The IFE would suggest that the Australian dollar will depreciate over time if Australian
interest rates are currently higher than foreign interest rates. Consequently, foreign investors who
purchased Australian securities would on average receive a similar yield as what they receive in their
own country, and Australian investors that purchased foreign securities would on average receive a
yield similar to Australian rates.
8. Real interest rate One assumption made in developing the IFE is that all investors in all countries
have the same real interest rate. What does this mean?
ANSWER: The real return is the nominal return minus the inflation rate. If all investors require the
same real return, then the differentials in nominal interest rates should be solely due to differentials
in anticipated inflation among countries.
9. Interpreting inflationary expectations If investors in the Australia and Singapore require the same
real interest rate, and the nominal rate of interest is 2 per cent higher in Singapore, what does this
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Chapter 6: Relationships among inflation, interest rates and exchange rates
imply about expectations of Australian inflation and Singaporean inflation? What do these
inflationary expectations suggest about future exchange rates?
ANSWER: Expected inflation in Singapore is 2 per cent above expected inflation in Australia. If these
inflationary expectations come true, PPP would suggest that the value of the Singaporean dollar
should depreciate by 2 per cent against the Australian dollar.
10. Source of weak currencies Currencies of some South Asian countries, such as India and
Bangladesh, frequently weaken against most other currencies. What concept in this chapter
explains this occurrence? Why don’t all Australia-based MNCs use forward contracts to hedge their
future remittances of funds from South Asian countries to Australia if they expect depreciation of
the currencies against the Australian dollar?
ANSWER: South Asian countries typically have very high inflation – more than 150 per cent
compared to Australian inflation rate. PPP theory would suggest that currencies of these countries
will depreciate against the Australian dollar (and other major currencies) in order to retain
purchasing power across countries. The high inflation discourages demand for South Asian imports
and places downward pressure in their South Asian currencies. Depreciation of the currencies
offsets the increased prices on South Asian goods from the perspective of importers in other
countries.
Interest rate parity forces the forward rates to contain a large discount due to the high interest rates
in South Asia, which reflects a disadvantage of hedging these currencies. The decision to hedge makes
more sense if the expected degree of depreciation exceeds the degree of the forward discount. Also,
keep in mind that some remittances cannot be perfectly hedged anyway because the amount of
future remittances is uncertain.
11. PPP Japan has typically had lower inflation than Australia. How would one expect this to affect the
Japanese yen’s value? Why does this expected relationship not always occur?
ANSWER: Japan’s low inflation should place upward pressure on the yen’s value. Yet, other factors
can sometimes offset this pressure. For example, Japan heavily invests in Australian securities, which
places downward pressure on the yen’s value.
12. IFE Assume that the nominal interest rate in India is 12 per cent and the interest rate in Australia is
4 per cent for one-year securities that are free from default risk. What does the IFE suggest about
the differential in expected inflation in these two countries? Using this information and the PPP
theory, describe the expected nominal return to Australian investors who invest in India.
ANSWER: If investors from Australia and India required the same real (inflation-adjusted) return,
then any difference in nominal interest rates is due to differences in expected inflation. Thus, the
inflation rate in India is expected to be about 8 per cent above the Australian inflation rate.
According to PPP, the Indian rupee should depreciate by the amount of the differential between
Australia and India inflation rates. Using an 8 per cent differential, the Indian rupee should
depreciate by about 8 per cent. Given a 12 per cent nominal interest rate in Indian and expected
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Chapter 6: Relationships among inflation, interest rates and exchange rates
depreciation of the rupees of 8 per cent, Australian investors will earn about 4 per cent. (This
answer used the inexact formula, since the concept is stressed here more than precision.)
13. IFE Shouldn’t the IFE discourage investors from attempting to capitalise on higher foreign interest
rates? Why do some investors continue to invest overseas, even when they have no other
transactions overseas?
ANSWER: According to the IFE, higher foreign interest rates should not attract investors because
these rates imply high expected inflation rates, which in turn imply potential depreciation of these
currencies. Yet, some investors still invest in foreign countries where nominal interest rates are
high. This may suggest that some investors believe that (1) the anticipated inflation rate embedded
in a high nominal interest rate is overestimated, or (2) the potentially high inflation will not cause
substantial depreciation of the foreign currency (which could occur if adequate substitute products
were not available elsewhere), or (3) there are other factors that can offset the possible impact of
inflation on the foreign currency’s value.
