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1. Multinational Business Finance Fifteenth Edition, Global Edition Chapter 6 International Parity Conditions Copyright © 2021 Pearson Education Ltd. All Rights Reserved Slides in this presentation contain hyperlinks. JAWS users should be able to get a list of links by using INSERT+F7

2. Learning Objectives 6.1 Examine how price levels and price level changes (inflation) in countries determine the exchange rates at which their currencies are traded 6.2 Show how interest rates reflect inflationary forces within each country and currency 6.3 Explain how forward markets for currencies reflect expectations held by market participants about the future spot exchange rate 6.4 Analyze how, in equilibrium, the spot and forward currency markets are aligned with interest differentials and differentials in expected inflation

3. International Parity Conditions (1 of 2) Some fundamental questions managers of M N E s, international portfolio investors, importers, exporters and government officials must deal with every day are: What are the determinants of exchange rates? Are changes in exchange rates predictable? The economic theories that link exchange rates, price levels, and interest rates together are called international parity conditions . These international parity conditions form the core of the financial theory that is unique to international finance.

4. International Parity Conditions (2 of 2) These theories do not always work out to be “true” when compared to what students and practitioners observe in the real world, but they are central to any understanding of how multinational business is conducted and funded in the world today. The mistake is often not with the theory itself, but with the interpretation and application of said theories.

5. Prices and Exchange Rates (1 of 2) If the identical product or service can be: sold in two different markets; and no restrictions exist on the sale; and transportation costs of moving the product between markets are equal, then the product’s price should be the same in both markets. This is called the law of one price .

6. Prices and Exchange Rates (2 of 2) A primary principle of competitive markets is that prices will equalize across markets if frictions (transportation costs) do not exist. Comparing prices then, would require only a conversion from one currency to the other: For long description, see

7. Appendix 1 Where the product price in U.S. dollars is the spot exchange rate is and the price in Yen is

8. Purchasing Power Parity and the Law of One Price If the law of one price were true for all goods and services, the purchasing power parity (P P P) exchange rate could be found from any individual set of prices. By comparing the prices of identical products denominated in different currencies, we could determine the “real” or P P P exchange rate that should exist if markets were efficient. This is the absolute version of the P P P theory. A fun example is the Big Mac Index published annually by the Economist. Exhibit 6.1 illustrates.

9. Exhibit 6.1 Selected Rates from the Big Mac Index For long description, see

10. Appendix 2 * These exchange rates are stated in U S$ per unit of local currency, ** Percentage under/over valuation against the dollar is calculated as (Implied – Actual)/(Actual), except for the Britain and Euro area calculations, which are (Actual-Implied)/(Implied) Source: Data for columns (1) and (2) drawn from “The Big Mac Index,” The Economist , July 13, 2017.

11. Relative Purchasing Power Parity (1 of 2) If the assumptions of the absolute version of the P P P theory are relaxed a bit more, we observe what is termed relative purchasing power parity (relative P P P). Relative P P P holds that P P P is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period. See Exhibit 6.2

12. Relative Purchasing Power Parity (2 of 2) More specifically, with regard to relative P P P: “If the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate.”

13. Exhibit 6.2 Relative Purchasing Power Parity (P P P) For long description, see

14. Appendix 3

15. Empirical Tests of Purchasing Power Parity Empirical testing of P P P and the law of one price has been done but has not proved P P P to be accurate in predicting future exchange rates. Two general conclusions can be made from these tests: P P P holds up well over the very long run but poorly for shorter time periods The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets.

16. Exchange Rate Indices: Real and Nominal Individual national currencies often need to be evaluated against other currency values to determine relative purchasing power to discover whether a nation’s exchange rate is “overvalued” or “undervalued” in terms of P P P. This problem is often dealt with through the calculation of exchange rate indices such as the nominal effective exchange rate index . For long description, see

17. Appendix 4 Exhibit 6.3 illustrates real effectives exchange rate indexes for Japan, the euro area, and the U.S.

18. Exhibit 6.3 Real Effective Exchange Rate Indexes (Base Year 2010 = 100) For long description, see

19. Appendix 5 Source: Bank for International Settlements, www.bis.org/statistics/eer/. B I S effective exchange rate (E E R), Real (C P I-based), narrow indices, monthly averages, January 1980–November 2017.

