MultinationalFinancialManagement

AlanShapiro

7thEdition

J.Wiley&Sons

PowerPointsbyJosephF.Greco,Ph.D.CaliforniaStateUniversity,Fullerton1CHAPTER4

PARITYCONDITIONSAND

CURRENCYFORECASTING2CHAPTEROVERVIEW

I. ARBITRAGEANDTHELAWOF ONEPRICEII. PURCHASINGPOWERPARITYIII. THEFISHEREFFECTIV. THEINTERNATIONALFISHEREFFECTV. INTERESTRATEPARITYTHEORY VI. THERELATIONSHIPBETWEEN THEFORWARDANDFUTURE SPOTRATEVII. CURRENCYFORECASTING 3PARTI.ARBITRAGEANDTHELAWOFONEPRICEI. THELAWOFONEPRICE A. Lawstates: Identicalgoodssellforthe samepriceworldwide.

4ARBITRAGEANDTHELAWOFONEPRICEB. Theoreticalbasis:

Ifthepriceafterexchange-rate adjustmentwerenotequal, arbitrageinthegoodsworldwide ensureseventuallyitwill.5ARBITRAGEANDTHELAWOFONEPRICEC. FiveParityConditionsResult FromTheseArbitrageActivities

1. PurchasingPowerParity(PPP) 2. TheFisherEffect(FE) 3. TheInternationalFisherEffect (IFE) 4. InterestRateParity(IRP) 5. UnbiasedForwardRate(UFR)

6ARBITRAGEANDTHELAWOFONEPRICED. FiveParityConditionsLinked by

1. Theadjustmentofvarious ratesandpricestoinflation.

7ARBITRAGEANDTHELAWOFONEPRICE2. Thenotionthatmoney shouldhavenoeffecton realvariables(sincethey havebeenadjustedfor pricechanges).8ARBITRAGEANDTHELAWOFONEPRICEE. Inflationandhomecurrency depreciation: 1. jointlydeterminedbythe growthofdomesticmoney supply; 2. Relativetothegrowthof domesticmoneydemand.9ARBITRAGEANDTHELAWOFONEPRICE F. THELAWOFONEPRICE -enforcedbyinternational arbitrage.10PARTII.PURCHASINGPOWERPARITYI. THETHEORYOFPURCHASINGPOWERPARITY:statesthatspotexchangeratesbetweencurrencieswillchangetothedifferentialininflationratesbetweencountries.11PURCHASINGPOWERPARITYII.ABSOLUTEPURCHASINGPOWERPARITYA.Pricelevelsadjustedforexchangeratesshouldbeequalbetweencountries12PURCHASINGPOWERPARITYII.ABSOLUTEPURCHASINGPOWERPARITYB.Oneunitofcurrencyhassamepurchasingpowerglobally.13PURCHASINGPOWERPARITYIII. RELATIVEPURCHASINGPOWERPARITYA.statesthattheexchangerateofonecurrencyagainstanotherwilladjusttoreflectchangesinthepricelevelsofthetwocountries.14PURCHASINGPOWERPARITY1.Inmathematicalterms:whereet=futurespotratee0=spotrateih=homeinflationif=foreigninflationt =thetimeperiod15PURCHASINGPOWERPARITY2.Ifpurchasingpowerparityisexpectedtohold,thenthebestpredictionfortheone-periodspotrateshouldbe16PURCHASINGPOWERPARITY3.Amoresimplifiedbutlesspreciserelationshipisthatis,thepercentagechangeshouldbeapproximatelyequaltotheinflationratedifferential.17PURCHASINGPOWERPARITY4.PPPsaysthecurrencywiththehigherinflationrateisexpectedtodepreciaterelativetothecurrencywiththelowerrateofinflation.18PURCHASINGPOWERPARITYB.RealExchangeRates:thequotedornominalrateadjustedforacountry’’sinflationrateis19PURCHASINGPOWERPARITYC.Realexchangerates1.Ifexchangeratesadjusttoinflationdifferential,PPPstatesthatrealexchangeratesstaythesame.20PURCHASINGPOWERPARITYC.Realexchangerates2.Competitivepositions:domesticandforeignfirmsareunaffected.21PARTIII.THEFISHEREFFECT(FE)I.THEFISHEREFFECTstatesthatnominalinterestrates(r)areafunctionoftherealinterestrate(a)andapremium(i)forinflationexpectations.R=a+i22THEFISHEREFFECTB.RealRatesofInterest1.Shouldtendtowardequalityeverywherethrougharbitrage.2.Withnogovernmentinterferencenominalratesvarybyinflationdifferentialorrh-rf=ih-if23THEFISHEREFFECTC.AccordingtotheFisherEffect,countrieswithhigherinflationrateshavehigherinterestrates.24THEFISHEREFFECTD.Duetocapitalmarketintegrationglobally,interestratedifferentialsareeroding.25PARTIV.THEINTERNATIONALFISHEREFFECT(IFE)I.IFESTATES:A.thespotrateadjuststotheinterestratedifferentialbetweentwocountries.26THEINTERNATIONALFISHEREFFECTIFE=PPP+FE27THEINTERNATIONALFISHEREFFECTB.Fisherpostulated1.Thenominalinterestratedifferentialshouldreflecttheinflationratedifferential.28THEINTERNATIONALFISHEREFFECTB. Fisherpostulated2. Expectedratesofreturnareequalintheabsenceofgovernmentintervention.29THEINTERNATIONALFISHEREFFECTC. SimplifiedIFEequation:(ifrfisrelativelysmall)30THEINTERNATIONALFISHEREFFECTD.ImplicationsofIFE1. Currencywiththelowerinterestrateexpectedtoappreciaterelativetoonewithahigherrate.31THEINTERNATIONALFISHEREFFECTD.ImplicationsofIFE2. Financialmarketarbitrage:insuresinterestratedifferentialisanunbiasedpredictorofchangeinfuturespotrate.32PARTVI.INTERESTRATEPARITYTHEORYI. INTRODUCTIONA.TheTheorystates:theforwardrate(F)differsfromthespotrate(S)atequilibriumbyanamountequaltotheinterestdifferential(rh-rf)betweentwocountries.33INTERESTRATEPARITYTHEORY2.Theforwardpremiumordiscountequalstheinterestratedifferential.(F-S)/S=(rh-rf)whererh=thehomeraterf=theforeignrate34INTERESTRATEPARITYTHEORY3. Inequilibrium,returnsoncurrencieswillbethesamei.e.Noprofitwillberealizedandinterestparityexistswhichcanbewritten(1+rh)=F(1+rf)S35INTERESTRATEPARITYTHEORYB. CoveredInterestArbitrage1.Conditionsrequired:interestratedifferentialdoesnotequaltheforwardpremiumordiscount.2. Fundswillmovetoacountrywithamoreattractiverate.36INTERESTRATEPARITYTHEORY3. Marketpressuresdevelop:a. Asonecurrencyismoredemandedspotandsoldforward.b.Inflowoffunddepressesinterestrates.c. Parityeventuallyreached.37INTERESTRATEPARITYTHEORYC. Summary:InterestRateParitystates:1. Higherinterestratesonacurrencyoffsetbyforward discounts.2. Lowerinterestratesareoffsetbyforwardpremiums.38PARTVI.THERELATIONSHIPBETWEENTHE

FORWARDANDTHEFUTURESPOTRATEI. THEUNBIASEDFORWARDRATEA. Statesthatiftheforwardrateisunbiased,thenitshouldreflecttheexpectedfuturespotrate.B.Statedasft=et39PARTVI.CURRENCYFORECASTINGI. FORECASTINGM