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International financial management

Submitted to: submitted by:

Prof. Gaurav Chabra Prem Retoliya
International Fisher effect

“The International Fisher effect is a hypothesis in international finance

that says that the difference in the nominal interest rates between two
countries determines the movement of the nominal exchange rate
between their currencies, with the value of the currency of the country
with the lower nominal interest rate increasing. This is also known as
the assumption of Uncovered Interest Parity.”

An economic theory that states that an expected change in the current

exchange rate between any two currencies is approximately equivalent to the
difference between the two countries' nominal interest rates for that time.

Calculated as:

"E" represents the % change in the exchange rate
"i1" represents country A's interest rate
"i2" represents country B's interest rate

For example, if country A's interest rate is 10% and country B's interest rate
is 5%, country B's currency should appreciate roughly 5% compared to
country A's currency.

The rational for the IFE is that a country with a higher interest rate will also
tend to have a higher inflation rate. This increased amount of inflation
should cause the currency in the country with the high interest rate to
depreciate against a country with lower interest rates.

A theory that the interest rate differential between two countries is equal to
the differential between the forward exchange rate and the spot exchange
rate. Interest rate parity plays an essential role in foreign exchange markets,
connecting interest rates, spot exchange rates and foreign exchange rates.

According to interest rate parity the difference between the (risk free)
interest rates paid on two currencies should be equal to the differences
between the spot and forward rates.

If interest rate parity is violated, then an arbitrage opportunity exists. The

simplest example of this is what would happen if the forward rate was the
same as the spot rate but the interest rates were different, and then investors

1. borrow in the currency with the lower rate

2. convert the cash at spot rates
3. enter into a forward contract to convert the cash plus the expected
interest at the same rate
4. invest the money at the higher rate
5. convert back through the forward contract
6. Repay the principal and the interest, knowing the latter will be less
than the interest received.

Therefore, we can expect interest rate parity to apply. However, there is

evidence of forward rate bias.

Covered interest rate parity

Assuming the arbitrage opportunity described above does not exist, then the
relationship for US dollars and pounds sterling is:

(1 + r£)/(1+r$) = (£/$f)/(£/$s)

Where r£ is the sterling interest rate (till the date of the forward),
r$ is the dollar interest rate,
£/$f is the forward sterling to dollar rate,
£/$s is the spot sterling to dollar rate
Unless interest rates are very high or the period considered is long, this is a
very good approximation:

r£ = r$ + f

Where f is the forward premium: (£/$f)/(£/$s) -1

The above relationship is derived from assuming that covered interest

arbitrage opportunities should not last, and is therefore called covered
interest rate parity.

Uncovered interest rate parity

Assuming uncovered interest arbitrage leads us to a slightly different


r = r2 + E[ΔS]

Where E[ΔS] is the expected change is exchange rates.

This is called uncovered interest rate parity.

As the forward rate will be the market expectation of the change in rates, this
is equivalent to covered interest rate parity - unless one is speculating on
market expectations being wrong.

The evidence on uncovered interest rate parity is mixed.

Purchasing power parity


PPP is a theory of long-term equilibrium exchange rates based on

relative price levels of two countries. The idea originated with the
School of Salamanca in the 16th century and was developed in its
modern form by Gustav Cassel in 1918. The concept is founded on
the law of one price; the idea that in absence of transaction costs,
identical goods will have the same price in different markets.

WHAT IS Purchasing power parity?

In its "absolute" version, the

purchasing power of different currencies is equalized for a given basket of
goods. In the "relative" version, the difference in the rate of change in prices
at home and abroad the difference in the inflation rates is equal to the
percentage depreciation or appreciation of the exchange rate. The best-
known and most-used purchasing power parity exchange rate is the
Geary-Khamis dollar (the "international dollar").

In its "absolute" version, the purchasing power of different currencies is

equalized for a given basket of goods. In the "relative" version, the
difference in the rate of change in prices at home and abroad the difference
in the inflation rates is equal to the percentage depreciation or appreciation
of the exchange rate. The best-known and most-used purchasing power
parity exchange rate is the Geary-Khamis dollar (the "international dollar").

