RISK ANALYSIS AND MANAGEMENT

LECTURE: 4
TOPIC: FOREIGN EXCHANGE RISK
 INTRODUCTION

Businesses that trade internationally or have overseas operations are exposed to foreign exchange risk
due to the volatility in the currency markets.
Exposure to foreign exchange risks result from are caused by several reasons, the most common is from
having to make overseas payments for your imports priced in a foreign currency or receiving foreign
currency receipts for your exports. However, exposure can also arise from:
Foreign currency borrowing/deposits
Overseas subsidiaries
Assets located overseas
 INTRODUCTION

The impact that exchange rate fluctuations have on profitability will vary but in many cases it can be significant. FX risk is best
explained with an example

Effective management of this risk is extremely crucial but not necessarily difficult. Each bank/ financial institution has their methods
of assessing their exposure to foreign exchange rate risk. For eg.:

• Understand your exposure

What proportion of your business relates to imports or exports?

What currencies are involved?

What impact would an adverse rate movement have on your profitability?

Etc…

• Understand the products

Lock into fixed rates – the use of a forward exchange contract. However, you can suffer an opportunity loss if the exchange rate
moves in your favour and you have no choice but to follow through with the contract.
Use flexible products - Currency options (where available) will offer you the potential for upside benefit if rates move in your favour
like a spot deal but will provide protection against adverse rate movements – like a forward exchange contract.

Do nothing and buy or sell your currency in the spot market - The strategy involves buying or selling foreign currency on the specified
day, with an exchange rate quoted and the transaction settled two working days later. This can be high-risk due to potential exchange
rate changes. You will not know how much Sterling you will need to pay or receive for your foreign currency until the day in question.
 INTRODUCTION

• Develop a strategy
The previous alternatives are not your only options or may not be your best options. It’s dependent on an
entity’s risk appetite, to manage foreign exchange risk, businesses often adopt a portfolio approach,
combining spot, forward exchange contracts, and currency options.
For eg., in an uncertain exchange rate environment, you may decide to transact 25%. of your currency in
spot, fix 25%. with a forward exchange contract and cover 50% with flexible solutions such as an option.
This way, if rates move in your favour, you will benefit on 75 % of your exposure (spot and options)
while if rates move against you, you are protected on 75% (forward exchange contracts and options).
• Implement it
Implementing a foreign exchange risk management strategy is crucial to protect profits in volatile
currency markets, despite potential short-term rate fluctuations.
 FOREIGN EXCHANGE RATES AND
TRANSACTIONS

Foreign exchange rates are listed in two ways:

The exchange rate for foreign currency is listed as a direct quote, where US dollars are received for one unit of the foreign
currency exchanged, or in US$, or as an indirect quote, where foreign currency is received for each US dollar exchanged.
Foreign Exchange Transactions
There are two basic types of foreign exchange rates and foreign exchange transactions, spot and forward

• Spot transactions involve the immediate exchange of currencies at the current spot exchange rate, conducted through
commercial banks or nonbank foreign currency dealers. Cross-currency exchange rates for eight major countries are
listed on Bloomberg’s website: www.bloomberg.com/markets/currencies/fxc.html.
• A country's currency's appreciation or depreciation affects foreign buyers and sellers. An appreciation makes goods
more expensive for foreign buyers, while a depreciation makes them cheaper for foreign buyers and more expensive
for foreign sellers. This affects domestic and foreign manufacturing. A classic case of China’s goods in the US market.
A forward foreign exchange transaction involves the exchange of currencies at a specified rate at a future date, typically
written for one-, three-, or six-month periods, but can be written over any given length. An example is an agreement today
(at time 0) to exchange dollars for euros at a given (forward) exchange rate three months in the future.
 SO U R C E S O F F O R E IG N E X C H A N G E R ISK E X P O SU R E

Liabilities to and Claims on Foreigners Reported by Banks in the United States, Payable in Foreign Currencies (in millions of dollars, end of period)

The US banks' foreign assets and liabilities from 1994 to 2012 were $319.4 billion and $235.3
billion respectively. The decline was attributed to financial crises in Asia, Russia, and
Argentina. However, growth accelerated after the crisis. US banks had more liabilities than
claims on foreigners, causing foreign exchange risk. After this period, growth accelerated
rapidly as the world economy recovered. In contrast, as the dollar depreciated relative to
foreign currencies, US banks experienced gains from foreign exchange exposures (2005
through 2012).
 SOURCES OF FOREIGN EXCHANGE RISK EXPOSURE