14. Changes in inflation Assume that the inflation rate in Bangladesh is expected to increase
substantially. How will this affect Bangladesh’s nominal interest rates and the value of its currency
(called the taka)? If the IFE holds, how will the nominal return to Australian investors who invest in
Bangladesh be affected by the higher inflation in Bangladesh? Explain.
ANSWER: Bangladesh’s nominal interest rate would likely increase to maintain the real return
required by Bangladesh investors. The Bangladesh taka would be expected to depreciate according
to the IFE. If the IFE holds, the return to Australian investors who invest in Bangladesh would not be
affected. Even though they now earn a higher nominal interest rate, the expected decline in the
Bangladesh taka offsets the additional interest to be earned.
15. Comparing PPP and IFE How is it possible for PPP to hold if the IFE does not?
ANSWER: For the IFE to hold, the following conditions are necessary:
1. investors across countries require the same real returns
2. the expected inflation rate embedded in the nominal interest rate occurs
3. the exchange rate adjusts to the inflation rate differential according to PPP.
If conditions (1) or (2) do not hold, PPP may still hold, but investors may achieve consistently higher
returns when investing in a foreign country’s securities. Thus, IFE would be refuted.
16. Estimating depreciation due to PPP Assume that the spot exchange rate of the New Zealand dollar
is A$0.75. How will this spot rate adjust according to PPP if New Zealand experiences an inflation
rate of 7 per cent while Australia experiences an inflation rate of 3 per cent?
ANSWER: According to PPP, the exchange rate of the New Zealand dollar will depreciate by -3.74
[(1.03/1.07) – 1] per cent.. Therefore, the spot rate would adjust to A$0.75 × [1+ (-0.0374)] =
A$0.7219.
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Chapter 6: Relationships among inflation, interest rates and exchange rates
17. Forecasting the future spot rate based on IFE Assume that the spot exchange rate of the Singapore
dollar is A$0.95. The one-year interest rate is 9 per cent in Australia and 5 per cent in Singapore.
What will the spot rate be in one year according to the IFE? What is the force that causes the spot
rate to change according to the IFE?
ANSWER: According to PPP, the exchange rate of the Singapore dollar will be appreciate by 3.81
[(1.09/1.05) – 1] per cent. Therefore, the spot rate will be A$0.9862 [A$0.95 × (1+ 0.0381)] in oneyear. The force that causes this expected effect on the spot rate is the inflation differential. The
anticipated inflation differential can be derived from interest rate differential.
18. Deriving forecasts of the future spot rate As of today, assume the following information is
available:
Australia
Real rate of interest required
by investors
Nominal interest rate
Spot rate
One-year forward rate
2%
5%
—
—
India
2%
11%
A$.20
A$.19
a. Use the forward rate to forecast the percentage change in the Indian rupee over the next year.
ANSWER: (A$.19 – A$.20)/A$.20 = –.05, or –5%
b. Use the differential in expected inflation to forecast the percentage change in the Indian
rupee over the next year.
ANSWER: [ 1.03 (1+5%-2%) / 1.09 (1+11%-2%)] – 1 = - 0.055 or -5.50% ; the negative sign
represents depreciation of the Indian rupee.
c. Use the spot rate to forecast the percentage change in the Indian rupee over the next year.
ANSWER: zero per cent change
19. IFE application to Asian crisis Before the Asian crisis, many investors attempted to capitalise on the
high interest rates prevailing in the South-East Asian countries, although the level of interest rates
primarily reflected expectations of inflation. Explain why investors behaved in this manner. Why
does the IFE suggest that the South-East Asian countries would not have attracted foreign
investment before the Asian crisis despite the high interest rates prevailing in those countries?
ANSWER: The investors’ behaviour suggests that they did not expect the international Fisher effect
(IFE) to hold. Since central banks of some Asian countries were maintaining their currencies within
narrow bands, they were effectively preventing the exchange rate from depreciating in a manner that
would offset the interest rate differential. Consequently, superior profits from investing in the foreign
countries were possible.