In its "absolute" version, the purchasing power of different currencies is

equalized for a given basket of goods. In the "relative" version, the
difference in the rate of change in prices at home and abroad the difference
in the inflation rates is equal to the percentage depreciation or appreciation
of the exchange rate. The best-known and most-used purchasing power
parity exchange rate is the Geary-Khamis dollar (the "international dollar").
The Concept of Purchasing Power Parity

With the increased globalization of markets for goods, services, finance,

labor and ideas, the need to measure and compare the standards of living
between the countries has become very important. Production of goods or
services and their prices, which showcases the standard of living are very
important for many people like foreign investors, traders, and potential
immigrants as it helps them to spend their money in a sensible way.

When it comes to comparing the value of money in terms of buying products

or goods in two different countries, exchange rate often comes to our mind.
Exchange rates are generally used to the convert the current values of
currency in one country to another. Exchange rates ignore the domestic
economic sectors where prices are fixed without any consultation with other
countries. Therefore, exchange rate does not reveal the real volume of output
of the goods or services that can be bought.

Therefore to measure the differences between the real prices of goods and
services across different countries, we need something to measure them on a
common scale. This is where Purchasing Power Parity (PPP) comes into
picture. Purchasing Power Parity converts local currencies to a common
currency and compares the buying power of different currencies. The
purchasing power parity is a method of measuring the effective purchasing
power of different countries’ currencies over the same types of goods and
services. It also states that, in ideally efficient markets, identical goods
should have similar price. While comparing the Purchasing Power Parities of
different countries, a standard single currency should be taken such as a US

But goods and services have widely varying prices across countries when
converted to a common currency. You can find more differences in goods or
services, which are not traded with other countries on international platform
such as products that are sold locally, costs of labour, housing, construction,
and healthcare services. That is the reason we get more number of haircuts
in India compared to US with the same amount of money. This also one of
the reasons many foreign companies to set up their offices and operate from
India. PPP is the main thing that is making the off shoring possible.

PPP is the best method to compare the standards of living in different

countries. According to The United Nations Statistics Division (UNSD), the
purchasing power parity conversion factor of India compared to US dollar is
16.537 in 2007. Purchasing power parity conversion factor is defined as the
required number of units of a country’s currency to buy the same amount of
goods and services in their local market as one U.S. dollar would buy in the
United States of America. In other words, when a person spends Rs.45 in US
to buy a product in his country, you can get the same product in India at
Rs.16.50 only. This means products in India are almost three times cheaper
than in the US.

According to 2005 International Comparison Program by World Bank,

individual household consumption expenditure was $1,183 in India where as
the same thing in US was about $29,368. Expenditure on household food
consumption was $317 in India, for the same purpose they spent $1,998 in
US. Household expenditure on health was $485 in India and it was $5,853 in

The PPP’s law of one price states that all the prices of goods or services
should equalize in the absence of local taxes, distributors margin and
shipping charges. But the price differences are less for goods that are widely
traded in international markets like electronic goods, machinery and
equipment. The theory of PPP is not working here with countries like India.
This is the reason some of the electronic goods and high-end cars in India
are expensive than in US.

There are some differences in the prices of goods and services between India
and US. Local goods, labour, food, housing, healthcare etc. are cheap in
India but some items like electronic goods, and high-end cars are overpriced.
Therefore be aware of things that are expensive and make sensible

NEED OF Purchasing power parity:

PPP exchange rate (the "real exchange rate") fluctuations are mostly due to
different rates of inflation between the two economies. Aside from this
volatility, consistent deviations of the market and PPP exchange rates are
observed, for example (market exchange rate) prices of non-traded goods
and services are usually lower where incomes are lower. (A U.S. dollar
exchanged and spent in India will buy more haircuts than a dollar spent in
the United States). Basically, PPP deduces exchange rates between
currencies by finding goods available for purchase in both currencies and
comparing the total cost for those goods in each currency.

Purchasing power parity measurement:

The PPP exchange-rate calculation is controversial because of the
difficulties of finding comparable baskets of goods to compare purchasing
power across countries. Estimation of purchasing power parity is
complicated by the fact that countries do not simply differ in a uniform price
level; rather, the difference in food prices may be greater than the difference
in housing prices, while also less than the difference in entertainment prices.
People in different countries typically consume different baskets of goods. It
is necessary to compare the cost of baskets of goods and services using a
price index . PPP comparisons are to be made over some interval of time
proper account needs to be made of inflationary effects.