Monthly US Bank Positions in Foreign Currencies and Foreign Assets and Liabilities, March 2012 (in currency of denomination)

The US banks' foreign currency positions and investments in major currencies as of June 2012 are categorized in the above
table. Foreign currency trading dominates direct portfolio investments, with aggregate trading positions appearing large but net
exposure positions being relatively small (Japanese Yen For eg.). A FI's overall FX exposure in any given currency can be
measured by net position exposure in local currency.
Net position exposure refers to the degree to which a FI is net long (positive) or net short (negative) in a given currency holding
more (fewer) assets than liabilities in a given currency).

𝑁𝑒𝑡 𝑒𝑥𝑝𝑜𝑠𝑢𝑟𝑒 = 𝐹𝑋 𝑎𝑠𝑠𝑒𝑡𝑠! − 𝐹𝑋 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠! + 𝐹𝑋 𝑏𝑜𝑢𝑔ℎ𝑡! − 𝐹𝑋 𝑠𝑜𝑙𝑑!

= 𝑁𝑒𝑡 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑎𝑠𝑠𝑒𝑡𝑠! + 𝑁𝑒𝑡 𝐹𝑋 𝑏𝑜𝑢𝑔ℎ𝑡!
i= the ith currency
 SO U R C E S O F F O R E IG N E X C H A N G E R ISK E X P O SU R E

• A US financial institution (FI) can reduce its foreign exchange net exposure to zero by matching its
foreign currency assets to liabilities in a given currency and offsetting imbalances in its trading book
(buys and sells) (a case of a balanced portfolio). Financial holding companies can aggregate their
foreign exchange exposure across all units, reducing their net exposure across all units (might have a
commercial bank, an insurance company, and a pension fund all under one umbrella).
• Failure to maintain a fully balanced position in any given currency exposes a US FI to fluctuations in
the foreign exchange rate against the dollar. The greater the volatility of foreign exchange rates, the
greater the fluctuations in a FI's foreign exchange portfolio.
• For eg., US banks had positive net FX exposures in two major currencies. A positive net exposure
position means a US financial institution (FI) is net long in a currency, buying more foreign currency
than selling it. A negative net exposure position means a FI has sold more foreign currency than
purchased, exposing them to currency fluctuations.
• Most large nonbank FIs have some FX exposure through asset-liability holdings or currency trading,
but these exposures are smaller than major US money center banks due to smaller asset sizes, prudent
person concerns, and regulations. For eg. a pension fund may invest approximately 5% of their asset
portfolios in foreign securities, and US life insurance companies generally hold less than 10% of their
assets in foreign securities.
 SO U R C E S O F F O R E IG N E X C H A N G E R ISK E X P O SU R E

Foreign Exchange Rate Volatility and FX Exposure

We can measure the potential size of a FI’s FX exposure by analyzing the asset, liability, and currency
trading mismatches on its balance sheet and the underlying volatility of exchange rate movements

𝐷𝑜𝑙𝑙𝑎𝑟 𝑙𝑜𝑠𝑠⁄𝑔𝑎𝑖𝑛 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑖

= 𝑁𝑒𝑡 𝑒𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑖 𝑚𝑒𝑎𝑠𝑢𝑟𝑒𝑑 𝑖𝑛 𝑈𝑆 𝑑𝑜𝑙𝑙𝑎𝑟
× 𝑆ℎ𝑜𝑐𝑘 𝑣𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑡𝑜 𝑡ℎ𝑒 $⁄𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑖 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒)
Foreign exchange rate (FX) volatility is influenced by fluctuations in a country's currency demand and
supply. A country's FX rate appreciates when demand (supply) is high (low), and depreciates when
demand (supply) is low (high). For instance, during the 2011 European crisis, Switzerland's safe financial
system and secure fiscal conditions led to significant appreciation of the Swiss franc against the US
dollar, euro, Japanese yen, and British pound.
 F O R E IG N C U R R E N C Y T R A D IN G