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Chapter 6: Relationships among inflation, interest rates and exchange rates
If investors believed in the IFE, the Asian countries would not attract a high level of
foreign investment because of exchange rate expectations. Specifically, the high nominal
interest rate should reflect a high level of expected inflation. According to purchasing
power parity (PPP), the higher interest rate should result in a weaker currency because of
the implied market expectations of high inflation.
Advanced questions
22. Arbitrage and PPP Assume that locational arbitrage ensures that spot exchange rates
are properly aligned. Also assume that you believe in purchasing power parity. The spot
rate of the Singapore dollar (S$) is A$0.95.. The spot rate of the Malaysian ringgit (MYR)
is 0.45 Singapore dollars. You expect that the one-year inflation rate is 7 per cent in
Singapore, 5 per cent in Malaysia and 1 per cent in Australia. The one-year interest rate
is 6 per cent in Singapore, 2 per cent in Malaysia and 4 per cent in Australia. What is
your expected spot rate of the Malaysian ringgit in one year with respect to Australian
dollar? Show your work.
ANSWER: MYR spot rate in A$ = (A$0.95/S$) × (S$0.45/MYR) = A$0.4275/MYR.
Expected % change in MYR in one year = (1.01)/(1.05) – 1 = –3.8%
Expected spot rate of MYR in one year = A$0.4275/MYR × (1- 0.038) = A$0.4113/MYR.
23. PPP and real interest rates The nominal (quoted) Australia one-year interest rate is 6
per cent, while the nominal one-year interest rate in Malaysia is 5 per cent. Assume
you believe in purchasing power parity. You believe the real one-year interest rate is 2
per cent in Australia, and the real one-year interest rate is 3 per cent in Malaysia.
Today, the Malaysian ringgit (MYR) spot rate is A$0.35. What do you think the spot
rate of the Malaysian ringgit will be in one year?
ANSWER: Expected inflation in Australia = 6% - 2%= 4%.
Expected inflation in Malaysia = 5% - 3% = 2%.
Expected % change in MYR = [(1 + .04)]/[(1 + .02)] – 1 = .0196 or
1.96%. Future spot rate of MYR in one year = A$0.35 × (1 + .0196) =
A$0.3569
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Chapter 6: Relationships among inflation, interest rates and exchange rates
24. PPP and cash flows BHP will receive 1 million Chinese yuan in one year from selling iron
ore. It did not hedge this future transaction. BHP believes that the future value of the
yuan will be determined by purchasing power parity (PPP). It expects that inflation in
China will be 12 per cent next year, while inflation in Australia will be 7 per cent next
year. Today, the spot rate of the yuan is A$0.21 and the one-year forward rate is A$0.25.
a.
Estimate the amount of Australian dollars that BHP will receive in one year when
converting its yuan (CNY) receivables into Australian dollars (A$).
ANSWER: Expected appreciation of yuan = (1+.07)/(1+.12)-1=-.04464
Expected spot rate of yuan in one year = A$0.21 × (1 - .04464) =
A$0.2006/CNY
Expected Australian dollars received from receivables = CNY1,000,000 × A$0.2006. =
A$200,600
b.
Today, the spot rate of the Hong Kong dollar is A$0.17. BHP believes that the
Hong Kong dollar will remain pegged to the Australian dollar for the next year. If
BHP decides to convert its 1 million yuan into Hong Kong dollars instead of
Australian dollars at the end of one year, estimate the amount of Hong Kong
dollars that BHP will receive in one year when converting its yuan receivables into
Hong Kong dollars.
ANSWER: Expected spot rate of HK$ in one year = A$0.17/HK$ since it will remain pegged.
Expected cross rate in one year = [(A$0.2006/CNY)/(A$0.17/HK$)] = HK$1.18/CNY So 1
million yuan will convert to 1,000,000 × 1.18 = HK$1,180,000
25. IFE and forward rate The one-year Treasury (risk-free) interest rate in Australia is
presently 6 per cent, while the one-year Treasury interest rate in India is 13 per cent.
The spot rate of the Indian rupee is A$0.21. Assume that you believe in the
international Fisher effect. You will receive 1 million Indian rupee in one year.
a. What is the estimated amount of Australian dollars you will receive when
converting the rupees to Australian dollars in one year at the spot rate at that
time?