NEED OF Purchasing power parity adjustments to GDP:

The exchange rate reflects transaction values for traded goods among
countries in contrast to non-traded goods, that is, goods produced for home-
country use. Also, currencies are traded for purposes other than trade in
goods and services, e.g., to buy capital assets whose prices vary more than
those of physical goods. Also, different interest rates, speculation, hedging
or interventions by central banks can influence the foreign-exchange market.

The PPP method is used as an alternative to correct for possible statistical

bias. The Penn World Table is a widely cited source of PPP adjustments,
and the so-called Penn effect reflects such a systematic bias in using
exchange rates to outputs among countries.


PPP numbers can vary with the specific basket of goods used, making it a
rough estimate.

Differences in quality of goods are hard to measure and thereby reflect in

PPP. PPP calculations are often used to measure poverty rates.
The International Monetary Fund
An international organization created for the purpose of:

1. Promoting global monetary and exchange stability.

2. Facilitating the expansion and balanced growth of international trade.
3. Assisting in the establishment of a multilateral system of payments for
current transactions.

UN specialized agency established in 1944 under Bretton Woods system to

help prevent unstable exchange rates and competitive devaluations of pre-
Second World War Western economies. It has since evolved into an
organization of 184 countries focused on preventing crises in international
monetary system via (1) surveillance through monitoring of national
economies and economic policies, (2) medium-term loans to tide over
balance-of-payment problems, and (3) technical assistance in formulating
and administering monetary, exchange rate, and taxation policies, central
bank operations, etc. Governed by a board of governors drawn from each
member country, its day to day decisions are taken by a 24-member board
who have voting-power in proportion to their respective country's economic
strength (and not on the basis of one-country, one-vote practice). The US
(with about 18 percent of the voting-power), UK, France, Germany, and
Japan are the most prominent members, followed by China, Russia, and
Saudi Arabia. The other 16 members are elected from groups of countries
called constituencies. IMF operates more like a credit union than an
investment bank because its capital (currently about $300 billion) is
contributed by its members based on a quota proportional to the member's
economic strength. Members can borrow against this contribution, but
lending is conditional on the borrower's pledge to follow certain hard
choices such exchange rate devaluation, cuts in social spending, control on
wages, and removal of price controls. Except in case of the poorest nations,
loans are advanced on market interest rates (currently about 3 percent) and,
if the borrowing exceeds the member's quota, more onerous conditions
(called conditionality) are imposed. Unlike the World Bank, IMF does not
provide project-specific loans but only temporary lending (up to 10 years)
for rebuilding of foreign exchange reserves, stabilization of the currency,
and payments for imports.
World Bank

The World Bank is an international institution, owned by about 180 member

countries, that provides financial and technical assistance to developing
nations. In that mission, the World Bank provides low-interest loans,
interest-free credit, and grants for education, health, infrastructure,
communications and other purposes. In 2005, the World Bank employed
9,300 people. The origins of the World Bank can be traced to the Bretton
Woods Conference in 1944 and the establishment of the International Bank
for Reconstruction and Development (IBRD) soon after. The IBRD remains
one of the two key components of the World Bank and focuses on assisting
middle income and creditworthy poor countries. The other main component
of the World Bank, the International Development Association (IDA),
focuses on helping the poorest nations. The World Bank can be
distinguished from the World Bank Group, which, besides the IBRD and the
IDA, includes the International Finance Corporation, the Multilateral
Investment Guarantee Agency, and the International Centre for Settlement
of Investment Disputes. Importantly, the World Bank Group does not
encompass the International Monetary Fund, although their activities are not
infrequently intertwined.

World Bank Operations

The World Bank exists to encourage poor countries to develop by providing

them with technical assistance and funding for projects and policies that will
realize the countries' economic potential. The Bank views development as a
long-term, integrated endeavor.

During the first two decades of its existence, two thirds of the assistance
provided by the Bank went to electric power and transportation projects.
Although these so-called infrastructure projects remain important, the Bank
has diversified its activities in recent years as it has gained experience with
and acquired new insights into the development process.

The Bank gives particular attention to projects that can directly benefit the
poorest people in developing countries. The direct involvement of the
poorest in economic activity is being promoted through lending for
agriculture and rural development, small-scale enterprises, and urban
development. The Bank is helping the poor to be more productive and to
gain access to such necessities as safe water and waste-disposal facilities,
health care, family-planning assistance, nutrition, education, and housing.
Within infrastructure projects there have also been changes. In transportation
projects, greater attention is given to constructing farm-to-market roads.
Rather than concentrating exclusively on cities, power projects increasingly
provide lighting and power for villages and small farms. Industrial projects
place greater emphasis on creating jobs in small enterprises. Labor-intensive
construction is used where practical. In addition to electric power, the Bank
is supporting development of oil, gas, coal, fuel wood, and biomass as
alternative sources of energy.

