Chapter 4 ing

Parity Conditions in International Finance and Currency Forecast

Five Parity Conditions Result From 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) Purchasing Power Parity (PPP) PPP states that spot exchange rates between currencies will change to the differ ential in inflation rates between countries. Example: A Big Mac in Britain costs 1.99 while it costs $2.71 in the U.S.. Calcul ate the PPP implied exchange rate. http://www.economist.com/markets/Bigmac/Index.cfm Relative Purchasing Power Parity Relative PPP states that the exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries. If purchasing power parity is expected to hold, then the best prediction for the one-period spot rate should be A more simplified but less precise relationship is that is, the percentage change should be approximately equal to the inflation ra te differential. PPP says the currency with the higher inflation rate is expected to depreciate r elative to the currency with the lower rate of inflation. Example: The United States and Europe are running annual inflation rates of 5 pe rcent and 3 percent, respectively, and the spot rate for the is $1.07. Calculate the expected spot rate based on PPP. Example: Projected inflation rates for the U.S. and Germany for the next twelve months are 10% and 4%, respectively. If the current exchange rate is $.50/dm, w hat should the future spot rate be at the end of next twelve months? Example: Suppose the current U.S. price level is 112 and the Swiss price level i s 107, relative to base price levels of 100. If the initial value of the Swiss f ranc was $0.58, calculate the new value based on PPP. The real exchange rate is the nominal exchange rate adjusted for changes in the relative purchasing power of each currency since some base period.

Example: Between 1980 and 1995, the /$ exchange rate moved from 226.63 to 93.96. Du

ring the same period, the CPI in Japan rose from 91.0 to 119.2 and the U.S. CPI rose from 82.4 to 152.4. If PPP held over this period, what would the /$ rate have been in 1995? What happened to the real value of the yen in terms of dollars during this perio d? The Fisher Effect (FE) The Fisher Effect states that the nominal interest rates r is made up of two com ponents: (1) a real required rate of return a and (2) an inflation premium equal to the expected amount of inflation i. A more simplified but less precise relationship is Example: The required real return is 3 percent and expected inflation is 10 perc ent. Calculate the nominal interest rate. The International Fisher Effect (IFE) Real rates of interest should tend toward equality everywhere through arbitrage. With no government interference nominal rates vary by inflation differential or According to the IFE, countries with higher inflation rates have higher interest rates. Due to capital market integration globally, interest rate differentials are erod ing. IFE states that the spot rate adjusts to the interest rate differential between two countries. Fisher postulated: 1. The nominal interest rate differential should reflect the inflation rate diff erential. 2. Expected rates of return are equal in the absence of government intervention.

A more simplified but less precise relationship is Example: In July, the one-year interest rate is 4 percent on Swiss francs and 13 percent on U.S. dollars. 1) If the current exchange rate is SFr 1 = $0.63, what is the expected future ex change rate in one year? 2) If a change in expectations regarding future U.S. inflation causes the expect ed future spot rate to rise to $0.70, what should happen to the U.S. interest ra te? Implications of IFE 1. Currency with the lower interest rate expected to appreciate relative to one with a higher rate. 2. Financial market arbitrage ensures interest rate differential is an unbiased predictor of change in future spot rate. Example: If the /$ spot rate is 108/$ and the interest rates in Tokyo and New Yor k are 6% and 12%, respectively, what is the future spot rate two years from now? Interest Rate Parity (IRP) The theory states that the forward rate differs from the spot rate at equilibriu m by an amount equal to the interest differential between two countries. 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 premium or discount equals the interest rate differential. A more simplified but less precise relationship is Example: If the Swiss franc is $.68/SF on the spot market and the annualized int erest rates in the U.S. and Switzerland, respectively, are 7.94% and 2%, what is the 180 day forward rate under parity conditions? Example: The interest rate in the U.S. is 10 percent; in Japan, the comparable r ate is 7 percent. The spot rate for the yen is $0.003800. If IRP holds, what is the 90 day forward rate? Covered Interest Arbitrage Example: Suppose an investor with $1,000,000 to invest for 90 days is trying to decide between investing in U.S. dollars at 8 percent or in Euros at 6 percent. The current spot rate is 1.13110/$, and the 90-day forward rate is 1.1256/$. Where should he invest? Example: Suppose the interest rate on pounds sterling is 12 percent in London, a nd the interest rate on a comparable dollar investment in New York is 7 percent. The pound spot rate is $1.75, and the one-year forward rate is $1.68. Calculate the profit on a $1,000,000 transaction. Unbiased Forward Rate (UFR) UFR states that if the forward rate is unbiased, then it should reflect the expe cted future spot rate. End-of-Chapter Problems 1. From base price levels of 100 in 2000, Japanese and U.S. price levels in 2003 stood at 102 and 106, respectively. a. If the 2000 $: exchange rate was $0.007692, what should the exchange rate be i n 2003? b. In fact, the exchange rate in 2003 was 1 = $0.008696. What might account for the discrepancy? (Price levels were measured using the consumer price index. 2. Two countries, the United States and England, produce only one good, wheat. S uppose the price of wheat is $3.25 in the United States and is 1.35 in England. a. According to the law of one price, what should the $: spot exchange rate be? b. Suppose the price of wheat over the next year is expected to rise to $3.50 in the United States and to 1.60 in England. What should the one year $: forward rate be? c. If the U.S. government imposes a tariff of $0.50 per bushel on wheat imported from England, what is the maximum possible change in the spot exchange rate tha t could occur? 3. If expected inflation is 100 percent and the real required return is 5 percen t, what will the nominal interest rate be according to the Fisher effect? 4. In early 1996, the short-term interest rate in France was 3.7%, and forecast French inflation was 1.8%. At the same time, the short-term German interest rate was 2.6% and forecast German inflation was 1.6%. a. Based on these figures, what were the real interest rates in France and Germa ny?