ANSWER: Expected movement in Indian rupee = [(1.06)/(1.13) - 1]
= -6.19% A$0.21 × (1 - .0619) =
A$0.1970 1,000,000 ×
A$0.1970 = A$197,000
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Chapter 6: Relationships among inflation, interest rates and exchange rates
b. Assume that interest rate parity exists. If you hedged your future receivables with a
one-year forward contract, how many dollars will you receive when converting the
rupees to Australia dollars in one year?
ANSWER: The forward rate premium = [(1.06)/(1.13) - 1]= -6.19% A$0.21 × (1 - .0619) =
A$0.1970 1,000,000 × A$0.1970 = A$197,000
26. PPP You believe that the future value of the Australian dollar will be determined by
purchasing power parity (PPP). You expect that inflation in Australia will be 6 per cent
next year, while inflation in the United States will be 2 per cent next year. Today the
spot rate of the Australian dollar is US$.81, and the one-year forward rate is US$.77.
What is the expected spot rate of the Australian dollar in one year?
ANSWER:
Expected depreciation of A$ = [(1+ 2%)/(1+6%)] – 1 = 0.0377 Expected spot rate of A$ in one year = $0.81 × (1 0.0377) = $0.7794.
27. Logic behind IFE Investors based in Australia can earn 11 per cent interest on a one-year
bank deposit in India (with no default risk) or 2 per cent on a one-year Australian bank
deposit in Australia (with no default risk).
Assess the following statement: ‘According to the international Fisher effect, if Australian
investors invest 1000 Indian rupees in an Indian bank deposit, they are expected to
receive only 20 rupees (2 per cent × 1,000 rupees) as interest.’ Is this statement a correct
explanation of why the IFE would discourage Australian investors from investing in India?
If not, provide a more accurate explanation for why investors who believe in IFE would
not pursue the Indian investment in this example.
ANSWER: The Indian investment will generate interest of 11 per cent, or 110 rupees for
every 1,000 rupees that are invested (not 2 per cent as is mentioned in the statement). It
is important to understand that the interest rate is much more favourable in this example,
and so investors earn more interest from investing in India. However, when converting the
rupees back to Australian dollars, the exchange rate effect must be considered. If there is
no change in the exchange rate, the Australian investors will earn a return of 11 per cent.
However, according to IFE, if the real interest rate of Australia and India are the same, the
higher Indian quoted interest rate reflects expectations of high inflation, and this can have
an impact on the exchange rate. The IFE relies on purchasing power parity (PPP), which
suggests that the inflation differential will cause depreciation in the Indian rupee that will
offset the interest rate advantage.
28. Influence of PPP Australia has expected inflation of 2 per cent, while Country A,
Country B, and Country C have expected inflation of 7 per cent. Country A engages
in much international trade with Australia. The products that are traded between
Country A and Australia can easily be produced by either country. Country B
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Chapter 6: Relationships among inflation, interest rates and exchange rates
engages in much international trade with Australia.
The products that are traded between Country B and Australia are important health
products, and there are not substitutes for these products that are exported from
Australia to Country B or from Country B to Australia. Country C engages in much
international financial flows with Australia but very little trade. If you were to use PPP to
predict the future exchange rate over the next year for the local currency of each country
against the Australian dollar, do you think PPP would provide the most accurate forecast
for the currency of Country A, Country B, or Country C? Briefly explain.
ANSWER: PPP should provide the most accurate forecast for the currency of Country A,
because there is much international trade, so price changes can affect the volume of
foreign exchange in each direction. Also, the products have substitutes, which cause each
country to shift its demand in response to price movements, which causes a shift in the
trade. This is not possible in the case of Country B, because substitute products are not
available. Therefore, price movements of Country B will not have a major impact on trade
flows, and will not have a major impact on the exchange rate. Country C does not have
much trade with Australia, so its exchange rate is influenced by factors other than PPP
forces.
29. Australia–Malaysia IFE Assume that one-year interest rates are 4 per cent in Australia
and 6 per cent in Malaysia. The spot rate between the Australian dollar and the
Malaysian ringgit is A$0.3546/MYR. Assuming that the international Fisher effect
holds, what should be the exchange rate in one year?
