International Financial Management

by Jeff Madura

1
 Relationships among Inflation, Interest
8 Rates and Exchange Rates
Chapter Objectives
 Explain the purchasing power parity (PPP) theory and
its implications for exchange rate changes

 Explain the International Fisher effect (IFE) theory and

its implications for exchange rate changes

 Compare the PPP theory, the IFE theory, and the theory
of interest rate parity (IRP), which was introduced in
the previous chapter

2
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 Purchasing Power Parity (PPP)

 When one country’s inflation rate rises relative to that of

another country, decreased exports and increased imports
depress the country’s currency.
 The theory of purchasing power parity (PPP) attempts to
quantify this inflation - exchange rate relationship.
 Absolute Form of PPP: without international barriers,
consumers shift their demand to wherever prices are lower.
Prices of the same basket of products in two different
countries should be equal when measured in common
currency (Law of One Price).
 Relative Form of PPP: Due to market imperfections, prices
of the same basket of products in different countries will
not necessarily be the same, but the rate of change in
prices should be similar when measured in common
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currency
 Rational Behind Relative PPP Theory

 Exchange rate adjustment is necessary for the

relative purchasing power to be the same whether
buying products locally or from another country.

 If the purchasing power is not equal, consumers

will shift purchases to wherever products are
cheaper until the purchasing power is equal.

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 Rational Behind Relative PPP Theory

 Assume home country’s price index (Ph) = foreign country’s price index (Pf)
 When inflation occurs, the exchange rate will adjust to maintain PPP:
Pf (1 + If ) (1 + ef ) = Ph (1 + Ih )
where Ih = inflation rate in the home country
If = inflation rate in the foreign country
ef = % change in the value of the foreign currency

 Since Ph = Pf , solving for ef gives:

ef = (1 + Ih ) – 1
(1 + If )
Þ If Ih > If , ef > 0 (foreign currency appreciates)
If Ih < If , ef < 0 (foreign currency depreciates)
If Ih = 5% & If = 3%, ef = 1.05/1.03 – 1 = 1.94%
Þ From the home country perspective, both price indexes rise by 5%.
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 Purchasing Power Parity

 When the inflation differential is small, simplified PPP

relationship
e f  Ih  I f

 Suppose IU.S. = 9%, IU.K. = 5%. Then PPP suggests that

e£  4%.
Then, U.K. goods will cost 5+4=9% more to U.S.
consumers, while U.S. goods will cost 9-4=5% more to
U.K. consumers

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 Using PPP to Estimate Exchange Rate Effects

 The relative form of PPP can be used to estimate

how an exchange rate will change in response to
differential inflation rates between countries.
 International trade is the mechanism by which the
inflation differential affects the exchange rate
according to this theory (Exhibit 8.1)

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 Exhibit 8.1 Summary of Purchasing Power Parity

8
 Graphic Analysis of Purchasing Power Parity

 Using PPP theory, we should be able to assess the

potential impact of inflation on exchange rates.
The points on the Exhibit 8.2 suggest that given
an inflation differential between the home and the
foreign country of X percent, the foreign
currency should adjust by X percent due to that
inflation differential.
 PPP Line - The diagonal line connecting all these
points together.

9
 Exhibit 8.2 Illustration of Purchasing Power Parity

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 Purchasing Power Disparity

 Any points off of the PPP line represent

purchasing power disparity. If the exchange rate
does not move as PPP theory suggests, there is a
disparity in the purchasing power of the two
countries.
 Point C in Exhibit 8.3 represents a situation
where home inflation (Ih) exceeds foreign
inflation (If ) by 4 percent. Yet, the foreign
currency appreciated by only 1 percent in
response to this inflation differential.
Consequently, purchasing power disparity exists.
11
 Exhibit 8.3 Identifying Disparity in Purchasing
Power

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 Testing the Purchasing Power Parity Theory

1. Simple tests of PPP (Exhibit 8.4)

Choose two countries (such as the United States and a foreign
country) and compare the differential in their inflation rates to
the percentage change in the foreign currency’s value during
several time periods.
2. Statistical Test of PPP
Apply regression analysis to historical exchange rates and
inflation differentials.
ef = a0 + a1 { (1+Ih)/(1+If) - 1 } + m
3. Results of Tests of PPP
Deviations from PPP are not as pronounced for longer time
periods, but they still exist. Thus, reliance on PPP to derive a
forecast of the exchange rate is subject to significant error, even
13 when applied to long-term forecasts.
 Exhibit 8.4 Comparison of Annual Inflation Differentials and
Exchange Rate Movements for Four Major Countries

14
 Testing the Purchasing Power Parity Theory (Cont.)

4. Limitation of PPP Tests

Results vary with the base period used. The base period chosen
should reflect an equilibrium position since subsequent periods are
evaluated in comparison to it. If a base period is used when the
foreign currency was relatively weak for reasons other than high
inflation, most subsequent periods could show higher appreciation
of that currency than what would be predicted by PPP.

