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 ASSIGNMENT SOLUTIONS GUIDE (2018-2019)
I.B.O.-6
International Business Finance
Disclaimer/Special Note: These are just the sample of the Answers/Solutions to some of the Questions given in the
Assignments. These Sample Answers/Solutions are prepared by Private Teacher/Tutors/Authors for the help and guidance
of the student to get an idea of how he/she can answer the Questions given the Assignments. We do not claim 100%

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accuracy of these sample answers as these are based on the knowledge and capability of Private Teacher/Tutor. Sample
answers may be seen as the Guide/Help for the reference to prepare the answers of the Questions given in the assignment.
As these solutions and answers are prepared by the private Teacher/Tutor so the chances of error or mistake cannot be

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denied. Any Omission or Error is highly regretted though every care has been taken while preparing these Sample Answers/

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Solutions. Please consult your own Teacher/Tutor before you prepare a Particular Answer and for up-to-date and exact

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information, data and solution. Student should must read and refer the official study material provided by the university.

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Q. 1. (a) An Adverse balance of payment is always a sign of weakness in the economy. Comment.

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Ans. Balance of Payment of a country is considered to be one of the imperative indicators for International

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Trade, which significantly affect the economic policies of a government. As every country struggle to have a favourable
balance of payments, the trends in and the position of, the balance of payments will considerably influence the nature

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and types of regulation of export and import business in particular.

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Balance of Payments is a methodical and abstract record of a country’s economic and financial transactions with
the rest of the world over a given period of time. The balance of trade takes into account only the transactions arising

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out of the exports and imports of the visible terms; it does not consider the exchange of invisible terms such as the

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services rendered by shipping, insurance and banking; payment of interest, and dividend; expenditure by tourists,

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etc. However, the balance of payments takes into account the exchange of both the visible and invisible terms.

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Hence, the balance of payments presents a better picture of a country’s economic and financial transactions with the
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rest of the world than the balance of trade.
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The transactions that fall under balance of payments are recorded in the standard double-entry book-keeping

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form, under which each international transaction undertaken by the country results in a credit entry and a debit entry
of equal size. As the international transactions are recorded in the double-entry book-keeping form, the balance of
payments must always balance. In other words, the total amount of debts must equal the total amount of credits.

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Sometimes, the balancing item, error and omissions, is required to be added to balance the balance of payments.
(b) Differentiate between:

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(i) Capital Account and current Account
Ans. Capital Account: According to the IMF's definition, the capital account "records the international flows of

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transfer payments relating to capital items". It therefore records a country's inflows and outflows of payments and
transfer of ownership of fixed assets (capital goods). Examples of such goods could be factories or heavy machinery
transferred to or from abroad and so on. In other words, the capital accounts for the transfer of capital goods. Also,
the term capital account usually refers to the financial account and capital account, combined.
Current Account: The current account is the net change in current assets from trade in goods and services
(balance of trade), net factor income (such as dividends and interest payments from abroad) and net unilateral
transfers from abroad (such as foreign aid, grants, gifts, etc). The current account balance is one of two major
metrics of the nature of a country's foreign trade (the other being the net capital outflow). A current account surplus
increases a country's net foreign assets by the corresponding amount, and a current account deficit does the reverse.
Both government and private payments are included in the calculation.

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 (ii) Capital Account and Reserve Account
Ans. Capital Account: According to the IMF's definition, the capital account "records the international flows of
transfer payments relating to capital items". It therefore records a country's inflows and outflows of payments and
transfer of ownership of fixed assets (capital goods). Examples of such goods could be factories or heavy machinery
transferred to or from abroad and so on. In other words, the capital accounts for the transfer of capital goods. Also,
the term capital account usually refers to the financial account and capital account, combined.
Official Reserves Account: The official reserve account records the change in stock of reserve assets (also
known as foreign exchange reserves) at the country’s monetary authority. Frequently, this is the responsibility of a
government established Central Bank. Although practically extinct, changes in reserve assets at private monetary
authorities are included, as well. Reserves include official gold reserves, foreign exchange reserves, IMF Special
Drawing Rights (SDRs) or nearly any foreign property held by the monetary authority all denominated in domestic
currency.

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Changes in the official reserve account equal the differences between the capital account and current account
(and errors and omissions) by accounting identity and are mostly composed of foreign exchange interventions and

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deposits into international organizations such as the IMF; the magnitude of these changes will depend upon monetary

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policy and government mandate.

