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Chapter Six
Chapter Six
FINANCIAL
MANAGEMENT
Fourth Edition
EUN / RESNICK
6-1 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
International Parity
Relationships & Forecasting
Foreign Exchange Rates Chapter Six
6
INTERNATIONAL
Chapter Objective: FINANCIAL
MANAGEMENT
This chapter examines several key international
parity relationships, such as interest rate parity and
Fourth Edition
purchasing power parity.
EUN / RESNICK
6-2 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
Interest Rate Parity
Covered Interest Arbitrage
Purchasing
Power Parity
IRP
ThePPP and Exchange
Deviations andRate Determination
the Real Exchange Rate
Fisher Effects
Reasons
Evidencefor
on Deviations from IRP
Forecasting
Exchange Rates Parity
Purchasing Power
Purchasing
The PowerApproach
Fisher Market
Efficient Effects Parity
The
Fisher Effects
Forecasting
FundamentalExchange
ApproachRates
Forecasting Exchange Rates
Technical Approach
6-3 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Interest Rate Parity
Interest Rate Parity Defined
Covered Interest Arbitrage
Interest Rate Parity & Exchange Rate
Determination
Reasons for Deviations from Interest Rate Parity
6-4 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Interest Rate Parity Defined
IRP is an arbitrage condition.
If IRP did not hold, then it would be possible for
an astute trader to make unlimited amounts of
money exploiting the arbitrage opportunity.
Since we don’t typically observe persistent
arbitrage conditions, we can safely assume that
IRP holds.
6-5 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Interest Rate Parity Carefully Defined
Consider alternative one year investments for $100,000:
1. Invest in the U.S. at i$. Future value = $100,000 × (1 + i$)
2. Trade your $ for £ at the spot rate, invest $100,000/S$/£ in
Britain at i£ while eliminating any exchange rate risk by
selling the future value of the British investment forward.
F$/£
Future value = $100,000(1 + i£)×
S$/£
Since these investments have the same risk, they must have
the same future value (otherwise an arbitrage would exist)
F$/£
(1 + i£) × = (1 + i$)
S$/£
6-6 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Alternative 2: $1,000 IRP
Send your $ on a
round trip to
S$/£
Step 2:
Britain
Invest those
pounds at i£
$1,000 Future Value =
$1,000
(1+ i£)
S$/£
Step 3: repatriate
Alternative 1: future value to the
invest $1,000 at i$ U.S.A.
$1,000
$1,000×(1 + i$) = (1+ i£) × F$/£
S$/£
IRP
Since both of these investments have the same risk, they must
have6-7the same future value—otherwise an arbitrage
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Interest Rate Parity Defined
The scale of the project is unimportant
$1,000 (1+ i ) × F
$1,000×(1 + i$) = £ $/£
S$/£
F$/£
(1 + i$) = × (1+ i£)
S$/£
6-8 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Interest Rate Parity Defined
Formally,
1 + i$ F$/£
=
1 + i£ S$/£
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Forward Premium
It’s just the interest rate differential implied by
forward premium or discount.
For example, suppose the € is appreciating from
S($/€) = 1.25 to F180($/€) = 1.30
S€/$ =1.25 to F180,€/$ =1.3
The forward premium is given by:
F180, €/$ – S€/$ 360 $1.30 – $1.25
f180,€v$ = × 180 = × 2 = 0.08
S($/€) $1.25
6-10 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Interest Rate Parity Carefully Defined
Depending upon how you quote the exchange rate
($ per € or € per $) we have:
1 + i€ F € /$ 1 + i$ F$/ €
= or =
1 + i$ S € /$ 1 + i€ S$/ €
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IRP and Covered Interest Arbitrage
If IRP failed to hold, an arbitrage would exist. It’s
easiest to see this in the form of an example.
Consider the following set of foreign and domestic
interest rates and spot and forward exchange rates.
