International fisher effect

INTERNATIONAL FINANCE INTERNATIONAL FINANCIAL MANAGEMENT

1. INTERNATIONAL FISHER EFFECT Dr. Mohamed Kutty Kakkakunnan Associate Professor P G Dept. of Commerce N A M College Kallikkandy Kannur – Kerala - India

2. International Fisher Effect Named after famous economist Irving Fisher More related with investment Investor invests with the expectation of getting return on his investment The returns can be divided into two Nominal return and Real return Nominal return is the return offered by the company or borrower, say 12%, 14% etc Real return is the inflation adjusted rate of return

3. An investor saves his income through postponement of consumption He expects a better return on his investment in future He puts off his consumption anticipating the saved money can be consumed in future and better returns can be earned on his investment If there is inflation his postponement is not effective

4. Suppose Mr. X’s has a savings of Rs. 200,000 on 1 st January, 2015 and he invests this in Mutual fund for two years and gets 12% per annum. His total wealth at the end of the second year (31 st December 2016) will be Rs. 250880. Suppose he wants to construct a house, requires Rs. 200,000 for constructing the house on 1 st January, 2015 and for constructing the same home on 31 st December 2016, he will require Rs. 300,000. Then whether the investment is profitable or not?

5. Explain your answer Thus, by not constructing the home on 1 st January 2015 and postponing it to 31 st December 2015, he incurs loss When the investment become profitable? Thus, the return on investment must be more than the price increase (inflation) To ascertain the exact benefit and increase in wealth due to investment, the return on investment must be measured in terms of real rates and not nominal rates. To maximize the wealth of investors, the rate of return on investment must be more than the inflation rates

6. The nominal interest rate varies directly with the expected inflation rates. This proposition is known as the Fisher Effect Quoted interest rates in a country reflect anticipated real returns adjusted for local inflation expectations In day-to-day transactions we use nominal interest rates It is the risk-free interest rates paid on treasury bills and expresses the rate of exchange between the current money and future money When prices change the value of money also change Decrease in prices increases the value and vice versa Investors consider value of money not in nominal but real

7. Since the investors are concerned with the real interest rate, the nominal interest rate composes of two elements :- 1. The real interest rate or the required rate of return and 2. The expected rate of inflation The fisher effect postulates relationship between nominal or actual interest rate and real or inflation adjusted rate of return

8. The relationship, now can be expressed in the following equation I + r = (1 + I) x (1 + a) Where :- r = Nominal rate a = real rate or expected rate of return I = inflation rate In case the inflation rate is low, the product terms of I x a can be ignored, then r≈ 1+a or r≈ r – I

9. The concept of real return can be extended to international investment also Accordingly, international return is guided by real return and not nominal return Now suppose – an American wants to invest his savings of $1000. Two countries are available – India and Pakistan Nominal return in India is 10% and that in Pakistan is 15% Which country the American prefer? However, Inflation rate in India is 6% and that in Pak is 12%. In this case, the exact benefit will be 4% (10-6) in India and 3% (15-12) in Pak. Now his decision will be reversed

10. In the long run, through the interaction of the market forces, international investment will balance How? In the present situation Americans prefer India for investments, and they are interested in Bonds. Increase in the foreign demand for Bonds in India, would increase the cost of debentures, resulting in the decline of real rate of returns At the same time, less demand for bonds result in decline of bond prices in Pakistan but, return remain the same. Availability of cheaper bonds and higher rate of return attract American investors to that country This leads to increase demand for bonds and to raise the bonds prices. Ultimately bond prices and rate of return of the two countries balance or reach in equilibrium And now aht = aft Where aht is the real rate of the home country during the number of years and aft is the real rate of the foreign country during the period

11. Fisher effect also throws light into the international monetary policy followed by countries Developing countries, especially, those with deficit balance of payment in current account, to attract foreign investment offer higher (or increase) nominal rates of interest. The inflow of foreign capital, increases the supply of foreign exchange, and surplus foreign exchange in capital account can be used to make good of the deficit in current account Fisher effect also says that foreign capital can be attracted through controlling inflation. But considering the difficulty in controlling inflation rate, politicians and authorities go to nominal rates. However, controlling of inflation rate is the better policy

12. Thus, there is a direct relationship between nominal interest rate and inflation rate. High inflation leads to high interest rate To offset the effect of high rate of inflation higher interest rate is to be offered Investment will take place only when the nominal rate of interest is higher than the real rate Further, if the real rate of interest is common in all countries of the world, the difference in nominal rate of interest will be due to inflation

13. Since, the real rate of interest ‘a’ is the same in all the countries, the following equation will be correct in the case of two countries A and B rA – IA = rB – IB In PPP theory, we related the inflation rate with the exchange rate and calculated the spot rate On the basis of Fisher effect, now it is possible to calculate the spot exchange rate by relating the relationship between interest rate and inflation rate Percentage change d = domestic country and f = foreign country

14. INTEREST RATE PARITY (IRP) Developed by Lord Keynes in 1930 Cornerstone of today’s international financial transactions PPP is based on Law of one price of commodities, IRP is also based on Law of one price of securities Argues that, when securities are quoted in a common currency, identical securities should have the same price

15. Interest rate parity is an equilibrium condition in which interest rate differential between two countries is offset by the forward premium or discount, so that a forward contract cannot be used to make a gain based on the interest rate differential IRP is based covered interest arbitrage Interest rate differentials between countries tend to be offset by the forward premium or discount between currencies Although it is called IRP it discusses the exchange rates as well as interest rates