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 Why Purchasing Power Parity Does Not Occur

1. Confounding effects
A change in a country’s spot rate is driven by more than the inflation
differential between two countries:

Since the exchange rate movement is not driven solely by ΔINF, the

16
 Why Purchasing Power Parity Does Not Occur
(Cont.)

2. No Substitutes for Traded Goods

If substitute goods are not available domestically,
consumers may not stop buying imported goods.

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 Example

 Assume that Venezuela’s inflation rate is 5 percent above the U.S.

inflation.
 From this information, PPP theory would suggest that the Venezuelan
bolivar should depreciate by about 5 percent against the U.S. dollar.
 Yet, if the government of Venezuela imposes trade barriers against
U.S. exports,
 Venezuela’s consumers and firms will not be able to adjust their
spending in reaction to the inflation differential.
 Therefore, the exchange rate will not adjust as suggested by PPP.
 Reconsider the previous example in which Venezuela’s inflation is 5
percent higher than the U.S. inflation rate.
 If U.S. consumers do not find suitable substitute goods at home,
they may continue to buy the highly priced goods in Venezuela,
 And the bolivar may not depreciate as expected according to PPP
theory.
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 International Fisher Effect (IFE)

1. The Fisher effect suggests that the nominal

interest rate contain two components:
a. Expected inflation rate
b. Real interest rate
2. The real rate of interest represents the return
on the investment to savers after accounting
for expected inflation.

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 International Fisher Effect (IFE)

 The nominal interest rate is 8 percent in the United States. Investors in the
United States expect a 6 percent rate of inflation, which means that they
expect to earn a real return of 2 percent over one year.
 The nominal interest rate in Canada is 13 percent. Given that investors in
Canada also require a real return of 2 percent, the expected inflation rate
in Canada must be 11 percent.
 According to PPP theory, the Canadian dollar is expected to depreciate by
approximately 5 percent against the U.S. dollar (since the Canadian
inflation rate is 5 percent higher).
 Therefore, U.S. investors would not benefit from investing in Canada
because the 5 percent interest rate differential would be offset by
investing in a currency that is expected to be worth 5 percent less by the
end of the investment period.
 U.S. investors would earn 8 percent on the Canadian investment, which is
the same as they could earn in the United States.
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 International Fisher Effect (IFE)

 The international Fisher effect (IFE) theory suggests that

currencies with higher interest rates will depreciate because
the higher rates reflect higher expected inflation.

 Hence, investors hoping to capitalize on a higher foreign

interest rate should earn a return no better than what they
would have earned domestically.

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 Example

 The nominal interest rate is 8 percent in the United States and 5

percent in Japan.
 The expected real rate of return is 2 percent in each country. The U.S.
inflation rate is expected to be 6 percent, while the inflation rate in
Japan is expected to be 3 percent.
 According to PPP theory, the Japanese yen is expected to appreciate
by the expected inflation differential of 3 percent.
 If the exchange rate changes as expected, Japanese investors who
attempt to capitalize on the higher U.S. interest rate will earn a return
similar to what they could have earned in their own country.
 Though the U.S. interest rate is 3 percent higher, the Japanese
investors will repurchase their yen at the end of the investment period
for 3 percent more than the price at which they sold yen.
 Therefore, their return from investing in the United States is no better
than what they would have earned domestically.
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 Example

 Given the information in the two previous examples, the

expected inflation differential between Canada and Japan is 8
percent.
 According to PPP theory, this inflation differential suggests
that the Canadian dollar should depreciate by 8 percent against
the yen.
 Therefore, even though Japanese investors would earn an
additional 8 percent interest on a Canadian investment, the
Canadian dollar would be valued at 8 percent less by the end of
the period.
 Under these conditions, the Japanese investors would earn a
return of 5 percent, which is the same as what they would earn
on an investment in Japan.

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 Using the IFE to Predict Exchange Rate Movements

1. Apply the Fisher Effect to Derive Expected

Inflation per Country
The first step is to derive the expected inflation rates
of the two countries based on the Fisher effect. The
Fisher effect suggests that nominal interest rates of
two countries differ because of the difference in
expected inflation between the two countries.
2. Rely on PPP to Estimate the Exchange Rate
Movement
The second step of the international Fisher effect is to
apply the theory of PPP to determine how the
exchange rate would change in response to those
expected inflation rates of the two countries.

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 Implications of the International Fisher Effect

1. The international Fisher effect (IFE) theory suggests that

currencies with high interest rates will have high expected
inflation (due to the Fisher effect) and the relatively high
inflation will cause the currencies to depreciate (due to the
PPP effect).
2. Implications of the IFE for Foreign Investors
The implications are similar for foreign investors who
attempt to capitalize on relatively high U.S. interest rates.
The foreign investors will be adversely affected by the
effects of a relatively high U.S. inflation rate if they try to
capitalize on the high U.S. interest rates.
3. Implications of the IFE for Two Non-U.S. Currencies
The IFE theory can be applied to any exchange rate, even
exchange rates that involve two non-U.S. currencies.
25
 Exhibit 8.5 Illustration of the International Fisher Effect (IFE)
from Various Investor Perspectives