• FX markets have grown significantly, with trading turnover reaching $4.7 trillion daily in recent years,
70 times the daily volume on the New York Stock Exchange. In 2011 Spot transactions accounted for
33.5 % of this volume, while forward and other transactions accounted for 66.5 %.
• In 1989, the average daily trading volume was $590 billion, with $317 billion (53.7%) being spot
foreign exchange transactions and $273 billion (46.3%) forward and other foreign exchange
transactions.
• The rise in forward foreign exchange transactions is driven by the ability to hedge foreign exchange
risk, making it a crucial source of steady income for global banks.
• Foreign exchange trading is considered the fairest market due to its vast volume and lack of central
control (no single institution can control the market’s direction). It operates 24-hourly, moving
between Tokyo, London, and New York, exposing traders to risk exposure even when other financial
institutions are closed.
• Mismatched FX positions increase risk. Top international banks trade most FX volume. Online trading
is increasing, accounting for 60% of global trading. Secure, internet-based platforms offer low-cost
spot and forward transactions, making it an ideal transnational platform.
 F O R E IG N C U R R E N C Y T R A D IN G

FX Trading Activities
A FI’s position in the FX markets generally reflects four trading activities:
• The purchase and sale of foreign currencies to allow customers to partake in and complete
international commercial trade transactions.
• The purchase and sale of foreign currencies to allow customers (or the FI itself) to take positions in
foreign real and financial investments.
• The purchase and sale of foreign currencies for hedging purposes to offset customer (or FI) exposure
in any given currency.
• The purchase and sale of foreign currencies for speculative purposes through forecasting or
anticipating future movements in FX rates.
 F O R E IG N C U R R E N C Y T R A D IN G

• A FI typically acts as an agent for customers, not assuming FX risk (first two activities). In defensive
activities, they act as a hedger to reduce FX exposure (third activity). For eg., a FI may take a short
(sell) position in the foreign exchange of a country to offset a long (buy) position in the foreign
exchange of that same country. FX risk exposure relates to open positions taken as principals for
speculative purposes, typically by taking an unhedged position in a foreign currency (fourth activity).
• FIs can engage in speculative trades with other FIs or specialist FX brokers (who require a brokerage
fee), utilizing various FX instruments like spot currency trades (most common), forward contracts,
futures, and options to profit from price differences.
• Foreign trading primarily generates profits or losses through open positions or currency speculation,
with market-making (bid-ask spread) and acting as agents providing only secondary revenue sources.
 F O R E IG N A S S E T A N D L IA B IL IT Y P O S IT IO N S : T H E
R E T U R N A N D R ISK O F FO R E IG N IN V E ST ME N T S

• The second dimension of a financial institution's foreign currency exposure is determined by any
discrepancies between its foreign financial assets and liabilities.
• The globalization of financial markets has expanded the options for raising funds in other currencies
besides the home currency.
• FIs should diversify their funds sources and utilize foreign banking market imperfections for higher
asset returns or lower funding costs.
The Return and Risk of Foreign Investments
Changes in foreign exchange rates can impact profits (returns) associated with foreign assets and
liabilities.
 F O R E IG N A S S E T A N D L IA B IL IT Y P O S IT IO N S : T H E
R E T U R N A N D R ISK O F FO R E IG N IN V E ST ME N T S

Calculating the Return on Foreign Exchange Transactions of a US FI

Assume a Fl has the following assets and liabilities:

Assets Liabilities
$100 million US loans (1 year ) in dollars 9% $200 million US CDs (1 year) in
dollars 8%
$100 million equivalent
UK loans (1 year)
(loans made in pounds) 15%

• The US FI is raising all its $200 million liabilities in dollars (1-year CDs) but investing 50 % in US
dollar assets (1-year maturity loans) and 50% in UK pound assets (1-year maturity loans).
 F O R E IG N A S S E T A N D L IA B IL IT Y P O S IT IO N S : T H E
R E T U R N A N D R ISK O F FO R E IG N IN V E ST ME N T S

• The promised 1-year US CD rate is 8% to be paid in $s at the end of the year

• That 1-year, default risk–free loans in the US are yielding 9%
• Suppose, however, that default risk–free, 1-year loans are yielding 15% in the UK
• To invest in the UK, the FI decides to take 50% of its $200 million in funds and make 1-year maturity
UK pound loans while keeping 50% of its funds to make US dollar loans. To invest $100 million (of
the $200 million in CDs issued) in 1-year loans in the UK, the US FI engages in the following
transactions:
ü At the beginning of the year sells $100 million for pounds on the spot currency markets. The exchange rate is
$1.60/£1. This is $100 million/1.6 = £62.5 million
ü The FI takes the £62.5 million and makes 1-year loans at a 15% interest rate ( r ).