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According to the standards published by the IMF in the IMF Balance of Payments Manual, net decreases of
official reserves indicate that a country is buying its domestic assets, usually currency then bonds, to support its value

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relative to whatever asset, usually a foreign currency, which they are selling in exchange. Countries with large net

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increases in official reserves are effectively attempting to keep the price of their currency low by selling domestic
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currency and purchasing foreign currency, increasing official reserves. For countries with floating exchange rates,
the official reserves will tend to change less, and be used as another tool of monetary policy to influence intervention
by directly controlling the domestic money supply (by buying or selling foreign currency).

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Interest in official reserve positions as a measure of balance of payments greatly diminished after 1973 as the

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major countries gave up their commitment to convert their currencies at fixed exchange rates. This reduced the need
for reserves and lessened concern about changes in the size of reserves.

reserves.

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Countries that attempt to control the price of their currency will tend to have large net changes in their official
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Q. 2. (a) Distinguish between gold standard and gold exchange standard.

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Ans. The first modern international monetary system was the gold standard. The gold standard provided for the

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free circulation between nations of gold coins of standard specification. Under the system, gold was the only standard
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of value. The groundwork of the gold standard is that a currency's cost is supported by some weight in gold. Under

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the gold standard system and based on its gold value, all participating currencies were convertible. Because currencies
were convertible in gold, then nations could ship gold among them to adjust their "balance of payments."

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In theory, all nations should have an optimal balance of payments of zero, i.e. they should not have either a trade
deficit or trade surplus. At the turn of the 20th century, many major trading nations used the gold standard to adjust
their monetary supply. However, the processes of the gold standard in reality lead to many issues.

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The operation of the gold standard in reality caused many problems. When gold left a nation, the ideal balancing
effect would not occur immediately. Instead, recessions and unemployment would often occur. This was because

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nations with a balance of payments deficit often neglected to take appropriate measures to stimulate economic
growth. Instead of altering tax rates or increasing expenditures - measures which should stimulate growth - governments
opted to not interfere with their nations’ economies. Thus, trade deficits would persist, resulting in chronic recessions
and unemployment.
With the eruption of the First World War in the year 1914, the international trading system busted out. Government
of respective nations took their currencies off the gold standard and simply ordered the value of their money. Subsequent
to the war, few nations tried to re-establish the gold standard system at pre-war rates, but drastic changes in the global
economy made such attempts ineffective. This leads to rise of Gold Exchange Standard. Under this new system,
currencies would be transferable not in gold but in the leading post-war currencies of the associated nations.

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 Because the world currencies were still exchangeable for gold, the “gold-exchange” standard became the existing
monetary exchange system for several years. However, due to the post war effects and the revival of other economies,
many nations could no longer comply to exchange currencies for gold. Hence, gold supply rapidly declined. And only
the severity of World War could lead to re-establishments of the economy.
The effect of the gold-exchange system was to make the United States the center for international currency
exchange. However, due to the inflationary effects of the Vietnam War and the resurgence of other economies, the
United States could no longer comply with its obligation to exchange dollars for gold. Its own gold supply was
rapidly declining. In 1971, President Richard Nixon removed the dollar from gold, ending the predominance of gold
in the international monetary system.
(b) What were the distinctive features of Bretton Woods system?
Ans. The Bretton Woods system as a monetary management system was set as the rules for commercial and

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financial relations among the world's major industrial nations. The planners at Bretton Woods established the
International Bank for Reconstruction and Development (IBRD) (now known as one of the five institutions in the
World Bank Group) and the International Monetary Fund (IMF) The reason behind setting up such a system of rules,

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institutions, and procedures was to manipulate the international monetary system. After satisfactory number of

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countries had ratified the agreement, this system became operational in the year 1946.

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Under main features of the Bretton Woods system, it was an obligation for each country to adopt a monetary

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policy that maintained the exchange rate of its currency within a fixed value. This value was expressed in
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terms of gold and the ability of the IMF to bridge temporary imbalances of payments. In the face of increasing strain,
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the system collapsed in 1971, following the United States’ suspension of convertibility from dollars to gold.

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By this time, due to inflation in the United States and a growing short fall in American trade were depressing the
value of the dollar. Americans advocated Germany and Japan to appreciate their currencies. But both of the countries
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already had favorable payments balances. And both of the nations were disinclined to this decision. Because of the
reason that raising their currency value might result in increased prices for there goods and which can further affect
their exports. Lastly, the United States neglected the fixed rate of the dollar and allowed it at "float" rate. This meant

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to change the value of dollar against other currencies. The value of dollar swiftly started falling down. World leaders
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wanted to stimulate the Bretton Woods system in 1971, but the effort failed. By 1973, the float rate system was

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adopted by United States and other nations.

