International Financial Management Parities and Forecasting

International Financial Management
Alan Shapiro and Peter Moles

1st Edition
John Wiley & Sons, Inc.
1 www.wiley.com/college/shapiro
CHAPTER 4
Currencies: Expectations,
Parities, and Forecasting
www.wiley.com/college/shapiro
2
ARBITRAGE AND THE LAW OF
ONE PRICE
I. THE LAW OF ONE PRICE
A. States that identical goods sell for

the same price worldwide.
www.wiley.com/college/shapiro 3
ONE PRICE
B. Theoretical basis
If the prices after exchange-rate adjustment were not
equal, arbitrage for the goods worldwide ensures that
eventually they will be.
ONE PRICE
C. Five parity conditions result from these
arbitrage activities
1. Purchasing Power Parity (PPP).
2. The Fisher Effect (FE).
3. The International Fisher Effect (IFE).
4. Interest Rate Parity (IRP).
5. Unbiased Forward Rate (UFR).
ONE PRICE
D. Five parity conditions linked by
1. The adjustment of various rates and prices

to inflation.
2. The notion that money should have no

effect on real variables (since they have
been adjusted for price changes).
ONE PRICE
E. Inflation and home currency depreciation
1. Jointly determined by the growth of

domestic money supply.
2. Relative to the growth of domestic money

demand.
ONE PRICE
F. The Law of One Price

‒ enforced by international arbitrage.
PURCHASING POWER PARITY
I. THE THEORY OF PURCHASING
POWER PARITY
States that spot exchange rates between currencies
will change to the differential in inflation rates between
countries.
II. ABSOLUTE PURCHASING POWER PARITY
A. Price levels adjusted for exchange

rates should be equal between
countries.
II. ABSOLUTE PURCHASING POWER PARITY
B. One unit of currency has same

purchasing power globally.
III. RELATIVE PURCHASING POWER PARITY
A. States that the exchange rate of one

currency against another will adjust to reflect
changes in the price levels of the two
countries.
•1. In
mathematical terms:
=
where et = future spot rate

e0 = spot rate
ih = home inflation
if = foreign inflation
t = the time period
• 2.
If purchasing power parity is expected to hold, then
the best prediction for the one-period spot rate
should be written as:
3. A more simplified but less precise relationship is
written:
et
 ih  i f
e0
that is, the percentage change should be
approximately equal to the inflation rate
differential.
4. PPP states:
the currency with the higher inflation rate is expected to
depreciate relative to the currency with the lower rate of
inflation.
B. Real exchange rates
The quoted or nominal rate adjusted for a
country’s inflation rate is:
(1  i f ) t
e '
t  et
(1  ih ) t
C. Real exchange rates
1. If exchange rates adjust to inflation differential,

PPP states that real exchange rates stay the
same.
C. Real exchange rates (cont’d)
2. Competitive positions:
domestic and foreign firms are unaffected.
THE FISHER EFFECT (FE)
I. THE FISHER EFFECT (FE)
A. Definition:
States that nominal interest rates (r) are a function of
the real interest rate (a) and a premium (i) for inflation
expectations.
R = a + i
THE FISHER EFFECT
B. Real rates of interest
1. Should tend toward equality

everywhere through arbitrage.
2. With no government interference

nominal rates vary by the inflation
differential or
rh - r f = i h - i f
THE FISHER EFFECT
C. According to the Fisher Effect
Countries with higher inflation rates have higher
interest rates.
THE FISHER EFFECT
Due to capital market integration globally,

interest rate differentials are eroding.
THE INTERNATIONAL FISHER EFFECT
(IFE)
I. IFE
A. States that the spot rate adjusts to the interest rate

differential between two countries.
IFE = PPP + FE
et (1  rh ) t

e0 (1  r f ) t
B. Fisher postulated:
1. The nominal interest rate differential should

reflect the inflation rate differential.
B. Fisher also postulated:
2. Expected rates of return are equal in the

absence of government intervention.
C. Simplified IFE equation:

(if rf is relatively small)
e1  e0
rh  rf 
e0
D. Implications of IFE
1. Currency with the lower interest rate is

expected to appreciate relative to the one
with a higher rate.
D. Implications of IFE (cont’d)

2. Financial market arbitrage:
insures interest rate differential is an unbiased
predictor of change in future spot rate.
INTEREST RATE PARITY THEORY
I. INTRODUCTION
A. The theory states:

the forward rate (F) differs from the spot rate
(S) at equilibrium by an amount equal to the
interest differential (rh - rf) between two countries.
•1. The
forward premium or discount equals the
interest rate differential.
where rh = the home interest rate

rf = the foreign interest rate
2. In equilibrium, returns on currencies will be the same
i.e. no profit will be realized and interest parity exists

which can be written:
F  1  rh 

S  1  rf 
B. Covered interest arbitrage
1. Conditions required:
Interest rate differential does not equal the
forward premium or discount.
2. Funds will move to a country with a more

attractive rate.
3. Market pressures develop:
a. As one currency is more demanded spot

and sold forward.
b. Inflow of funds depresses interest rates.
c. Parity eventually reached.
C. Summary
Interest rate parity states:
1. Higher interest rates on a currency are offset by

forward discounts.
2. Lower interest rates are offset by forward premiums.
THE FORWARD RATE AND THE
FUTURE SPOT RATE
I. THE UNBIASED FORWARD RATE
A. States that, if the forward rate (ft) is

unbiased, then it should reflect the
expected future spot rate (et).
B. Stated as:
ft = e t
CURRENCY FORECASTING
I. FORECASTING MODELS
A. Created to forecast exchange rates in

addition to parity conditions.
B. Two types of forecast:

1. Market-based.
2. Model-based.
1. Market-based forecasts
– derived from market indicators.
a. The current forward rate contains
implicit information about exchange rate changes
for one year.
b. Interest rate differentials may be used to
predict exchange rates beyond one year.
2. Model-based forecasts
‒ include fundamental and technical analysis.
a. Fundamental analysis relies on key

macroeconomic variables and policies which
are most likely to affect exchange rates.
b. Technical analysis relies on use of

1. Historical volume and price data.
2. Charting and trend analysis.

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International Financial Management

Alan Shapiro and Peter Moles

A. States that identical goods sell for

1. The adjustment of various rates and prices

2. The notion that money should have no

1. Jointly determined by the growth of

2. Relative to the growth of domestic money

F. The Law of One Price

II. ABSOLUTE PURCHASING POWER PARITY

A. Price levels adjusted for exchange

II. ABSOLUTE PURCHASING POWER PARITY

B. One unit of currency has same

III. RELATIVE PURCHASING POWER PARITY

A. States that the exchange rate of one

where et = future spot rate

1. If exchange rates adjust to inflation differential,

1. Should tend toward equality

2. With no government interference

Due to capital market integration globally,

A. States that the spot rate adjusts to the interest rate

1. The nominal interest rate differential should

B. Fisher also postulated:

2. Expected rates of return are equal in the

C. Simplified IFE equation:

1. Currency with the lower interest rate is

D. Implications of IFE (cont’d)

A. The theory states:

where rh = the home interest rate

i.e. no profit will be realized and interest parity exists

2. Funds will move to a country with a more

a. As one currency is more demanded spot

b. Inflow of funds depresses interest rates.

c. Parity eventually reached.

Interest rate parity states:

1. Higher interest rates on a currency are offset by

2. Lower interest rates are offset by forward premiums.

A. States that, if the forward rate (ft) is

A. Created to forecast exchange rates in

B. Two types of forecast:

a. Fundamental analysis relies on key

b. Technical analysis relies on use of

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