b. To what would you attribute any discrepancy in real rates between France and Germany? 5. In July, the one year interest rate is 12% on British pounds and 9% on U.S. dol lars. a. If the current exchange rate is $1.63:1, what is the expected future exchange rate in one year? b. Suppose a change in expectations regarding future U.S. inflation causes the e xpected future spot rate to decline to $1.52:1. What should happen to the U.S. in terest rate? 6. Suppose that in Japan the interest rate is 8% and inflation is 3%. Meanwhile, the expected inflation rate in France is 12%, and terest rate is 14%. To the nearest whole number, what is the best e one year forward exchange premium (discount) at which the pound relative to the French franc? expected to be the English in estimate of th will be selling

7. Chase Econometrics has just published projected inflation rates for the Unite d States and Germany for the next five years. U.S. inflation is expected to be 1 0 percent per year, and German inflation is expected to be 4 percent per year. a. If the current exchange rate is $0.95/ , what should the exchange rates for the next five years be? b. Suppose that U.S. inflation over the next five years turns out to average 3.2 %, German inflation averages 1.5%, and the exchange rate in five years is $0.99/ . What has happened to the real value of the euro over this five-year period? 8. During 1995, the Mexican peso exchange rate rose from Mex$5.33/U.S.$ to Mex$7 .64/U.S.$. At the same time, U.S. inflation was approximately 3% in contrast to Mexican inflation of about 48.7%. a. By how much did the nominal value of the peso change during 1995? b. By how much did the real value of the peso change over this period? 9. Suppose three year deposit rates on Eurodollars and Eurofrancs (Swiss) are 12 p ercent and 7 percent, respectively. If the current spot rate for the Swiss franc is $0.3985, what is the spot rate implied by these interest rates for the franc three years from now? 10. Assume the interest rate is 16 percent on pounds sterling and 7 percent on e uros. At the same time, inflation is running at an annual rate of 3 percent in G ermany and 9 percent in England. a. If the euro is selling at a one-year forward premium of 10 percent against th e pound, is there an arbitrage opportunity? Explain. b. What is the real interest rate in Germany? in England? c. Suppose that during the year the exchange rate changes from 1.8/1 to 1.77/1. What are the real costs to a German company of borrowing pounds? Contrast this cost to its real cost of borrowing euros. d. What are the real costs to a British firm of borrowing euros? Contrast this c ost to its real cost of borrowing pounds. 11. Suppose the Eurosterling rate is 15 percent, and the Eurodollar rate is 11.5 percent. What is the forward premium on the dollar? Explain. 12. Suppose the spot rates for the euro, pound sterling, and Swiss franc are $0. 92, $1.13, and $0.38, respectively. The associated 90 day interest rates (annualiz ed) are 8 percent, 16 percent, and 4 percent; the U.S. 90 day rate (annualized) i s 12 percent. What is the 90 day forward rate on an ACU (ACU 1 = 1 + 1 + SFr 1) if i nterest parity holds?

13. Suppose that three-month interest rates (annualized) in Japan and the United States are 7 percent and 9 percent, respectively. If the spot rate is 142:$1 and the 90-day forward rate is 139:$1: a. Where would you invest? b. Where would you borrow? c. What arbitrage opportunity do these figures present? d. Assuming no transaction costs, what would be your arbitrage profit per dollar or dollar-equivalent borrowed? 14. Here are some prices in the international money markets: Spot rate = $0.95/ Forward rate (one year) =$0.97/ Interest rate ( ) =7% per year Interest rate ($) = 9% per year a. Assuming no transaction costs or taxes exist, do covered arbitrage profits ex ist in the above situation? Describe the flows. b. Suppose now that transaction costs in the foreign exchange market equal 0.25% per transaction. Do unexploited covered arbitrage profit opportunities still ex ist? c. Suppose no transaction costs exist. Let the capital gains tax on currency pro fits equal 25%, and the ordinary income tax on interest income equal 50%. In thi s situation, do covered arbitrage profits exist? How large are they? Describe th e transactions required to exploit these profits. 15. Suppose today's exchange rate is $1.05/ . The six-month interest rates on doll ars and euros are 6 percent and 3 percent, respectively. The six-month forward r ate is $1.0478. A foreign exchange advisory service has predicted that the euro will appreciate to $1.0790 within six months. a. How would you use forward contracts to profit in the above situation? b. How would you use money market instruments (borrowing and lending) to profit? c. Which alternatives (forward contracts or money market instruments) would you prefer? Why?