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Thus, the delayed adjustment of the parities to change in the economic environment of the countries was the

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weakest point of Bretton Woods Agreement. This led to a lack of trust and strike at the foundations of guesswork
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Another considerable problem was that one national currency had to be an international reserve currency at that
time. This made the national monetary and economic policy of the United States liberated from external fiscal

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pressures, while greatly influencing those external economies. To guarantee international liquidity; USA was enforced
to run shortage in their balance of payments, to avoid world inflation. However, in the 1960s they ran a policy that

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restricted the convertibility of the U.S. dollar to compete the insufficient reserves to meet the currency supply and
demand. But other member nations were not ready to accept the high inflation rates and the value of dollar ended up

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being weak. Hence, the system of Bretton Woods collapsed.
Q. 3. (a) What is translation exposure? Is management of translation exposure more important that economic
exposure? Discuss.
Ans. Translation exposure is also referred to as accounting exposure. This arises because the financial statements
of foreign subsidiaries must be restated in the parent's reporting currency for the firm to prepare its consolidated
financial statements. Translation exposure is the potential for an increase or decrease in the parent's net worth and
reported income caused by a change in exchange rates since the last transaction. Translation methods differ by
country along two dimensions. One is a difference in the way a foreign subsidiary is characterised depending on its
independence. The other is the definition of which currency is most important for the subsidiary.

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 The restatement of foreign currency financial statements in terms of a reporting currency is termed translation.
The exposure arises from the periodic need to report consolidated worldwide operations of a group in one reporting
currency and to give some indication of the financial position of that group at those times in that currency.
Economic Exposure: Economic exposure refers to the degree to which a firm’s present value of future cash
flows can be influenced by exchange rate fluctuations. Economic exposure is a more managerial concept than an
accounting concept. A company can have an economic exposure to say Pound/Rupee rates even if it does not have
any transaction or translation exposure in the British currency. This situation would arise when the company’s competitors
are using British imports. If the Pound weakens, the company loses its competitiveness (or vice versa if the Pound
becomes strong).
Thus, economic exposure to an exchange rate is the risk that a variation in the rate will affect the company’s
competitive position in the market and hence its profits. Further, economic exposure affects the profitability of the
company over a longer time span than transaction or translation exposure. Under the Indian exchange control,

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economic exposure cannot be hedged while both transaction and translation exposure can be hedged.
Translation exposure is measured at the time of translating foreign financial statements for reporting purposes
and indicates or exposes the possibility that the foreign currency denominated financial statement elements can

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change and give rise to further translation gains or losses, depending on the movement that takes place in the currencies
concerned after the reporting date. Such translation gains and losses may well reverse in future accounting periods

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but do not, in themselves, represent realized cash flows unless and until, the assets and liabilities are settled or

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liquidated in whole or in part. This type of exposure does not, therefore, require management action unless there are
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particular covenants, e.g. regarding gearing profiles in a loan agreement, that may be breached by the translated
domestic currency position, or if management believes that translation gains or losses will materially affect the value
of the business.

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It is the degree to which a firm's foreign currency denominated financial statements is affected by exchange rate

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changes. All financial statements of a foreign subsidiary have to be translated into the home currency for the purpose
of finalizing the accounts for any given period. If a firm has subsidiaries in many countries, the fluctuations in exchange

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rate will make the assets valuation different in different periods. The changes in asset valuation due to fluctuations in
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exchange rate will affect the group's asset, capital structure ratios, profitability ratios, solvency ratios, etc. FASB 52

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specifies that US firms with foreign operations should provide information disclosing effects of foreign exchange rate

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changes on the enterprise consolidated financial statements and equity. The following procedure has been followed:
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Assets and liabilities are to be translated at the current rate that is the rate prevailing at the time of preparation
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of consolidated statements.