The Bank provides most of its financial and technical assistance to

developing countries by supporting specific projects. Although IBRD loans
and IDA credits are made on different financial terms, the two institutions
use the same standards in assessing the soundness of projects. The decision
whether a project will receive IBRD or IDA financing depends on the
economic condition of the country and not on the characteristics of the

Its borrowing member countries also look to the Bank as a source of

technical assistance. By far the largest element of Bank-financed technical
assistance--running over $1 billion a year recently--is that financed as a
component of Bank loans or credits extended for other purposes. But the
amount of Bank-financed technical assistance for free-standing loans and to
prepare projects has also increased. The Bank serves as executing agency for
technical assistance projects financed by the United Nations Development
Program in agriculture and rural development, energy, and economic
planning. In response to the economic climate in many of its member
countries, the Bank is now emphasizing technical assistance for institutional
development and macroeconomic policy formulation.

Every project supported by the Bank is designed in close collaboration with

national governments and local agencies, and often in cooperation with other
multilateral assistance organizations. Indeed, about half of all Bank-assisted
projects also receive co financing from official sources, that is, governments,
multilateral financial institutions, and export-credit agencies that directly
finance the procurement of goods and services, and from private sources,
such as commercial banks.
Other sources of finance. It assists only those projects for which the required
capital is not available from other sources on reasonable terms. Through its
work, the Bank seeks to strengthen the economies of borrowing nations so
that they can graduate from reliance on Bank resources and meet their
financial needs, on terms they can afford directly from conventional sources
of capital.

The range of the Bank's activities is far broader than its lending operations.
Since the Bank's lending decisions depend heavily on the economic
condition of the borrowing country, the Bank carefully studies its economy
and the needs of the sectors for which lending is contemplated. These
analyses help in formulating an appropriate long-term development
assistance strategy for the economy.

Graduation from the IBRD and IDA has occurred for many years. Of the 34
very poor countries that borrowed money from IDA during the earliest
years, more than two dozen have made enough progress for them no longer
to need IDA money, leaving that money available to other countries that
joined the Bank more recently. Similarly, about 20 countries that formerly
borrowed money from the IBRD no longer have to do so. An outstanding
example is Japan. For a period of 14 years, it borrowed from the IBRD.
Now, the IBRD borrows large sums in Japan.

Foreign Exchange Management Act

The government of India has formulated the Foreign Exchange Management
Act (FEMA), which relates to the foreign direct investment in the country.
Foreign Exchange Management Act (FEMA) has helped the country by
encouraging external payment and trade.

Formulation of Foreign Exchange Management Act (FEMA):

In 1999, the Indian government formulated the Foreign Exchange
Management Act (FEMA).
On the 1st of June, 2000, FEMA came into force replacing the Foreign
Exchange Regulation Act (FERA), which was formulated in 1973. Extensive
economic reforms were undertaken in India in the early 1990s and this led to
the deregulation and liberalization of the country's economy. Foreign
Exchange Management Act (FEMA) was thus formulated in order to be
compatible with the policies of pro- liberalization of the Indian government.

Extent of Foreign Exchange Management Act (FEMA):

Foreign Exchange Management Act (FEMA) is applicable to the entire
country. Agencies, branches, and offices, outside India, that are owned by
Indian residents, also fall under the jurisdiction of this act. Foreign Exchange
Management Act (FEMA) also extends to any dispute that are committed in
offices, agencies and branches outside India that are owned by individuals
covered by this act.

Objectives of Foreign Exchange Management Act (FEMA):

Among the various objectives of the Foreign Exchange Management Act
(FEMA), an important one is to revise and unite all the laws that relate to
foreign exchange. Further FEMA aims to promote foreign payments and
trade in the country. Another important objective of the Foreign Exchange
Management Act (FEMA) is to encourage the orderly maintenance and
development of the foreign exchange market in India.

Implementation of Foreign Exchange Management Act (FEMA):

Extensive efforts have been undertaken to ensure the effective
implementation of FEMA in India. Proper implementation measures and
efficient supervision are important preconditions for the success of the
Foreign Exchange Management Act (FEMA).