26
 Derivation of the International Fisher Effect

 According to the IFE, E(rf ), the expected effective return on a foreign

money market investment, should equal rh , the effective return on a
domestic investment.
 rf = (1 + if ) (1 + ef ) – 1
if = interest rate in the foreign country
ef = % change in the foreign currency’s value
 rh =ih = interest rate in the home country
 Setting rf = rh : (1 + if ) (1 + ef ) – 1 = ih
 Solving for ef : ef = (1 + ih ) _ 1
(1 + if )
Þ If ih > if , ef > 0 (foreign currency appreciates)
If ih < if , ef < 0 (foreign currency depreciates)
If ih = 8% & if = 9%, ef = 1.08/1.09 – 1 = - 0.92%
27
Þ This will make the return on the foreign investment equal to the domestic
return.
 Derivation of the International Fisher Effect

1. Relationship between the interest rate (i) differential

between two countries and expected exchange rate (e)

1  ih
ef  1
1 i f

2. Simplified relationship

e f  ih  i f

3. Summarized in Exhibit 8.6

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 Exhibit 8.6 Summary of International Fisher Effect

29
 Exhibit 8.7 Illustration of IFE Line (When Exchange Rate
Changes Perfectly Offset Interest Rate Differentials)

30
 Graphic Analysis of the International Fisher Effect

1. Point E in Exhibit 8.7 reflects a situation where the foreign

interest rate exceeds the home interest rate by three percentage
points. The foreign currency has depreciated by 3 percent to
offset its interest rate advantage.
2. Point F represents a home interest rate 2 percent above the
foreign interest rate. IFE theory suggests that the currency
should appreciate by 2 percent to offset the interest rate
disadvantage.
3. Point F illustrates the IFE from a foreign investor’s perspective.
The home interest rate will appear attractive to the foreign
investor. However, IFE theory suggests that the foreign
currency will appreciate by 2 percent.

31
 Graphic Analysis of the International Fisher Effect

1. Points on the IFE Line

All the points along the IFE line reflect exchange rate
adjustments to offset the differential in interest rates. This
means investors will end up achieving the same yield
(adjusted for exchange rate fluctuations) whether they invest
at home or in a foreign country.
2. Points below the IFE Line
Points below the IFE line generally reflect the higher returns
from investing in foreign deposits.
3. Points above the IFE Line
Points above the IFE line generally reflect returns from
foreign deposits that are lower than the returns possible
domestically.
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 Tests of the International Fisher Effect

What Can be Tested

If the actual points (one for each period) of interest rates and
exchange rate changes were plotted over time on a graph, we
could determine whether
 the points are systematically below the IFE line (suggesting
higher returns from foreign investing),
 above the line (suggesting lower returns from foreign
investing), or
 evenly scattered on both sides (suggesting a balance of higher
returns from foreign investing in some periods and lower
foreign returns in other periods).
Statistical Test of the IFE
Apply regression analysis to historical exchange rates and the
nominal interest rate differential.
33 ef = a0 + a1 { (1+ih)/(1+if) – 1 } + m
 Exhibit 8.8 Illustration of IFE Concept (When Exchange Rate
Changes Offset Interest Rate Differentials on Average)

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 Limitations of the IFE

The IFE theory relies on the Fisher effect and PPP

1. Limitation of the Fisher Effect
The difference between the nominal interest rate and actual
inflation rate is not consistent. Thus, while the Fisher effect can
effectively use nominal interest rates to estimate the market’s
expected inflation over a particular period, the market may be
wrong.
2. Limitation of PPP
Other country characteristics besides inflation (income levels,
government controls) can affect exchange rate movements.
Even if the expected inflation derived from the Fisher effect
properly reflects the actual inflation rate over the period,
relying solely on inflation to forecast the future exchange rate
is subject to error.
35
 IFE Theory versus Reality

1. The IFE theory contradicts how a country with a high

interest rate can attract more capital flows and therefore
cause the local currency’s value to strengthen (Ch 4).
2. IFE theory also contradicts how central banks may
purposely try to raise interest rates in order to attract
funds and strengthen the value of their local currencies
(Ch 6).
3. Whether the IFE holds in reality is dependent on the
countries involved and the period assessed.
4. The IFE theory may be especially meaningful to
situations in which the MNCs and large investors consider
investing in countries where the prevailing interest rates
are very high.
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 Comparison of the IRP, PPP, and IFE

Although all three theories relate to the determination of

exchange rates, they have different implications.
 IRP focuses on why the forward rate differs from the spot
rate and on the degree of difference that should exist. It
relates to a specific point in time.
 PPP and IFE focus on how a currency’s spot rate will
change over time.
 Whereas PPP suggests that the spot rate will change in
accordance with inflation differentials, IFE suggests that it
will change in accordance with interest rate differentials.
 PPP is related to IFE because expected inflation
differentials influence the nominal interest rate differentials
between two countries.

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 Exhibit 8.9 Comparison of the IRP, PPP, and IFE Theories

38
Impact of Inflation on an MNC’s Value

Effect of Inflation

m 
n 

E  CFj , t   E ER j , t   
 j 1 
Value =   
t =1  1  k  t

 
E (CFj,t )= expected cash flows in currency j to be
received by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which
currency j can be converted to dollars at the end of
period t
k = weighted average cost of capital of the