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All revenues and expenses are to be translated at the actual exchange rates prevailing on the date of transactions.
For items occurring numerous times weighted averages for exchange rates can be used.
●

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Translation adjustments (gains or losses) are not to be charged to the net income of the reporting company.
Instead these adjustments are accumulated and reported in a separate account shown in the shareholders

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equity section of the balance sheet, where they remain until the equity is disposed off.
● Measurement of translation exposure is defined as Translation exposure = (Exposed assets - Exposed liabilities)

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(change in the exchange rate).
Since translation exposures are serious threats, there are special hedging strategies designed for translation
exposures. These are fund flow adjustment, forward contracts, exposure netting. Fund flow adjustment technique
involves altering the amounts or the currencies of the planned cash flows of the parent or the subsidiaries to reduce
the firm’s local currency accounting exposure. In such cases, if the local currency devaluation occurs, direct fund
adjustment method will include pricing exports in hard currencies and imports in the local currency, investing in hard
currency securities and replacing hard currency borrowings with local currency loans. The indirect methods include
adjusting transfer prices on the sale of goods between affiliates, speeding up the payment of dividends, fees and
royalties, and adjusting the leads and lags of inter- subsidiary accounts.

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 Forward contract can also be used to hedge translation exposure by creating an offsetting asset or liability in a
foreign currency. Any loss (gain) on its translation exposure will then be offset by a corresponding gain (loss) on its
forward contract. However, it is to be noted that the gain (or loss) on the forward contract is of a cash flow nature and
is netted against an unrealized translation loss (or gain).
Exposure netting is another hedging technique that can be used by multinational firms with positions in more
than one foreign currency or with offsetting positions in the same currency. This technique involves offsetting
exposures in one currency with exposures in the same or another currency such that gains and losses on the two
currency positions will offset each other.
(b) What are Euro Bonds and Foreign Bonds?
Ans. There is a substantial difference between Euro bonds and foreign bonds. A Euro bond is a bond that is
issued and traded within a country other than the one in which its currency is denominated i.e. the country of origin.

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In other words, a foreign bond is a bond issued in a local market for a foreign borrower. Foreign bonds tend to be
more synchronized than Euro bonds and are usually issued by a domestic group of banks. However, a Euro bond
does not essentially have to start off or end up in Europe although non-European bodies issue most debt instruments
of this type to European investors.

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The major risk of a foreign bond is that it is an unenforceable claim. An investor who is the owner of the bonds

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of a company in his or her home country has explicit legal option in the event of default. Foreign bonds, however,
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does not possess such protection.

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A Euro bond is something dissimilar. It is not a foreign bond issued within the European Union. Relatively, it is

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a bond issued and traded within the mostly unregulated Euro market. Although that market originated within Europe
and is still mostly centred within Europe, it is actually an international market. Dealings are not subjected to regulations
of any particular nation.

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These bonds are issued in bearer form and usually pay annual as compared to semiannual coupons. They are
denominated in different currencies. Since the launch of the Euro in 1999, many European corporations have turned

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to the Euro bond market to expand their funding away from bank loans. In this way, the Euro bond market has
become both an international market and somewhat of an unregulated domestic bond market for Europe.

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Trading between the foreign bond and Euro bond markets lead to the development of global bonds. These are

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bonds that blend characteristics of foreign bonds and Euro bonds and are issued in both markets simultaneously.

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Q. 4. (a) What is political risk? Discuss the various approaches for assessment of political risk.

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Ans. Political risk is the risk associated with doing business in or with other country having different culture,

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laws, traditions, customs and having a different currency. All international trade and investments face political
risk though in different degrees. This type of risk is that an investment's returns could suffer as a result of political
changes or instability in a country. Instability affecting investment returns could stem from a change in

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government, legislative bodies, other foreign policy makers, or military control.
Political risk is also known as “geopolitical risk”, and becomes more of a factor as the time horizon of an

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investment gets longer. Political risks are notoriously hard to quantify because there are limited sample sizes or case
studies when discussing an individual nation. Some political risks can be insured against through international

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agencies or other government bodies.
The outcome of a political risk could drag down investment returns or even go so far as to remove the ability to
withdraw capital from an investment. Broadly, political risk refers to the complications businesses and governments
may face as a result of what are commonly referred to as political decisions.
One of the major concerns for multinationals intending to invest in other countries is the assessment and
measurement of political risk in these countries.
Rummel and Heenan identify at least five major approaches which are employed to assess political risk. The first
is the grand tour approach wherein a company engages in some preliminary market research towards a country by
dispatching an executive or a team on an in-country inspection tour. Once the tour was completed, the team meets
with the top management and discusses the potential strengths and weaknesses of the proposed investment.