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IRP and Covered Interest Arbitrage
A trader with $1,000 could invest in the U.S. at 7.1%, in one
year his investment will be worth
$1,071 = $1,000 (1+ i$) = $1,000 (1,071)
Alternatively, this trader could
1. Exchange $1,000 for £800 at the prevailing spot rate,
2. Invest £800 for one year at i£ = 11,56%; earn £892,48.
3. Translate £892,48 back into dollars at the forward rate
F360, £/$ = $1,20/£, the £892,48 will be exactly $1,071.
6-13 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Alternative 2: Arbitrage I
buy pounds £800
£1 Step 2:
£800 = $1,000×
$1.25 Invest £800 at
i£ = 11.56%
$1,000 £892.48 In one year £800
will be worth
Step 3: repatriate £892.48 =
to the U.S.A. at £800 (1+ i£)
F360($/£) =
Alternative 1:
$1.20/£
invest $1,000 $1,071 F£(360)
at 7.1% $1,071 = £892.48 ×
£1
FV = $1,071
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Interest Rate Parity
& Exchange Rate Determination
According to IRP only one 360-day forward rate,
F360($/£), can exist. It must be the case that
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Arbitrage Strategy I
If F360, £/$ > $1.20/£
i. Borrow $1,000 at t = 0 at i$ = 7.1%.
ii. Exchange $1,000 for £800 at the prevailing spot
rate, (note that £800 = $1,000÷$1.25/£) invest £800
at 11.56% (i£) for one year to achieve £892.48
iii. Translate £892.48 back into dollars, if
F360, £/$ > $1.20/£, then £892.48 will be more than
enough to repay your debt of $1,071.
6-16 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Step 2: Arbitrage I
buy pounds
£800
£1 Step 3:
£800 = $1,000×
$1.25 Invest £800 at
i£ = 11.56%
$1,000 £892.48 In one year £800
will be worth
£892.48 =
Step 4: repatriate £800 (1+ i£)
to the U.S.A.
Step 1:
borrow $1,000 More F£(360)
Step 5: Repay than $1,071 $1,071 < £892.48 ×
£1
your dollar loan
with $1,071.
If F£(360) > $1.20/£ , £892.48 will be more than enough to repay
your dollar obligationCopyright
6-17 of $1,071.
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Arbitrage Strategy II
If F360, £/$ < $1.20/£
i. Borrow £800 at t = 0 at i£= 11.56% .
ii. Exchange £800 for $1,000 at the prevailing spot
rate, invest $1,000 at 7.1% for one year to achieve
$1,071.
iii. Translate $1,071 back into pounds, if
F360, £/$ < $1.20/£, then $1,071 will be more than
enough to repay your debt of £892.48.
6-18 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Step 2:
buy dollars Arbitrage II
£800
$1.25
$1,000 = £800× Step 1:
£1
borrow £800
$1,000 Step 5: Repay
Step 3: More
than your pound loan
Invest $1,000
£892.48 with £892.48 .
at i$
Step 4:
repatriate to
the U.K.
In one year $1,000
F£(360)
will be worth $1,071 $1,071 > £892.48 ×
£1
6-24 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Transactions Costs Example
Try borrowing $1.000 at 5%:
Trade for € at the ask spot rate $1.01 = €1.00
Invest €990.10 at 5.5%
6-26 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Purchasing Power Parity and
Exchange Rate Determination
The exchange rate between two currencies should
equal the ratio of the countries’ price levels:
P$
S£/$ =
P£
For example, if an ounce of gold costs $300 in
the U.S. and £150 in the U.K., then the price of
one pound in terms of dollars should be:
P$ $300
S£/$ = = = $2/£
P£ £150
6-27 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Purchasing Power Parity and
Exchange Rate Determination
Suppose the spot exchange rate is $1.25 = €1.00
If the inflation rate in the U.S. is expected to be
3% in the next year and 5% in the euro zone,
Then the expected exchange rate in one year
should be $1.25×(1.03) = €1.00×(1.05)
6-28 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Purchasing Power Parity and
Exchange Rate Determination
The euro will trade at a 1.90% discount in the forward
market:
$1.25×(1.03)
F€/$ €1.00×(1.05) 1.03 1 + $
= = =
S€/$ $1.25 1.05 1 + €
€1.00
6-30 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Expected Rate of Change in Exchange
Rate as Inflation Differential
We could also reformulate
our equations as inflation or F€/$ 1 + $
=
interest rate differentials: S€/$ 1 + €
F€/$– S€/$ 1 + $ 1 + $ 1 + €
= –1= –
S€/$ 1 + € 1 + € 1 + €
F€/$ – S€/$ $ – €
E(e) = = ≈ $ – €
S€/$ 1 + €
6-31 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Expected Rate of Change in Exchange
Rate as Interest Rate Differential
F€/$ – S€/$ i $ – i€
E(e) = = ≈ i$ – i€
S€/$ 1 + i€
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Quick and Dirty Short Cut
Given the difficulty in measuring expected
inflation, managers often use
$ – € ≈ i$ – i€
6-33 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Evidence on PPP
PPP probably doesn’t hold precisely in the real
world for a variety of reasons.