ü At the end of the year, pound revenue from the loans will be £62.5 million (1 + r (0.15)) = £71. 875 million.
ü The FI repatriates theses funds back to the US at the end of the year. That is, the US FI sells the £71.875 million in
the FX market at the spot exchange rate that exists at that time, the end of the year spot rate.
 F O R E IG N A S S E T A N D L IA B IL IT Y P O S IT IO N S : T H E
R E T U R N A N D R ISK O F FO R E IG N IN V E ST ME N T S

Suppose the spot foreign exchange rate has not changed over the year, it remains fixed at $1.60/£1. Then
the $ proceeds from the UK investment will be £71.875 × $1.60/£1 = $115 million.
$""# $%&&%'( )$"** $%&&%'(
As a return, $"** $%&&%'(
= 15%

Given this, the weighted return on the bank’s investment portfolio would be: US asset return + UK asset
return
(0.50) (0.09) + (0.5) (0.15) = 0.12 or 12%
This exceeds the CD rate of the FI 4% (12% - 8%).
 F O R E IG N A S S E T A N D L IA B IL IT Y P O S IT IO N S : T H E
R E T U R N A N D R ISK O F FO R E IG N IN V E ST ME N T S

Suppose, however, that at the end of the year the British pound falls in value relative to the dollar. The
return on the UK loans could be far less than 15 % even in the absence of interest rate or credit risk. For
eg., suppose the exchange rate falls from $1.60/£1 at the beginning of the year to $1.45/£1 at the end of
the year when the FI needs to repatriate the principal and interest on the loan. At an exchange rate of
$1.45/£1, the pound loan revenues at the end of the year translate into:
£ 71.875million × $1.45/£1 = $104.22million

or as a return on the original dollar investment of:

$#$%.'' ()**)+, -$#$$ ()**)+,
$#$$ ()**)+,
= 0.0422 or 4.22%

The weighted return on the FI’s asset portfolio would be:

(0.5)(0.09) + (0.5)(0.0422) = 0.0661 or 6.61%

• In this case, the FI has a loss or has a negative interest margin (6.61% - 8% = -1.39%) on its balance
sheet investments. The loss is attributed to the depreciation of the pound from $1.60 to $1.45, which
has reduced the attractive yield on British pound loans compared to domestic US
 F O R E IG N A S S E T A N D L IA B IL IT Y P O S IT IO N S : T H E
R E T U R N A N D R ISK O F FO R E IG N IN V E ST ME N T S

Suppose the pound appreciated against the dollar over the year to $1.70/£1 then the US FI would have
generated a dollar return from its UK loans of:
• £71.875 × $1.70 = $122.188 million
or a % return of 22.188 %.
Then the US FI would receive a double benefit from investing in the United Kingdom: a high yield on the
domestic British loans plus an appreciation in pounds over the 1-year investment period.
 F O R E IG N A S S E T A N D L IA B IL IT Y P O S IT IO N S :
R ISK A N D H E D G IN G

A FI manager can control FX exposure through on-balance-sheet hedging and off-balance-sheet hedging,
which involve changes in assets and liabilities to protect profits from FX risk. Off-balance-sheet hedging
involves taking a position in forward or other derivative securities to hedge FX risk without any on-
balance-sheet changes.
On-Balance-Sheet Hedging
Suppose that instead of funding the $100 million investment in 15% British loans with US CDs, the FI
manager funds the British loans with $100 million equivalent 1-year pound CDs at a rate of 11%. Now
the balance sheet of the bank would look like this:

Assets Liabilities
$100 million US loans 9% $100 million US CDs 8%

$100 million equivalent $100 million equivalent

UK loans 15% UK CDs (11%)
(loans made in pounds) (deposits raised in pounds)
 F O R E IG N A S S E T A N D L IA B IL IT Y P O S IT IO N S :
R ISK A N D H E D G IN G

