Fluent Essays

1. Any Topic from Chapters 5-8  2. APA format, minimum 4 sources  3. Explain the chosen international finance topic in general terms AND cover how it is implemented in the student’s chosen pretend business.  4. Paper will be a minimum of 750 and a maximum of 900 words. (This includes title section, content, and references…in other words the entire paper) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. International Financial Management 11th Edition by Jeff Madura 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Part 2 Exchange Rate Behavior © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Exchange Rate Systems Exchange rate systems can be classified according to the degree of government control and fall into the following categories:  Fixed  Freely floating  Managed float  Pegged © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Fixed Exchange Rate System 1. Exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries. 2. Central bank can reset a fixed exchange rate by devaluing or reducing the value of the currency against other currencies. 3. Central bank can also revalue or increase the value of its currency against other currencies. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 Fixed Exchange Rate System  Examples:  Bretton Woods Agreement 1944 – 1971 - Each currency was valued in terms of gold.  Smithsonian Agreement 1971 – 1973 - called for a devaluation of the U.S. dollar by about 8 percent against other currencies.  Advantages of fixed exchange rate system  Insulate country from risk of currency appreciation.  Allow firms to engage in direct foreign investment without currency risk.  Disadvantages of fixed exchange rate system  Risk that government will alter value of currency.  Country and MNC may be more vulnerable to economic conditions in other countries. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Freely Floating Exchange Rate System  Exchange rates are determined by market forces without government intervention.  Advantages of freely floating system:  Country is more insulated from inflation of other countries.  Country is more insulated from unemployment of other countries.  Does not require central bank to maintain exchange rates within specified boundaries.  Disadvantages of freely floating system:  Can adversely affect a country that has high unemployment.  Can adversely affect a country with high inflation. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Managed Float Exchange Rate System  Governments sometimes intervene to prevent their currencies from moving too far in a certain direction.  Critics suggest that managed float allows a government to manipulate exchange rates to benefit its own country at the expense of others.  Currencies of most large developed countries are allowed to float, although they may be periodically managed by their respective central banks. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Exhibit 6.1 Exchange Rate Arrangements © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Pegged Exchange Rate System  Home currency value is pegged to one foreign currency or to an index of currencies.  May attract foreign investment because exchange rate is expected to remain stable.  Weak economic or political conditions can cause firms and investors to question whether the peg will be broken. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 Pegged Exchange Rate Systems (Cont.)  Currency Boards Used to Peg Currency Values - a system for pegging the value of the local currency to some other specified currency. The board must maintain currency reserves for all the currency that it has printed.  Interest Rates of Pegged Currencies - Interest rate will move in tandem with the interest rate of the currency to which it is tied.  Exchange Rate Risk of a Pegged Currency – (Exhibit 6.2) provides examples of countries that have pegged the exchange rate of their currency to a specific currency. Currencies are commonly pegged to the U.S. dollar or to the euro. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 Exhibit 6.2 Pegged Exchange Rates © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12 Dollarization  Replacement of a foreign currency with U.S. dollars.  This process is a step beyond a currency board because it forces the local currency to be replaced by the U.S. dollar. Although dollarization and a currency board both attempt to peg the local currency’s value, the currency board does not replace the local currency with dollars. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13 A Single European Currency  Monetary Policy in the Eurozone  European Central Bank - based in Frankfurt and is responsible for setting monetary policy for all participating European countries  Objective is to control inflation in the participating countries and to stabilize (within reasonable boundaries) the value of the euro with respect to other major currencies.  Impact on Firms in the Eurozone - Prices of products are now more comparable among European countries.  Impact on Financial Flows in the Eurozone - Bond investors who reside in the eurozone can now invest in bonds issued by governments and corporations in these countries without concern about exchange rate risk, as long as the bonds are denominated in euros. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14 A Single European Currency  Exposure of Countries within the Eurozone  A single European monetary policy prevents any individual European country from solving local economic problems with its own unique monetary policy.  Any given monetary policy used in the eurozone during a particular period may enhance conditions in some countries and adversely affect others.  Impact of Crises within the Eurozone - may affect the economic conditions of the other participating countries because they all rely on the same currency and same monetary policy. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15 Reasons for Government Intervention 1. Smooth exchange rate movements If a central bank is concerned that its economy will be affected by abrupt movements in its home currency’s value, it may attempt to smooth the currency movements over time. 2. Establish implicit exchange rate boundaries Some central banks attempt to maintain their home currency rates within some unofficial, or implicit, boundaries. 3. Respond to temporary disturbances A central bank may intervene to insulate a currency’s value from a temporary disturbance. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 Direct Intervention To force the dollar to depreciate, the Fed can intervene directly by exchanging dollars that it holds as reserves for other foreign currencies in the foreign exchange market. By “flooding the market with dollars” in this manner, the Fed puts downward pressure on the dollar. If the Fed desires to strengthen the dollar, it can exchange foreign currencies for dollars in the foreign exchange market, thereby putting upward pressure on the dollar. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 Direct Intervention  Reliance on reserves The potential effectiveness of a central bank’s direct intervention is the amount of reserves it can use.  Nonsterilized versus sterilized intervention (See Exhibit 6.4)  When the Fed intervenes in the foreign exchange market without adjusting for the change in the money supply, it is engaging in a nonsterilized intervention.  In a sterilized intervention, the Fed intervenes in the foreign exchange market and simultaneously engages in offsetting transactions in the Treasury securities markets.  Speculating on direct intervention Some traders in the foreign exchange market attempt to determine when Federal Reserve intervention is occurring and the extent of the intervention in order to capitalize on the anticipated results of the intervention effort. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18 Exhibit 6.4 Forms of Central Bank Intervention in the Foreign Exchange Market © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19 Indirect Intervention Government Control of Interest Rates by increasing or reducing interest rates Foreign Exchange Controls such as restrictions on the exchange of the currency Intervention Warnings intended to warn speculators. The announcements could discourage additional speculation and might even encourage some speculators to unwind (liquidate) their existing positions in the currency. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20 Intervention as a Policy Tool 1. A weak home currency can stimulate foreign demand for products. (See Exhibit 6.5) 2. A strong home currency can encourage consumers and corporations of that country to buy goods from other countries. (See Exhibit 6.6) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21 Exhibit 6.5 How Central Bank Intervention Can Stimulate the U.S. Economy © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22 Exhibit 6.6 How Central Bank Intervention Can Reduce Inflation © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23 SUMMARY  Exchange rate systems can be classified as fixed rate, freely floating, managed float, and pegged. In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries. In a freely floating exchange rate system, exchange rate values are determined by market forces without intervention. In a managed float system, exchange rates are not restricted by boundaries but are subject to government intervention. In a pegged exchange rate system, a currency’s value is pegged to a foreign currency or a unit of account and moves in line with that currency (or unit of account) against other currencies. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24 SUMMARY (Cont.)  Numerous European countries use the euro as their home currency. The single currency allows international trade by firms within the eurozone without foreign exchange expenses and without concerns about future exchange rate movements. However, countries that participate in the euro do not have complete control of their monetary policy because one monetary policy is applied to all countries in the eurozone. In addition, some countries might be more susceptible to a crisis in another country in the eurozone as a result of being in the eurozone. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25 SUMMARY (Cont.)  Governments can use direct intervention by purchasing or selling currencies in the foreign exchange market, thereby affecting demand and supply conditions and, in turn, affecting the equilibrium values of the currencies. When a government purchases a currency in the foreign exchange market, it puts upward pressure on the currency’s equilibrium value. When a government sells a currency in the foreign exchange market, it puts downward pressure on the currency’s equilibrium value. Governments can use indirect intervention by influencing the economic factors that affect equilibrium exchange rates. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26 SUMMARY (Cont.)  When government intervention is used to weaken the U.S. dollar, the weak dollar can stimulate the U.S. economy by reducing the U.S. demand for imports and increasing the foreign demand for U.S. exports. Thus, the weak dollar tends to reduce U.S. unemployment, but it can increase U.S. inflation. When government intervention is used to strengthen the U.S. dollar, the strong dollar can increase the U.S. demand for imports, thereby intensifying foreign competition. The strong dollar can reduce U.S. inflation but may cause a higher level of U.S. unemployment. Slide Number 1 Part 2 Exchange Rate Behavior Exchange Rate Systems Fixed Exchange Rate System Fixed Exchange Rate System Freely Floating Exchange Rate System Managed Float Exchange Rate System Exhibit 6.1 Exchange Rate Arrangements Pegged Exchange Rate System Pegged Exchange Rate Systems (Cont.) Exhibit 6.2 Pegged Exchange Rates Dollarization A Single European Currency A Single European Currency Reasons for Government Intervention Direct Intervention Direct Intervention Exhibit 6.4 Forms of Central Bank Intervention in the Foreign Exchange Market Indirect Intervention Intervention as a Policy Tool Exhibit 6.5 How Central Bank Intervention Can Stimulate the U.S. Economy Exhibit 6.6 How Central Bank Intervention Can Reduce Inflation SUMMARY SUMMARY (Cont.) SUMMARY (Cont.) SUMMARY (Cont.) