International Finance

1
International Finance

• Lecture 3

2
Foundations of International Financial Management

• Globalization and the Multinational Firm
• International Monetary System
• Balance of Payments
• The Market for Foreign Exchange
• International Parity Relationships

3
International Parity Relations

• Interest rate __________
• Purchasing __________ parity
• __________ effect
• Using the parity relations in forecasting
  exchange rates

4
Interest Rate Parity

• F forward rate, FC/DC
• S spot rate, FC/DC
• rFC interest rate of foreign currency
  __________
• rDC interest rate of domestic currency
  __________

5
Interest Rate Parity

• You observe that spot EUR/USD1.05, one-year
  interest rates are rUSD1.76, rEUR3.39, what
  is the 1-year forward EUR/USD rate?

6
Interest Rate Parity

• IRP is an __________ condition.
• If IRP did not hold, then it would be possible
  for a trader to make __________ amounts of money
  without risk exploiting the arbitrage
  opportunity.
• Since we dont typically observe persistent
  arbitrage conditions, we can safely assume that
  IRP holds.
• If it does not hold for long time, it is due to
  __________ costs and government-imposed capital
  ________ that make arbitrage impossible

7
Interest Rate Parity
8
Interest Rate Parity and Expected Exchange Rates

• Forward rate can be viewed as the best guess
  about the future spot rate, given todays
  information.
• Ft ESt1Informationt
• Recall
• St ESt1Informationt(1rDC)/ (1rFC)
• Todays __________ exchange rate depends on the
  todays interest rates and an expectation about
  the future exchange rate FC/DC

9
Interest Rate Parity

• You observe that spot EUR/USD1.05, interest
  rates are rUSD1.76, rEUR3.39 per annum, what
  is the 3-months forward EUR/USD rate?

10
IRP and Covered Interest Arbitrage

• If IRP failed to hold, an arbitrage would exist.
  Its 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.

Spot exchange rate S(/) 1.25
360-day forward rate F360(/) 1.20
Canadian interest rate i 7.10
British interest rate i 11.56
11
IRP and Covered Interest Arbitrage

• Alternative 1. Invest 1,000 in Canada _at_ 7.1, in
  one year investment will be worth 1,071
  1,000?(1 i) __________
• Alternative 2.
• Exchange 1,000 for 800 at the going spot rate,
  (note that 800 1,0001.25/),
• invest 800 in the UK at i 11.56 for one
  year, receive __________
• Translate 892.48 back into dollars at F360(/)
  1.20/, the 892.48 will be exactly 1,071.
• Note that _______ alternatives 1 and 2 are the
  same.

12
IRP and Covered Interest Arbitrage

• According to IRP it must be the case that
• F360(/) __________
• If F360(/) ? 1.20/, riskless arbitrage is
  possible
• As usual, __________

13
Arbitrage Strategy I

• If F360(/) gt 1.20/, lets say 1.30. Forward
  GBP overpriced (CAD is underpriced). Sell forward
  GBP and buy spot GBP to make it riskless.
• __________ 1,000 at t 0 at i 7.1.
• __________ 1,000 for 800 at the prevailing spot
  rate, (note that 800 1,0001.25/) invest
  800 at 11.56 (i) for one year to achieve
  892.48
• __________ 892.48 back into dollars, if
• F360(/) gt 1.20/ , 892.48 will be more than
  enough to repay your dollar obligation of 1,071.
  892.48 1.3 1160.22, profit __________

14
Arbitrage Strategy II

• If F360(/) lt 1.20/, lets say 1.10. Forward
  GBP underpriced (CAD overpriced). Buy forward GBP
  (sell forward CAD), sell spot GBP, get CAD to
  make it riskless.
• __________ 800 at t 0 at i 11.56 .
• __________ 800 for 1,000 at the prevailing spot
  rate, invest 1,000 at 7.1 for one year to
  achieve 1,071.
• __________ 1,071 back into pounds, if
• F360(/) lt 1.20/ , 1,071 will be more than
  enough to repay your obligation of 892.48.
  1,071/1.10 973.64, profit __________

15
IRP and Covered Interest Arbitrage

• You observe the following. Spot CHF/USD1.6627,
  6-months forward CHF/USD1.6558. Interest rates
  are 3.5 in the USA and 3.0 p.a. in Switzerland
  (compounded semiannually). Ignore transaction
  costs. Are there any arbitrage opportunities? If
  yes, what are they?

