Lecture 14
March 22, 2004
Forward Rate *
Spot Rate * 1 Month
3 Months 1 Year
Europe
EMU (euro)
Norway (krone)
Sweden (krona)
Switzerland (franc)
United Kingdom (pound)
Americas:
Canada (dollar_
Mexico (peso)
Pacific/ Africa:
Hong Kong (dollar)
Japan (yen)
South Africa (rand)
South Korea (won)
1.2375
6.8168
7.4509
1.2559
1.8472
1.2364
6.8217
7.4601
1.2549
1.8421
1.2346
6.8292
7.4738
1.2532
1.8325
1.2285
6.861
7.5284
1.2451
1.7877
1.3276
10.9815
1.3289
11.0338
1.3311
11.126
1.3388
11.5775
7.7928
106.83
6.4662
1160.5
7.7858
106.72
6.5107
1163.8
7.774
106.53
6.5917
1169.2
7.739
105.505
6.9812
1186
* Rates are per $US, other than Euro and UK Pounds
Exchange Rate - Amount of one currency needed
to purchase one unit of another.
Spot Rate of Exchange - Exchange rate for an
immediate transaction.
Forward Exchange Rate - Exchange rate for a
forward transaction.
Forward Premiums and Forward Discounts
Example - The Peso spot price is 10.9815 peso per
dollar and the 1 year forward rate is 11.5775 Peso
per dollar, what is the premium and discount
relationship?
Forward Premiums and Forward Discounts
Example - The Peso spot price is 10.9815 peso per
dollar and the 1 year forward rate is 11.5775 Peso per
dollar, what is the premium and discount relationship?
 Spot Price

T 
- 1 = Premium or (-Discount )
 Forward Price 
 10.9815 
1 
- 1 = -5.15%
 11.5775 
Forward Premiums and Forward Discounts
Example - The Peso spot price is 10.9815 peso per dollar
and the 1 year forward rate is 11.5775 Peso per dollar,
what is the premium and discount relationship?
Answer - The dollar is selling at a 5.15% premium, relative
to the peso. The peso is selling at a 5.15% discount,
relative to the dollar.

Basic Relationships
1 + rforeign
1 + r$
1 + i foreign
equals
equals
equals
E(sforeign / $)
f foreign / $
S foreign / $
1 + i$
equals
S foreign / $
1) Interest Rate Parity Theory
1 + rforeign
1 + r$

=
f foreign / $
S foreign / $
The ratio between the risk free interest rates in two
different countries is equal to the ratio between the
forward and spot exchange rates.
Example - You have the opportunity to invest
$1,000,000 for one year. All other things being
equal, you have the opportunity to obtain a 1 year
Mexican bond (in peso) @ 6.7 % or a 1 year US
bond (in dollars) @ 1.22%. The spot rate is
10.9815 peso:$1 The 1 year forward rate is 11.5775
peso:$1
Which bond will you prefer and why?
Ignore transaction costs
Example - You have the opportunity to invest $1,000,000 for one year. All
other things being equal, you have the opportunity to obtain a 1 year Mexican
bond (in peso) @ 6.7 % or a 1 year US bond (in dollars) @ 1.22%. The spot
rate is 10.9815 peso:$1 The 1 year forward rate is 11.5775 peso:$1
Which bond will you prefer and why? Ignore transaction costs
Value of US bond = $1,000,000 x 1.0122 = $1,012,200
Value of Mexican bond = $1,000,000 x 10.9815 = 10,981,500 peso exchange
10,981,500 peso x 1.067 = 11,717,261 peso
11,717,261 peso / 11.5775 = $1,012,072
bond pmt
exchange
2) Expectations Theory of Exchange Rates
f foreign / $
S foreign / $
=
E(sforeign / $)
S foreign / $
Theory that the expected spot exchange rate
equals the forward rate.
3) Purchasing Power Parity
1 + i foreign
1 + i$
=
E(sforeign / $)
S foreign / $
The expected change in the spot rate equals
the expected difference in inflation between
the two countries.
Example - If inflation in the US is forecasted at
1.5% this year and Mexico is forecasted at 6.5%,
what do we know about the expected spot rate?
Given a spot rate of 10.9815 peso:$1
1 + i foreign
1 + i$
=
E(sforeign/$)
S foreign/$
1  .065 E(sforeign/$ )
=
1 + .015 10.9815
solve for Es
Es = 11.5225
4) International Fisher effect
1 + rforeign
1 + r$
=
1 + i foreign
1 + i$
The expected difference in inflation rates
equals the difference in current interest rates.
Also called common real interest rates
4) International Fisher effect
1.067 1.065

 1.05
1.0122 1.015
The expected difference in inflation rates
equals the difference in current interest rates.
Also called common real interest rates
Example - The real interest rate in each country is
about the same
r ( real ) 
1 + rforeign
1 + iforeign
1.067
=
- 1 = .0019
1.065
1 + r$ 1.0122
r ( real ) 
=
- 1 = -.0028
1 + i$ 1.015
Percent error in the one month forward rate for Swiss Franc per US $
compared to actual spot rate
15
5
-10
-15
4/1/2004
4/1/2002
4/1/2000
4/1/1998
4/1/1996
4/1/1994
4/1/1992
4/1/1990
4/1/1988
-5
4/1/1986
0
4/1/1984
Percent error
10
The Big Mac Index
– The price of a
Big Mac in
different countries
(Jan 22, 2015)
Relative change in exchange rate, percent
100
80
60
40
20
-100
-50
0
-20 0
50
-40
-60
-80
-100
Relative change in purchasing power, percent
100
Nominal versus Real Exchange Rates
10
U.S. Dollar /
British Pound
(in log scale)
1999
1989
1979
1969
1959
1949
1940
1930
1920
1910
1900
1
Countries with the highest interest rates generally have the highest
inflation rates. In this diagram each of the 129 points represents a
different country.
40
Average money market rate, percent,
latest 5 years to 2003
35
30
25
20
15
10
5
0
-10
0
10
20
Average inflation rate, percent, latest 5 years to 2003
30
Example - Honda builds a new car in Japan for a cost +
profit of 1,715,000 yen. At an exchange rate of 120.700Y:$1
the car sells for $14,209 in Indianapolis. If the dollar rises
in value, against the yen, to an exchange rate of 134Y:$1,
what will be the price of the car?
1,715,000 = $12,799
134
Conversely, if the yen is trading at a
forward discount, Japan will
experience a decrease in
purchasing power.
Example - Harley Davidson builds a motorcycle for a
cost plus profit of $12,000. At an exchange rate of
120.700Y:$1, the motorcycle sells for 1,448,400 yen in
Japan. If the dollar rises in value and the exchange rate is
134Y:$1, what will the motorcycle cost in Japan?
$12,000 x 134 = 1,608,000 yen


Currency Risk can be reduced by using
various financial instruments
Currency forward contracts, futures contracts,
and even options on these contracts are
available to control the risk