ANSWER: Malaysian ringgit (MYR) depreciates by - 1.89% [(1.04/1.06) -1]
If IFE holds, then the exchange rate in one year A$0.3478/MYR [A$0.3546/MYR × (1-0.0189)]
30. International capital market and PPP BHP Billiton, an Australian multinational
company, has borrowed funds from China for its subsidiary in China and will pay 2
million Chinese yuan (CNY), including interest in one year. The nominal interest rate
in Australia and China is 8.80 per cent and 11.70 per cent, respectively, and the spot
rate is A$0.1957/CNY. However, both Australian and Chinese real interest is 3.36 per
cent. If BHP considers that purchasing power parity (PPP) does hold, how much in
Australian dollars will BHP pay equivalent to 2 million CNY after one year?
ANSWER: Australian dollar inflation = 8.80% – 3.36% = 5.44%
Chinese yuan inflation = 11.70% – 3.36% = 8.34%
Expected exchange rate after one year = (A$0.1957/CNY) × [(1+5.44%)/(1+8.34%)] =
A$0.1905/CNY
BHP will pay = (A$0.1905/CNY) × CNY2,000,000 = A$380923
31. International investment and IFE BlackRock, an Australian managed funds
company, has invested in Thailand and will receive 3 million Thai baht (THB)
investment proceeds in one year. Australia and Thailand have the same 3.93 per
cent real interest rate.
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Chapter 6: Relationships among inflation, interest rates and exchange rates
However, the nominal interest rate in Australia and Thailand is 8.9 per cent and 11.8
per cent, respectively, and the spot rate is A$0.1553/THB. If BlackRock believes in the
international Fisher effect, how many Australian dollars will BlackRock receive
equivalent to 3 million THB after one year?
ANSWER: Expected exchange rate after one year = (A$0.1553/THB) × [(1+8.9%)/(1+11.8%)]
= A$0.1513/THB
BlackRock will receive after one year = (A$0.1513/THB) × THB3,000,000 = A$453,900
32. Exporting and PPP An Australian exporter has supplied goods to Singapore with an
agreement to receive 4 million Singapore dollars (SGD) in one year. The nominal
interest rate in Singapore and Australia is 11.32 per cent and 7.05 per cent,
respectively, and the spot rate is A$0.2253/SGD. However, both Australia and
Singapore provide a 4.80 per cent real interest rate. If purchasing power parity exists
in the market, calculate the Australian dollar profit or loss in one year for the
exporter.
ANSWER: Australian dollar inflation = (7.05% 4.80%) = 2.25% Singapore dollar inflation = (11.32%
- 4.80%) = 6.52%
Expected exchange rate after one year = (A$0.2253/SGD) × (1+2.25%)/(1+6.52%) =
A$0.2163/SGD Profit/loss for the exporter = (A$0.2163/SGD × SGD4,000,000) –
(A$0.2253/SGD × SGD4,000,000)
= A$865,200 – A$901,200 = - A$36,000
The exporter will make a loss of A$36,000 due to depreciation of SGD value against A$ in one
year.
33. Importing and IFE An Australian importer has an account payable amount of 3 million
Indian rupee (INR) in one year for receiving goods from India. The Australian and
Indian real interest rate is 4.71 per cent. However, the nominal interest rate of the
Australian dollar and Indian rupee is 7.01 per cent and 12.16 per cent, respectively,
and the spot rate is A$0.2186/INR. If the importer considers the IFE, how many
Australian dollars in profit or loss will the importer have after one year?
ANSWER: Expected exchange rate after one year = (A$0.2186/INR) × (1+7.01%)/(1+12.16%)
= A$0.2086/INR
Profit/loss for the exporter = (A$0.2186/INR × INR3,000,000) - (A$0.2086/INR × INR3,000,000)
= A$655,800 – A$625,800
= A$30,000
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Chapter 6: Relationships among inflation, interest rates and exchange rates
The importer will make a profit of A$30,000 due to depreciation of INR value against A$ in
one year.
34. Importing and PPP McDonald’s Australia has imported gift toys from Bangladesh and
will pay 2 million Bangladeshi takas (BDT) in one year. The nominal interest rate in
Australia and Bangladesh is 7.08 per cent and 12.12 per cent, respectively, and the
spot rate is A$0.1904/BDT. However, both Australian and Bangladeshi real interest is
4.81 per cent. Calculate the Australian dollar profit or loss in percentage terms after
one year for McDonald’s if the market holds purchasing power parity.