16
IRP and Covered Interest Arbitrage
17
IRP and Covered Interest Arbitrage

• You observe the following. Spot JPY/USD108,
  3-months forward JPY/USD107.30. Interest rates
  are 5.20 in the USA and 1.2 p.a. in Switzerland
  (compounded quarterly). Ignore transaction costs.
  Are there any arbitrage opportunities? If yes,
  what are they?

18
IRP and Covered Interest Arbitrage
19
Hedging Currency Risk

• Hedging a part of risk management
• Taking a position, with the purpose of reducing
  risk, based on the view that an unfavorable event
  will occur in the market.
• Hedging never __________ all risk, should be
  viewed as risk reducing, not risk eliminating
  strategy.
• Reduces loss __________, but also reduces the
  gain potential.

20
IRP and Hedging Currency Risk

• You are a Canadian importer of British woolens
  and have just ordered next years inventory.
  Payment of 100M is due in one year.

Spot exchange rate S(/) 1.25/
360-day forward rate F360(/) 1.20/
Canadian interest rate i 7.10
British interest rate i 11.56
IRP implies that there are two ways that you fix
the cash outflow to a certain Canadian dollar
amount a) Enter ________________________
contract on the pound. You will pay
(100M)(1.2/) __________ today. b) Form a
forward market __________ as shown below.
21
IRP and Hedging Currency Risk

• To form a forward market hedge
• __________ 112.05 million in Canada (in one year
  you will owe 120 million).
• __________ 112.05 million into pounds at the
  spot rate S(/) 1.25/ to receive 89.64
  million.
• __________ 89.64 million in the UK at i
  11.56 for one year.
• In one year your investment will have grown to
  100 millionexactly enough to pay your supplier.

22
IRP and Forward Bid-Ask Spread

• Profit in FC per unit DC
• Sbid (1rbid,FC) -Fask (1rask,DC) 0
• Fbid (1rbid,DC) - Sask (1rask,FC)0
• F forward exchange rate, _________
• S spot exchange rate, _________
• rbid,FC, rask,FC interest rates on lending (i.e.
  on your savings account) and _________(i.e. if
  you want to get a loan) in the foreign country
• rbid,DC, rask,DC lending and borrowing interest
  rates in the home country (country of the
  currency that is in the denominator in the
  _________ exchange rate)

23
IRP and Bid-Ask Spread

• You see the following rates. Spot
  USD/EUR1.1865-70, JPY/USD108.10-20. Short-term
  annualized interest rates are r5-5.25,
  rEUR3.25-3.5, rJPY1.25-1.5. What should be the
  spot JPY/EUR rate and 3-month forward JPY/EUR,
  EUR/USD and JPY/USD rates?

24
IRP and Bid-Ask Spread

• Solution (2) 3-month forward JPY/EUR rate

25
IRP and Bid-Ask Spread

• Solution (3) 3-month forward EUR/USD rate

26
IRP and Bid-Ask Spread

• Solution (4) 3-month forward JPY/USD rate

27
Interest Rate Parity
28
Interest Rate Parity
29
Purchasing Power Parity

• The exchange rate between two currencies should
  equal the ratio of the countries price levels
• 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

30
Purchasing Power Parity

• If the law of one price were true for all goods
  and services, the purchasing power parity
  exchange rate can be found from any set of
  prices.
• This is __________ purchasing power parity.
• Hamburger standard compares Big Mac prices with
  the exchange rates to determine whether or not
  overvaluation or undervaluation exist.
• Index introduced by The Economist, shortly after
  the Big Mac they introduced the Tall Latte index.
  Subscription required. They offer free online
  subscription, try and see the articles.

31
Absolute PPP indices
32
Purchasing Power Parity

• Absolute PPP never works for most
  goods/commodities
• Less Strict version uses a basket of goods
  instead of individual items.
• Relative Purchasing Power Parity
• If the spot exchange rate between two countries
  starts in __________,
• any change in differential rate of inflation
  between them tends to be offset over in the long
  run by an equal but opposite change in the spot
  exchange rate.