Consider the FI’s profitability or spread between the return on assets and the cost of funds when the
pound depreciates in value against the dollar over the year from $1.60/£1 to $1.45/£1
• When the pound falls in value to $1.45/£1, the return on the British loan portfolio is 4.22%. Consider
what happens to the cost of $100 million in pound liabilities in dollar terms:
• At the beginning of the year, the FI borrows $100 million equivalent in pound CDs for one year at a
promised interest rate of 11%. At an exchange rate of $1.60/£1, this is a pound equivalent amount of
borrowing of $100 million/1.6 = £62.5 million
• At the end of the year, the bank must pay back the pound CD holders their principal and interest,
£62.5 million (1.11) = £69.375 million.
• If the pound depreciates to $1.45/£1 over the year, the repayment in dollar terms would be £69.375
million × $1.45/£1 = $100.59 million, or a dollar cost of funds of 0.59%
 F O R E IG N A S S E T A N D L IA B IL IT Y P O S IT IO N S :
R ISK A N D H E D G IN G

Thus, at the end of the year

• Average return on assets (ROA) : US asset return + UK asset return = Overall return
(0.5)(0.09) + (0.5) (0.0422) = 0.0661 or 6.61%

• Average cost of funds: US cost of funds + UK cost of funds = Overall cost

(0.5)(0.08) + (0.5)(0.0059) = 0.04295 or 4.295%

• Net return: Average return on assets - Average cost of funds

6.61% - 4.295% = 2.315%
 F O R E IG N A S S E T A N D L IA B IL IT Y P O S IT IO N :
R ISK A N D H E D G IN G

The Appreciating Pound

When the pound appreciates over the year from $1.60/£1 to $1.70/£1, the return on British loans is equal to 22.188. Now consider the
dollar cost of British 1-year CDs at the end of the year when the US FI must pay the principal and interest to the CD holder:

£69.375million × $1.70 /£1 = $117.9375million

or a dollar cost of funds of 17.9375% .

Thus, at the end of the year:

• Average return on assets:

(0.5)(0.09) + (0.5)(0.22188) = 0.15594 or 15.594%

• Average cost of funds:

(0.5)(0.08) + (0.5)(0.179375) = 0.12969 or 12.969%

• Net return:

15.594 - 12.969 = 2.625%

By directly matching its foreign asset and liability book, a FI can lock in a positive return or profit spread in whichever direction
exchange rates change over the investment period.
 FOREIGN ASSET AND LIABILITY POSITION:
RISK AND HEDGING

Hedging with Forwards

• Using the previous example, the FI could have opted to remain unhedged on the balance sheet and
hedge by taking a position in the forward market for foreign currencies.
• The forward FX contract helps offset future spot rate uncertainty on pounds at the end of a 1-year
investment horizon. It allows a financial institution to sell its expected principal and interest earnings
on the loan at today's known forward exchange rate, thereby reducing future spot rate uncertainty and
investment returns uncertainty.
Consider the transactional steps when the FI hedges its FX risk immediately by selling its expected 1-
year pound loan proceeds in the forward FX market
The US FI sells $100 million for pounds at the spot exchange rate today and receives
$100 million/1.6 = £62.5 million.
The FI then immediately lends the £62.5 million to a British customer at 15 % for one year.
 F O R E IG N A S S E T A N D L IA B IL IT Y P O S IT IO N :
R ISK A N D H E D G IN G

The FI also sells the expected principal and interest proceeds from the pound loan forward for dollars at
today’s forward rate for 1-year delivery. Let the current forward 1-year exchange rate between dollars and
pounds stand at $1.55/£1, or at a 5-cent discount to the spot pound; as a % discount:
($1.55 - $1.60) / $1.6 = −3.125%
This means that the forward buyer of pounds promises to pay:
£62.5million (1.15) × $1.55/£1 = £71.875million × $1.55/£1 = $111.406million
to the FI (the forward seller) in one year when the FI delivers the £71.875 million proceeds of the loan to
the forward buyer.
In one year, the British borrower repays the loan to the FI plus interest in pounds (£71.875 million).
The FI delivers the £71.875 million to the buyer of the 1-year forward contract and receives the promised
$111.406 million.
 F O R E IG N A S S E T A N D L IA B IL IT Y P O S IT IO N :
R ISK A N D H E D G IN G