ANSWER: Australian dollar inflation = (7.08% 4.81%) = 2.27% Singapore dollar inflation = (12.12%
- 4.81%) = 7.31%
Expected exchange rate after one year = (A$0.1904/BDT) × (1+2.27%)/(1+7.31%) =
A$0.1815/BDT
Profit/loss for the importer = (A$0.1904/BDT × BDT2,000,000) – (A$0.1815/BDT ×
BDT2,000,000)
= A$380,800 – A$363,000= A$17,800
Profit in percentage = (A$17,800/ A$380,800) × 100 = 4.67%
35. Exporting and IFE Asia-Pacific Co., an Australian exporter, has an account receivable
amount of 2 million Chinese yuan (CNY) in one year for delivering liquor to China. The
Chinese nominal interest rate is 11.79 per cent, which is higher than the 8.72 per cent
Australian nominal interest rate, and the spot rate is A$0.1980/CNY. However, both
Australian and Chinese real interest is
3.73 per cent. If Asia-Pacific Co. considers the IFE, how many Australian dollars in
profit or loss will Asia-Pacific Co. have in percentage terms after one year?
ANSWER: Expected exchange rate after one year = (A$0.1980/CNY) × (1+8.72%)/(1+11.79%)
= A$0.1926/CNY
Profit/loss for the exporter = (A$0.1926/CNY × CNY2,000,000) – (A$0.1980/CNY ×
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Chapter 6: Relationships among inflation, interest rates and exchange rates
CNY2,000,000)
= (A$385,200 – A$396,000) = -A$10,800
Loss in percentage = (-A$10,800/A$396,000) × 100 = -2.73%
36. PPP and cross exchange rate You consider that the market holds purchasing power
parity. The spot rate between the Singapore dollar (SGD) and the Australian dollar
(AUD) is AUD0.9418/SGD. The spot rate of the Malaysian ringgit (MYR) against the
Singapore dollar is SGD0.4701/MYR.
You expect that the one-year inflation rate is 6.24 per cent in Singapore, 4.89 per
cent in Malaysia and 2.34 per cent in Australia. Further, the one-year interest rate is
9.51 per cent in Singapore, 7.24 per cent in Malaysia and 5.99 per cent in Australia.
What is the expected spot rate of the Malaysian ringgit against the Australian dollar
(AUD/MYR) in one year?
ANSWER: Expected exchange rate between SGD and AUD =
(AUD0.9418/SGD) × [(1+2.34%)/(1+6.24%)] = AUD0.9072/SGD
Expected exchange rate between MYR and SGD = (SGD0.4701/MYR) × [(1+6.24%)/(1+4.89%)]
= SGD0.4762/MYR
Expected cross exchange rate between MYR and AUD = (AUD0.9072/SGD) ×
(SGD0.4762/MYR)
= AUD0.4320/MYR
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Chapter 6: Relationships among inflation, interest rates and exchange rates
37. IFE and cross exchange rate Assume that you believe in the international Fisher effect.
The spot rate of the Singapore dollar (SGD) against the Australian dollar (AUD) is
AUD0.9051/SGD. The spot rate of the Malaysian ringgit (MYR) against the Singapore
dollar is SGD0.5002/MYR. You expect that the one-year inflation rate is 6.28 per cent
in Singapore, 4.63 per cent in Malaysia and 2.60 per cent in Australia. You also
consider that the one-year interest rate is 9.04 per cent in Singapore, 7.82 per cent in
Malaysia and 5.48 per cent in Australia. Calculate the expected spot rate between the
Malaysian ringgit and the Australian dollar (AUD/MYR) after one year.
ANSWER: Expected exchange rate between SGD and AUD =
(AUD0.9051/SGD) × [(1+5.48%)/(1+9.04%)] = AUD0.8755/SGD
Expected exchange rate between MYR and SGD = (SGD0.5002/MYR) × [(1+9.04%)/(1+7.82%)]
= SGD0.5059/MYR
Expected cross exchange rate between MYR and AUD = (AUD0.8755/SGD) ×
(SGD0.5059/MYR)
= AUD0.4429/MYR
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