33
Purchasing Power Parity

• S0 spot rate at the start of the period, FC/DC
• S1 expected spot rate at the start of the
  period, FC/DC
• ?FC expected inflation rate of foreign country
  (FC)
• ?DC expected inflation rate of domestic country
  (DC)

34
Purchasing Power Parity and Exchange Rate
Determination

• Relative PPP states that the rate of change in
  the exchange rate is equal to the differences in
  the rates of inflation

35
Purchasing Power Parity

• Spot CAD/GBP 2.235, inflation in Canada is 1.3
  and in the UK 2.1. What is the expected spot
  exchange rate one year from now, according to the
  PPP?

36
Evidence on PPP

• PPP probably __________ 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 __________
  commodity that is actively traded across borders.
• Shipping costs, as well as tariffs and quotas can
  lead to __________ from PPP.
• PPP-determined exchange rates still provide a
  valuable benchmark.

37
The Fisher Effects (Long Run)

• An increase (decrease) in the expected rate of
  inflation will cause a proportionate increase
  (decrease) in the interest rate in the country.
• For Canada, the Fisher effect is written as
• 1 i (1 ?)(1 E?)
• approximation
• ? is the equilibrium expected real Canadian
  interest rate
• E? is the expected rate of Canadian inflation
• i is the equilibrium expected nominal Canadian
  interest rate

38
Expected Inflation

• The Fisher effect implies that the expected
  inflation rate is approximated as the difference
  between the nominal and real interest rates in
  each country, i.e.

i ? (1 ?)E? ? E?
39
International Fisher Effect

• If the Fisher effect (FE) holds in Canada
• 1 i
• and the Fisher effect holds in Japan,
• 1 i
• and if the real rates are the same in each
  country
• ?
• then we get the International Fisher Effect
  (IFE)

40
International Fisher Effect

• If the expected inflation is 8.91 in the US and
  12.87 in Eurozone, and the US riskless rate is
  10, what is the nominal riskless rate in the
  Eurozone? Assume the International Fisher Effect
  is true.

41
International Fisher Effect

• If the International Fisher Effect (IFE) holds,

and if IRP also holds
then forward rate PPP (FPPP) holds
42
Exact Equilibrium Exchange Rate Relationships
FEP
43
Exchange rate expectation

• The spot USD/EUR1.25, US riskless rate is 10
  and the Eurozone riskless rate is 14. What is
  the expected spot rate one year from now?

44
Forecasting Exchange Rates

• Efficient __________ Approach
• __________ Approach
• Technical Approach
• Performance of the Forecasters

45
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 ESt1
• and
• Predicting exchange rates using the efficient
  markets approach is affordable and is hard to
  beat.

46
Fundamental Approach

• Based on theoretical general or partial
  equilibrium models
• __________ macroeconomics
• Model production, balance of payments, etc and
  solve for exchange rates
• Based on asset market values
• Another group of theoretical __________, solve
  for long-run __________ exchange rates,
• Infer current spot rates, and see if there is a
  potential for exchange rate movement towards the
  long-run values

47
Technical Approach

• Infer future movements of the exchange rates
  based on historical rates
• Technical analysis
• Assumes markets are __________

48
Example

• Canadian and Euro deposit rates are 5 and 6,
  respectively. Current exchange rate S0
  CAD1.3/.
• Bank of Canada announces a permanent increase in
  the money supply of 10. On this news Canadian
  interest rate drops to 4. Whats the effect on
  S0 in SR?
• Two effects
• ____________________________________________.
  This alone would lead to S0ES(1R )/(1R)
  1.2881.06/1.04 1.3128 (pre-event ES is
  computed from uncovered interest parity).
• _____________________ Ms up by 10 gt ES up by
  approximately 10 now (t0).
• Finally, ___________________________________

49
Example Contd

• What is S0 in the LR?
• P _______ until R is _________
• S0 _________________________

50
Exchange Rate Overshooting

• The exchange rate is said to _________ when its
  immediate response to a change is greater than
  its long run response.
• We assume that changes in the money supply have
  immediate effects on interest rates and exchange
  rates.
• We assume that people change their expectations
  about inflation immediately after a change in the
  money supply.
• Overshooting helps explain why exchange rates are
  so ____________.
• Overshooting occurs in the model because prices
  ________________, but expectations about prices
  ______.

51
Exchange Rate Volatility
Changes in price levels are less volatile,
suggesting that price levels change slowly.
Exchange rates are influenced by interest rates
and expectations, which may change rapidly,
making exchange rates volatile.