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 The second is a hands-on approach in which the company places great trust in the recommendations made by
academicians, diplomats, business representatives and other outsiders who have knowledge about the target country.
The third approach uses the Delphi techniques. The potential investing firm initially lists selective dements
which might influence a nation's political future, such as the size and composition of the armed forces or the history
of leadership succession. The firm then asks a number of outside experts to rank the importance of these factors for
the country under consideration. The data may then be aggregated and the country ranked on a high moderate or low
risk basis.
The fourth method uses quantitative methods, somewhat akin to econometric forecasting of economic events.
Multivariate analysis is used to predict political trends based on current and historical information. It analyses the
relationship among underlying political, economic, sociological and cultural relationships.
The fifth approach combines both the subjective and objective approaches and provides a systematic framework
for both the qualitative and quantitative interpretation of data.

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(b) What is transfer pricing? Why do the Transnational Corporations resort to transfer pricing?
Ans. It is corporate function, transfer pricing, that is potentially relevant to each of these activities. It is a
technique to transfer the funds from one location to another. Whenever a payment crosses borders in a treasury

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context whether to provide a loan, purchase a receivable, provide a guarantee, sweep cash, factor a receivable,
provide a hedge or insurance product a transfer pricing issue is present.

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Transfer pricing is often viewed as a taxation issue and thus the responsibility of the corporate tax department.

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This include challenges that view, and makes the case that an integrated, multi-functional approach to MNE treasury
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planning in the context of transfer pricing can be an important component in improving the efficiency of cross-
border financial management. It also states conceptual and empirical information as well as numerical examples to
illustrate relevant tax and transfer pricing concepts for policy planners and others responsible for MNE treasury and
tax planning.
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Inter company financing transactions are becoming increasingly important to Multinational Enterprises (MNEs)

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as they expand internationally. Corporate treasurers of MNEs have many responsibilities, including the management

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of international capital structure and cost of capital, the financing of cross-border acquisitions, foreign direct
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investment, international capital budgeting and cash management, management of foreign exchange and transactional
risk, and port folio and investment management. .

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Funds Transfer Pricing is an analysis tool that can be used to help a bank measure its profitability in a variety of

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different ways. It allows management to compare the profitability of different product lines within the company and

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it can be drilled down even further to allow comparison between individual employees. It is also very useful for
comparison between branches. This study will discuss the fundamentals of Fund Transfer Pricing (FTP) and talk
about how Funds Transfer Pricing will affect the profitability of two branches of a bank.

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Also focuses on a corporate function, transfer pricing that is potentially relevant to each of these activities.
Whenever a payment crosses borders in a treasury context whether to provide a loan, purchase a receivable, provide

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a guarantee, sweep cash, factor a receivable, provide a hedge or insurance product a transfer pricing issue is present.
Transfer pricing is often viewed as a taxation issue and thus, the responsibility of the corporate tax department.

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Banking businesses face a problem of accurately estimating the profits earned from their various fund raising and
deployment activities.
The mismatch between the source of the funds and the deployment raises issues of interest rate risk that cloud
accurate profitability measurement. This involves the costs of managing the interest rate risk as a bank-wide activity,
and delineating the benefits and costs of this activity is important for accurate performance measurement. The funds
transfer pricing module is designed to help both manage risk effectively and to accurately measure performance in
various divisions of the bank.
The funds transfer pricing engine's output drives both the interest rate risk management within the bank as well
as the measurement of profits clearly differentiating the rewards and responsibility of different units. It can be
explained by this example as well. Reveleus Customer Profitability and Reveleus Product Profitability take in data

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from the Transfer Pricing module for accurate and consistent Net Interest Income definition as well as other costs
data to provide a complete performance measurement solution for your bank. Reveleus’ funds transfer pricing also
integrates with the Risk suite of products that handle the risk arising out of interest rate changes in the marketplace.
Reveleus Funds Transfer Pricing also uses the same cash flow engine as well as assumptions about the behavioral
characteristics used in the management of the interest rate risk of the bank.
In simple terms, transfer pricing is “A transfer price measures the value of products furnished by a profit centre
to other responsibility centre within a company. Internal exchanges that are measured by transfer prices result in (i)
revenue for the responsibility centre furnishing (i.e. selling) the product and (ii) costs for the responsibility centre
receiving (i.e. buying) the product.” (Anthony, 2004). In the banking industry, this would be deposits that are
collected by one branch and used by another to fund loans.

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When a bank makes a loan to a customer, the funding for this loan has to come from one source or another.
Typically, the funding in a financial institution will come from deposits collected by the bank. This type of funding

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is normally the cheapest and most desirable; however, when deposits are not sufficient to fund all the needs for cash
that the bank has, the bank will have to get additional funding in the wholesale market.