The forward contract ensures a guaranteed return on the British loan throughout the investment period,
despite potential defaults or reneging by the forward buyer of:
$###.%$. ()**)+, -$#$$ ()**)+,
$#$$ ()**)+,
= 0.11406 or 11.406%

The loan investment's return is fully hedged against any changes in the dollar/pound exchange rate over
the 1-year holding period. Given this return on British loans, the overall expected return on the FI’s asset
portfolio is:
(0.5)(0.09) + (0.5)(0.11406) = 0.10203 or 10.203%

The FI secured a risk-free return spread of 2.203 % on $200 million US CDs, despite spot exchange rate
fluctuations, by locking in the cost of funds.
The FI is shifting from domestic US loans to hedged foreign UK loans, citing higher hedged dollar
returns (foreign loans of 11.406% are much higher than 9% domestic loans and requiring more spot
pounds.
 F O R E IG N A S S E T A N D L IA B IL IT Y P O S IT IO N S :
MU LT IC U R R E N C Y F OR E IGN A S S E T– L IA B IL IT Y
P OS IT ION S

Many FIs hold multicurrency asset-liability positions, and diversifying across multiple markets can potentially reduce portfolio risk
and fund costs, if interest rates or stock returns don't move closely.

The one-period nominal interest rate r! fixed income securities in a country consists of real interest rate reflecting real sector demand
and supply, and expected inflation rate reflecting additional interest lenders demand from borrowers.
r! = rr! + i"!

where

r! Nominal interest rate in country i

rr! Real interest rate in country I

i"! Expected one-period inflation rate in country i

Nominal interest rates are highly correlated across financial markets if real savings, investment demand, supply pressures, inflationary
expectations, and economic integration exist across countries.

Rising German real interest rates due to high investment fund demand could trigger capital outflows from other countries toward
Germany, potentially causing higher real and nominal interest rates in other countries.

The world capital market's unintegrated state may lead to significant interest deviations, weak correlation of foreign asset or liability
returns, and significant diversification opportunities.
 IN T E R A C T IO N O F IN T E R E S T R AT E S , IN F L AT IO N ,
A N D E X C H A N G E R AT E S

Global financial markets are increasingly interlinked, affecting interest rates, inflation, and foreign
exchange rates. For eg. Higher domestic interest rates can attract foreign investment and influence the
value of the domestic currency.
Purchasing power parity (PPP) and Interest rate parity (IRP) are key factors in determining the impact of
inflation on foreign currency exchange rates and the relationship between domestic and foreign interest
rates and spot and forward foreign exchange rates.
Purchasing Power Parity
In simple terms, whatever a basket of goods and services costs in one country (domestic) when converted
to another currency, you should be able to buy the exact level of goods and services in the foreign
country.
 IN T E R A C T IO N O F IN T E R E S T R AT E S , IN F L AT IO N ,
A N D E X C H A N G E R AT E S:P P P

One factor affecting a country’s foreign currency exchange rate with another country is the relative inflation rate in each
country
r/0 = i/0 + rr/0
And
r0 = i0 + rr0
r/0 Interest rate in the United States
r0 Interest rate in Switzerland (or another foreign country)

i/0 Inflation rate in the United States

i0 Inflation rate in Switzerland (or another foreign country)

rr/0 Real rate of interest in the United States

rr0 Real rate of interest in Switzerland (or another foreign country)
 IN T E R A C T IO N O F IN T E R E S T R AT E S , IN F L AT IO N ,
A N D E X C H A N G E R AT E S:P P P

Assuming real rates of interest (or rates of time preference) are equal across countries:
rr/0 = rr0

Then
r/0 − r0 = i/0 − i0
The (nominal) interest rate spread between the United States and Switzerland reflects the difference in inflation rates
between the two countries.
Foreign currency exchange rates should adjust to account for differences in price levels between countries, as inflation
rates and interest rates fluctuate.
The PPP theorem asserts that the change in exchange rates between two countries' currencies is directly proportional to the
difference in their inflation rates. That is,

i1+(234)5 − i6+72)8, = ∆S1+(234)5/6+72)8,/S1+(234)5/6+72)8,

Where
S1+(234)5/6+72)8, Spot exchange rate of the domestic currency for the foreign currency (e.g., US dollars for Swiss francs)

