International Finance
INTERNATIONAL PARITY CONDITIONS
What are the determinants of exchange rate?
Are changes in exchange rates predictable?
The economic theory that link exchange rates, price levels, and
interest rates together are called International Parity conditions.
Price & exchange rates
If the identical product or service can be sold in the different
markets, the product’s price should be the same in both
markets.
If two markets situated in two different countries comparing
price would require only a conversion from one currency to the
other.
p$ * s = p¥
Exchange rate could be deduced from the local product prices.
s =p¥ / p$
Purchasing power parity PPP – absolute or the law of one
price
Exchange rate between currencies of two countries should be
equal to the ratio of the countries price level.
Absolute PPP states that the spot exchange rate is determined
by the relative price of the similar basket of goods.
A Big Mac Switzerland costs SFr 6.30 which the same Big Mac
in the USA is $ 2.49. Calculate the PPP exchange rate.
How ever on the date of survey, the actual exchange rate was
SFr1.66/$. Calculate the percentage of over or under value of
SFr.
Relative PPP
If the spot exchange rate between two countries starts in
equilibrium, any change in the expected differential rate of
inflation between them tends to be offset over the long run by an
equal but opposite change in the spot exchange rate.
Empirical test of PPP
Two general conclusions can be made from these tests
PPP holds up well over the very long run but poorly for
shorter time periods.
The theory holds better for countries with relatively high
rates of inflation and underdeveloped capital markets.
Effective Exchange Rate
• On any given day, a currency may appreciate in
value relative to some currencies while
depreciating in value against others.
• An effective exchange rate is a measure of the
weighted-average value of a currency relative to
a select group of currencies.
• Thus, it is a guide to the general value of the
currency.
Weighted Average Value
• To construct an EER, we must first pick a
set of currencies we are most interested in.
• Next, we must assign relative weights. In
the following example, we weight the
currency according to the country’s
importance as a trading partner.
Weights
• Suppose that of all the trade of the US with
Canada, Mexico, and the UK, Canada accounts
for 50 percent, Mexico for 30 percent, and the
UK for 20 percent.
• These constitute our weights (0.50, 0.30, and
0.20).
• Now consider the following exchange rate data.
Exchange Rate Data
Today
Year Ago
C$
1.44
1.52
P
9.56
10.19
£
0.62
0.61
Calculating the EER
• The EER is calculating by summing the
weighted values of the current period rate
relative to the base year rate.
• The weighted-average value is calculated as:
(weight i)(current exchange value i)/(base exchange value i)
where i represents each individual country
included in the weighted average.
Calculating the EER
• Commonly this sum is multiplied by 100 to
express the EER on a 100 basis.
• Hence, an EER is an index.
• As we shall see next, the base-year value of
the index is 100.
• The index, therefore, is useful is showing
changes in the weighted average value from
one period to another.
Example
• Let last year be the base year.
• The effective exchange rate last year was:
[(1.52/1.52)*0.50 + (10.19/10.19)*0.30
+ (0.61/.61)*0.20]*100
= 100.
• As with any index measure, the base year
value is 100.
Example
• Today’s value of the EER is:
(1.44/1.52)*0.50 + (9.56/10.19)*0.30
+ (0.62/0.61)*0.20
• or (0.958) 95.8
• The dollar, therefore, has experienced a
4.2 percent depreciation in weighted
value.
Effective Exchange Measures
• There are a number of effective exchange
measures available in the popular press.
Some common measures are:
• Bank of England Index: The Economist.
• J.P. Morgan: The Wall Street Journal and
the Financial Times.
Exchange rate pass-through
Pass-through is the measure of response of imported and
exported prices to exchange rate changes.
BMW produces an automobile in Germany and pays all
production expenses in Euros. The price of BMW in U.S market
should simply be;
P$BMW = P€BMW * S = €35000 * $1.000/€ = $35000
If € appreciate 20% versus the USD, from $1.00/€ to $1.200/ €,
calculate the theoretical price of BMW in U.S market.
Interest rates & exchange rates
Fisher effect
The fisher effect holds that an increase (decrease) in the
expected inflation rate in a country will cause a proportionate
increase (decrease) in the interest tare in the country.
i = r + E(л)
Eg. Real interest rate 2% per year. Expected inflation rate is 4%,
the nominal interest rate set at 6% then. The lender will be fully
compensated for the expected erosion of the purchasing power
of money while still expecting to realize a 2% real return.
The forward parity
The forward rate is calculated for any specific maturity by
adjusting the current spot exchange rate by the ratio of Euro
currency interest rates of the same maturity for the two subject
currencies.
Eg. 90-day forward rate for the Swiss franc/USD exchange rate
is;
FSF/$90 = SSF/$ * [1+(iSF * 90/360)] / [1+ (i$ * 90/360)]
Spot rate of SF 1.4800/$, 90-day Euro Swiss franc deposit rate
4% per annum, 90-day Euro dollar deposit rate of 8% per
annum. Calculate the 90-day forward rate of SF/$
Currency yield curves and the forward premium
Interest rate parity - IRP
Linkage between the foreign exchange markets and the international money
markets.
Covered Interest Arbitrage – CIA
Uncovered Interest Arbitrage –UIA
Equilibrium between interest rates and exchange rates
Forecasting exchange rates
Efficient market approach
Fundamental approach
Technical approach