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 7 International Arbitrage And Interest Rate Parity  Explain the conditions that will result in various forms of international arbitrage and the realignments that will occur in response  Explain the concept of interest rate parity  Explain the variation in forward rate premiums across maturities and over time 1 Chapter Objectives © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 International Arbitrage  Defined as capitalizing on a discrepancy in quoted prices by making a riskless profit.  Arbitrage will cause prices to realign.  Three forms of arbitrage:  Locational arbitrage  Triangular arbitrage  Covered interest arbitrage © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Locational Arbitrage 1. Defined as the process of buying a currency at the location where it is priced cheap and immediately selling it at another location where it is priced higher. (See Exhibit 7.1) 2. Gains from locational arbitrage are based on the amount of money used and the size of the discrepancy. (See Exhibit 7.2) 3. Realignment due to locational arbitrage drives prices to adjust in different locations so as to eliminate discrepancies. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Exhibit 7.1 Currency Quotes for Locational Arbitrage Example 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 Exhibit 7.2 Locational Arbitrage 5 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Triangular Arbitrage 1. Defined as currency transactions in the spot market to capitalize on discrepancies in the cross exchange rates between two currencies. (See Exhibits 7.3, & 7.5) 2. Accounting for the Bid/Ask Spread: Transaction costs (bid/ask spread) can reduce or even eliminate the gains from triangular arbitrage. 3. Realignment due to triangular arbitrage forces exchange rates back into equilibrium. (See Exhibit 7.6) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Exhibit 7.3 Example of Triangular Arbitrage 7 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Exhibit 7.5 Example of Triangular Arbitrage Accounting for Bid/Ask Spreads 8 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Exhibit 7.6 Impact of Triangular Arbitrage 9 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 Covered Interest Arbitrage 1. Defined as the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk with a forward contract. 2. Consists of two parts: (See Exhibit 7.7) a. Interest arbitrage: the process of capitalizing on the difference between interest rates between two countries. b. Covered: hedging the position against interest rate risk. 3. Realignment: due to covered interest arbitrage causes market realignment. 4. Timing of realignment may require several transactions before realignment is completed. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 Exhibit 7.7 Example of Covered Interest Arbitrage 11 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12 Comparison of Arbitrage Effects 1. The threat of locational arbitrage ensures that quoted exchange rates are similar across banks in different locations. 2. The threat of triangular arbitrage ensures that cross exchange rates are properly set. 3. The threat of covered interest arbitrage ensures that forward exchange rates are properly set. Any discrepancy will trigger arbitrage, which should eliminate the discrepancy. 4. Thus, arbitrage tends to allow for a more orderly foreign exchange market. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13 Exhibit 7.8 Comparing Arbitrage Strategies 13 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14 Interest Rate Parity 1. Interest Rate Parity (IRP) is a theory that says the difference between the interest rates of two countries is equal based on the difference calculated by using the forward exchange rate and the spot exchange rate techniques. 1. Interpretation of Interest Rate Parity Interest rate parity does not imply that investors from different countries will earn the same returns. Interest rate parity brings together interest rates, spot exchange rates, and foreign exchange rates. 14 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15 Considerations When Assessing Interest Rate Parity 1. Transaction costs The actual point reflecting the interest rate differential and forward rate premium must be farther from the IRP line to make covered interest arbitrage worthwhile. (See Exhibit 7.10) 2. Political risk A crisis in the foreign country could cause its government to restrict any exchange of the local currency for other currencies. 3. Differential tax laws Covered interest arbitrage might be feasible when considering before-tax returns but not necessarily when considering after-tax returns. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 Variation in Forward Premiums 1. Forward Premiums across Maturities The annualized interest rate differential between two countries can vary among debt maturities, and so will the annualized forward premiums.(See Exhibit 7.11) 2. Changes in Forward Premiums over Time Exhibit 7.12 illustrates the relationship between interest rate differentials and the forward premium over time, when interest rate parity holds. The forward premium must adjust to existing interest rate conditions if interest rate parity holds. 3. Explaining Changes in the Forward Rate The forward rate is indirectly affected by all the factors that can affect the spot rate (S) over time, including inflation differentials, interest rate differentials, etc. The change in the forward rate can also be due to a change in the premium. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 Exhibit 7.11 Quoted Interest Rates for Various Times to Maturity 17 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18 Exhibit 7.12 Relationship between the Interest Rate Differential and the Forward Premium 18 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19 SUMMARY  Locational arbitrage may occur if foreign exchange quotations differ among banks. The act of locational arbitrage should force the foreign exchange quotations of banks to become realigned, and locational arbitrage will no longer be possible.  Triangular arbitrage is related to cross exchange rates. A cross exchange rate between two currencies is determined by the values of these two currencies with respect to a third currency. If the actual cross exchange rate of these two currencies differs from the rate that should exist, triangular arbitrage is possible. The act of triangular arbitrage should force cross exchange rates to become realigned, at which time triangular arbitrage will no longer be possible. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20 SUMMARY (Cont.)  Covered interest arbitrage is based on the relationship between the forward rate premium and the interest rate differential. The size of the premium or discount exhibited by the forward rate of a currency should be about the same as the differential between the interest rates of the two countries of concern. In general terms, the forward rate of the foreign currency will contain a discount (premium) if its interest rate is higher (lower) than the U.S. interest rate.  If the forward premium deviates substantially from the interest rate differential, covered interest arbitrage is possible. In this type of arbitrage, a foreign short term investment in a foreign currency is covered by a forward sale of that foreign currency in the future. In this manner, the investor is not exposed to fluctuation in the foreign currency’s value. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21 SUMMARY (Cont.)  Interest rate parity (IRP) is a theory that states that the size of the forward premium (or discount) should be equal to the interest rate differential between the two countries of concern. When IRP exists, covered interest arbitrage is not feasible because any interest rate advantage in the foreign country will be offset by the discount on the forward rate. Thus, the act of covered interest arbitrage would generate a return that is no higher than what would be generated by a domestic investment. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22 SUMMARY (Cont.)  Because the forward premium of a currency from a U.S. perspective is influenced by the interest rate of that currency and the U.S. interest rate and because those interest rates change over time, the forward premium changes over time. Thus the forward premium may be large and positive in one period when the interest rate of that currency is relatively low, but it could become negative (reflecting a discount) if that interest rate rises above the U.S. interest rate. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23 8 Relationships among Inflation, Interest Rates and Exchange Rates  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 23 Chapter Objectives © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24 Purchasing Power Parity (PPP) Interpretations of Purchasing Power Parity  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.  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 currency © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25 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. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26 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) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27 Exhibit 8.1 Summary of Purchasing Power Parity © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28 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 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29 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. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30 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. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31 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. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 32 Exhibit 8.5 Illustration of the International Fisher Effect (IFE) from Various Investor Perspectives © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 33 Exhibit 8.6 Summary of International Fisher Effect © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 34 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. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 36 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. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 37 Exhibit 8.9 Comparison of the IRP, PPP, and IFE Theories © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 38 SUMMARY  Purchasing power parity (PPP) theory specifies a precise relationship between relative inflation rates of two countries and their exchange rate. In inexact terms, PPP theory suggests that the equilibrium exchange rate will adjust by the same magnitude as the differential in inflation rates between two countries. Though PPP continues to be a valuable concept, there is evidence of sizable deviations from the theory in the real world. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 39 SUMMARY (Cont.)  The international Fisher effect (IFE) specifies a precise relationship between relative interest rates of two countries and their exchange rates. It suggests that an investor who periodically invests in foreign interest-bearing securities will, on average, achieve a return similar to what is possible domestically. This implies that the exchange rate of the country with high interest rates will depreciate to offset the interest rate advantage achieved by foreign investments. However, there is evidence that during some periods the IFE does not hold. Thus, investment in foreign short-term securities may achieve a higher return than what is possible domestically. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 40 SUMMARY (Cont.)  The PPP theory focuses on the relationship between the inflation rate differential and future exchange rate movements. The IFE focuses on the interest rate differential and future exchange rate movements. The theory of interest rate parity (IRP) focuses on the relationship between the interest rate differential and the forward rate premium (or discount) at a given point in time. Running head: INTERNATIONAL FINANCE MARKETS 1 INTERNATIONAL FINANCE MARKETS 5 International Finance Markets. The international finance market is a place where individuals as well as countries trade financial wealth amongst themselves. (Pilbeam, 2018) This market can also be viewed as a wide set of guidelines and organizations whereby wealth is merchandised between the business managers in overabundance and trustees in indebtedness and where organizations set the rules. (Mosley, 2000). This paper aims to give a clear explanation on what defines International Finance Markets and how these markets are implemented in a homemade candle store. International finance markets are of various types. The first type is the international capital market. This is a type of market where investments and savings are herded between the people and or organizations with capital to lend or invest and the people who are in need. They bring vendors and vendees together to for the purpose of doing trade of stocks as well as other monetary valuables. (Mosley, 2001). International Capital markets are inclusive of both the stock market and the bond market. They greatly assist individuals with proposals on how to become entrepreneurs Another type of international finance market is the international credit market. This is a market where there is exchange of debt securities as well as transitory commercial paper. Firms together with the countries’ leaderships are able to earn morning through granting the investors the consent to acquire these debt securities. (Pilbeam, 2018). The activities that are undertaken in credit markets are time and again used to measure the investor sentiment. These credit market have the aim of achieving the highest possible rate of profit as well as achieving political benefits. International finance markets have key roles they play at the world level as far as markets are concerned. To start with, these markets allow for the determination of price of the financial assets being traded. This is made possible through the interactivity of vendees and the vendors. They offer a signal for the funds allocation in the economy according to the demand and to the supply. (Pilbeam, 2018). This is done via a mechanism well known as the process of price discovery. Another responsibility played by these finance markets is mobilization of funds. In today’s world, the stock markets are a representation of a healthy economy. This is because these markets are the major way of mobilization for long term savings and investment and formation of fixed capital. (Lewis, 1995). Exchanges of stock permits and opens doors for businesses to raise kitty primarily through equitabness. Taking an instance of a business like a homemade candle store, the international finance markets can be effectively implemented in various ways. The major reason for this is because a homemade candle store will include giving its products on credit to the customers. By the same token, international finance markets are with much efficiency implemented as this homemade candle store will act like the international credit market which is a type of the international finance market. The international financial markets will also be implemented in the homemade candle business when it sells the products to the customers and profit is achieved. In the finance market, this is compared to the international capital market. (Lewis 1995). In both the homemade candle business and the international capital market, buyers will have together with an aim of bonding as well as to sell stocks and other financial assets. For this reason, the international financial market will be effectively implemented in a homemade candle store. Just like the international finance markets, the homemade candle store will be a place where individuals trade their wealth but in this case in exchange of a specific product, the homemade candles. (Pilbeam, 2018). Just like the way the international financial market is, this homemade candle store can also be viewed as a wide set of guidelines and organizations whereby wealth is merchandised between the business managers in overabundance and trustees in indebtedness and where organizations set the rules. In that way, the international finance markets are implemented in the homemade candle store. In conclusion, despite the fact that the International finance markets play a major role in the economic sector on a worldwide basis, they also play vital roles in implementing small scale businesses such as the homemade candle store discussed in the above essay. This is because in both, they form a basis where buyers and sellers can make great impacts in the world market hence balancing the economy of the world. References Buljevich, E. C., & Park, Y. S. (1999). Project financing and the international financial markets. Springer Science & Business Media. Lewis, K. K. (1995). Puzzles in international financial markets. Handbook of international economics, 3, 1913-1971. Levich, R. M. (2001). International financial markets. McGraw-Hill/Irwin. Mosley, L. (2000). Room to move: International financial markets and national welfare states. International organization, 54(4), 737-773. Pilbeam, K. (2018). Finance & financial markets. Macmillan International Higher Education. 5