∆S1+(234)5/6+72)8, Change in the one-period spot foreign exchange rate

 IN T E R A C T IO N O F IN T E R E S T R AT E S , IN F L AT IO N ,
A N D E X C H A N G E R AT E S:P P P

PPP suggests that price differences in open economies significantly influence exchange rates, as these
changes drive trade flows, demand for and supply of currencies.

For eg. Suppose that the current spot exchange rate of US dollars for Russian rubles, S+,/. is 0.17 (i.e.,
0.17 dollar, or 17 cents, can be received for 1 ruble). The price of Russian-produced goods increases by
10% (i.e., inflation in Russia, i. , is 10%), and the US price index increases by 4% (i.e., inflation in the
United States, i+, , is 4%). According to PPP, the 10% rise in the price of Russian goods relative to the
4% rise in the price of US goods results in a depreciation of the Russian ruble (by 6 %). Specifically, the
exchange rate of Russian rubles to US dollars should fall, so that:
i+, − i. = ∆S+,/. /S+,/.
Therefore,
0.04−0.10 = ∆S+,/. /S+,/. = ∆S+,/. /0.17/." = −0.06 = ∆S+,/. /S+,/. = ∆S+,/. /0.17/."

We get ∆S+,/. = −0.06 × 0.17 = − 0.0102

Thus, it costs 1.02 cents less to receive a ruble (i.e., 1 ruble costs 15.98 cents or 0.1598 of $1 can be
received for 1 ruble. The Russian ruble depreciates in value by 6% against the US dollar because of its
higher inflation rate.
 IN T E R A C T IO N O F IN T E R E S T R AT E S , IN F L AT IO N ,
A N D E X C H A N G E R AT E S:IR P T

Spot rates and forward rates for a given currency differ. For eg. On July 4, 2012, the spot exchange rate between
the British pound and the US dollar was 1.5591, while the three-month forward rate was 1.5590. The specific
relationship that links spot exchange rates, interest rates, and forward exchange rates is described as the Interest
Rate Parity Theorem (IRPT ) determined by the spot exchange rate and interest rate differential.
The IRPT suggests that investors can achieve the same returns on both domestic and foreign investments by
hedging in the forward exchange rate market, a no-arbitrage relationship. The eventual equality between the cost
of domestic funds and the hedged return on foreign assets, or the IRPT, can be expressed as:
=
1 ?
1 + 𝑟:;< = × (1 + 𝑟:>< )×𝐹<
𝑆<
Rate on US investment = Hedged return on foreign (UK) investment
=
1 + 𝑟:;< 1 plus the interest rate on US CDs for the FI at time t
𝑆< $/£ spot exchange rate at time t
?
1 + 𝑟:>< 1 plus the interest rate on UK CDs at time t
𝐹< $/£ forward exchange at time t
 IN T E R A C T IO N O F IN T E R E S T R AT E S , IN F L AT IO N ,
A N D E X C H A N G E R AT E S:IR P T

An Application of IRPT
1 A
Suppose r/04 8% and r/@4 11% as in our preceding example. As the FI moves into more British CDs, suppose the spot
exchange rate for buying pounds rises from $1.60/£1 to $1.63/£1. In equilibrium, the forward exchange rate would have to
fall to $1.5859/£1 to eliminate completely the attractiveness of British investments to the US FI manager. That is:
1
1.08 = 1.11 1.5859
1.63
This is a no-arbitrage relationship in the sense that the hedged dollar return on foreign investments just equals the FI’s
dollar cost of domestic CDs. Rearranging, the IRPT can be expressed as:
7$ &
!"# -7!%# 6# -0#
& ≃
#B 7!%# 0#

$.$C-$.## #.DCDE-#..F
#.##
≃ #..F

−0.0270 ≃ −0.0270
That is, the discounted spread between domestic and foreign interest rates ≃ % spread between forward and spot exchange
rates.
RISK ANALYSIS AND MANAGEMENT

THE END