Haircuts cost 10 times as much in the developed world
as in the developing world.
Film, on the other hand, is a highly standardized
commodity that is actively traded across borders.
Shipping costs, as well as tariffs and quotas can lead to
deviations from PPP.
PPP-determined exchange rates still provide a
valuable benchmark.
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Approximate Equilibrium Exchange
Rate Relationships
E(e)
≈ IFE ≈ FEP
≈ PPP F–S
(i$ – i¥) ≈ IRP
S
≈ FE ≈ FRPPP
E($ – £)
6-35 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
The Exact Fisher Effects
An increase (decrease) in the expected rate of inflation
will cause a proportionate increase (decrease) in the
interest rate in the country.
For the U.S., the Fisher effect is written as:
1 + i$ = (1 + $ ) × E(1 + $)
Where
$ is the equilibrium expected “real” U.S. interest rate
E($) is the expected rate of U.S. inflation
i$ is the equilibrium expected nominal U.S. interest rate
6-36 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
International Fisher Effect
If the Fisher effect holds in the U.S.
1 + i$ = (1 + $ ) × E(1 + $)
and the Fisher effect holds in Japan,
1 + i¥ = (1 + ¥ ) × E(1 + ¥)
and if the real rates are the same in each country
$ = ¥
then we get the 1 + i¥ E(1 + ¥)
International Fisher Effect: 1 + i$ = E(1 + $)
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International Fisher Effect
If the International Fisher Effect holds,
1 + i¥ E(1 + ¥)
=
1 + i$ E(1 + $)
1 + i¥ PPP F¥ / $
IRP
1 + i$ S¥ /$
FE FRPPP
E(1 + ¥)
E(1 + $)
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Forecasting Exchange Rates
Efficient Markets Approach
Fundamental Approach
Technical Approach
Performance of the Forecasters
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Efficient Markets Approach
Financial Markets are efficient if prices reflect all
available and relevant information.
If this is so, exchange rates will only change when
new information arrives, thus:
St = E[St+1]
and
Ft = E[St+1| It]
Predicting exchange rates using the efficient
markets approach is affordable and is hard to beat.
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Fundamental Approach
Involves econometrics to develop models that use
a variety of explanatory variables. This involves
three steps:
step 1: Estimate the structural model.
step 2: Estimate future parameter values.
step 3: Use the model to develop forecasts.
The downside is that fundamental models do not
work any better than the forward rate model or
the random walk model.
6-42 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Technical Approach
Technical analysis looks for patterns in the past
behavior of exchange rates.
Clearly it is based upon the premise that history
repeats itself.
Thus it is at odds with the EMH
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Performance of the Forecasters
Forecasting is difficult, especially with regard to
the future.
As a whole, forecasters cannot do a better job of
forecasting future exchange rates than the forward
rate.
The founder of Forbes Magazine once said:
“You can make more money selling financial
advice than following it.”
6-44 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
End Chapter Six
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