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Therefore, each deposit brought in to the bank has a value to the financial institution for funding purposes, and,
by the same token, a loan also has an underlying cost of funds and is not just interest income for the bank, as it would

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look in a typical income statement analysis. The purpose of FTP is to place a value on each deposit and assign a cost
to each loan that a bank has.
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Q. 5. (a) Discuss the issues in the taxation of business investment abroad.
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Ans. As at present, tile issues of business investment abroad by Indian businesses have not attracted much
consideration, because stepping up exports in a priority in view of the urgent need of increasing the rate of economic

are treated quite sympathetically. m

growth. Thus, incomes earned by exports are given liberal treatment. Incomes earned by Indian businesses abroad

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However, if in the course of next five to ten years (or even twenty years) India becomes a major industrial nation

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with its businesses having spread their operations in many countries, the tax considerations for foreign investments
and tax treatment of incomes earned abroad by Indian businesses may become an important issue. The discussion of

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issues in the area of Indian taxation of business investment abroad will not be out of context.

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Investment decisions are determined by the after tax rates of returns that are available. However, the complexity

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from trivia.
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of taxes impinging on the international investment decisions of many firms makes the application of this point far

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The host country governments have the first opportunity to tax the income earned within their borders. Typically,
this income is subjected to the same corporate income tax that the local firms pay. When the income from these

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investments is actually repatriated to the parent, an additional tax, called a "withholding tax" may be levied by the
host government. When these dividends are received by the parent firm, the government may tax them again. Thus,

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leads to double taxation.
The effective rate of taxation, to which a U.S. investor should respond in making its foreign investment decisions,

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is, therefore, a complicated concept. In particular, the tax rate depends on the firm's repatriation decisions, as well as
its location of investment decisions. At each point in time, the firm earns an after-tax rate on each dollar it retains
abroad, and it a on each dollar it repatriates. What rate, or combination of rates, should enter into the firm’s investment
decisions? This issue has often been resolved in empirical studies by simply taking a weighted average of the
applicable tax rates.
(b) Differentiate between fisher effect and international fisher effect.
Ans. The relationship between interest rates and inflation was first put forward by Fisher, postulates that the
nominal interest rate in any period is equal to the sum of the real interest rate and the expected rate of inflation. This
is termed the Fisher effect. The Fisher hypothesis says that the real interest rate in an economy is independent of
monetary variables. If we add to this the assumption that real interest rates are equated across countries, then the

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country with the lower nominal interest rate would also have a lower rate of inflation and hence the real value of its
currency would rise over time.
This is the opposite of what is usually seen in practice, where investors tend to move money from countries with
lower nominal interest rates to those with higher nominal interest rates, in order to obtain the highest rate of return
on their deposits. This practice even extends to borrowing in the country with the lower nominal interest rate to
deposit the money in the country with the higher nominal interest rate, when it is profitable to do so (carry trade).
These international money movement practices cause an increase in the value of the currency of the country with the
higher nominal interest rate, contrary to the International Fisher Effect.
Fisher (1930) hypothesized that the nominal interest rate could be decomposed into two components, a real rate
plus an expected inflation rate. He claimed a one-to-one relationship between inflation and interest rates in a world
of perfect foresight, with real interest rates being unrelated to the expected rate of inflation and determined entirely

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by the real factors in an economy, such as the productivity of capital and investor time preference. This is an
important prediction of the Fisher hypothesis for, if real interest rates are related to the expected rate of inflation,

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changes in the real rate will not lead to full adjustment in nominal rates in response to expected inflation.
A problem that arises when testing for the Fisher effect is the lack of any direct measure of inflationary expectations.

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For this reason, a proxy variable for inflationary expectations must be employed. Over the years, a number of
approaches have been used to derive proxies for the expected rate of inflation. The majority of early studies on the

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Fisher effect used some form of distributed lag on past inflation rates to proxy for inflationary expectations.

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The International Fisher Effect is a hypothesis in international finance that says that the difference in the nominal

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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.

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The International Fisher Effect observation holds that a country with higher interest rate will also be inclined to
have a higher inflation rate.

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The International Fisher Effect also estimates the future exchange rates based on the nominal interest rate
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relationships. The estimate of the spot exchange rate 12 months from now is calculated by multiplying the current

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spot exchange rate by the nominal annual U.S. interest rate and then dividing it by the nominal annual British

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interest rate.

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