20. Exchange Rate Pass-Through (1 of 3) Exchange rate pass-through is a measure of the response of imported and exported product prices to changes in exchange rates.

21. Exchange Rate Pass-Through (2 of 3) Price elasticity of demand is an important factor when determining pass-through levels. The own-price elasticity of demand for any good is the percentage change in quantity of the good demanded as a result of the percentage change in the good’s price. For long description, see

22. Appendix 6

23. Exchange Rate Pass-Through (3 of 3) A number of emerging market countries have chosen in recent years to change their objectives and choices. These countries have shifted from choosing a pegged exchange rate and independent monetary policy over the free flow of capital (point A in Exhibit 6.4) to policies allowing more capital flows at the expense of a pegged or fixed exchange rate (toward point C in Exhibit 6.4).

24. Exhibit 6.4 Pass-Through, the Impossible Trinity, and Emerging Markets For long description, see

25. Appendix 7

26. Interest Rates and Exchange Rates (1 of 3) The Fisher effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. This equation reduces to (in approximate form): Where i = nominal interest rate, r = real interest rate and = expected inflation. Empirical tests (using ex-post) national inflation rates have shown the Fisher effect usually exists for short-maturity government securities (treasury bills and notes).

27. Interest Rates and Exchange Rates (2 of 3) The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the international Fisher effect . “Fisher-open,” as it is termed, states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries.

28. Interest Rates and Exchange Rates (3 of 3) More formally: For long description, see

29. Appendix 8 Where are the respective national interest rates and S is the spot exchange rate using indirect quotes (¥/$). Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates.

30. The Forward Rate (1 of 4) A forward rate is an exchange rate quoted for settlement at some future date. A forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought forward or sold forward at a specific date in the future.

31. The Forward Rate (2 of 4) The forward rate is calculated for any specific maturity by adjusting the current spot exchange rate by the ratio of eurocurrency interest rates of the same maturity for the two subject currencies. For example, the 90-day forward rate for the Swiss franc/U.S. dollar exchange rate is found by multiplying the current spot rate by the ratio of the 90-day euro-Swiss franc deposit rate over the 90-day eurodollar deposit rate

32. The Forward Rate (3 of 4) Formulaic representation of the forward rate: For long description, see

33. Appendix 9

34. The Forward Rate (4 of 4) The forward premium or forward discount is the percentage difference between the spot and forward exchange rate, stated in annual percentage terms. For long description, see

35. Appendix 10 This is the case when the foreign currency price of the home currency is used (S F/$). See Exhibit 6.5

36. Exhibit 6.5 Currency Yield Curves and the Forward Premium For long description, see

37. Appendix 11

38. Interest Rate Parity (I R P) The theory of Interest Rate Parity (I R P) provides the linkage between the foreign exchange markets and the international money markets. The theory states, “The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs.” See Exhibit 6.6

39. Exhibit 6.6 Interest Rate Parity (I R P) For long description, see

40. Appendix 12

41. Covered Interest Arbitrage (C I A) The spot and forward exchange rates are not constantly in the state of equilibrium described by interest rate parity. When the market is not in equilibrium, the potential for “risk-less” or arbitrage profit exists. The arbitrager will exploit the imbalance by investing in whichever currency offers the higher return on a covered basis. See Exhibit 6.7

42. Exhibit 6.7 Covered Interest Arbitrage (C I A) For long description, see

43. Appendix 13

44. Uncovered Interest Arbitrage (U I A) In the case of uncovered interest arbitrage (U I A), investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceed into currencies that offer much higher interest rates. The transaction is “uncovered” because the investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period. See Exhibit 6.8

45. Exhibit 6.8 Uncovered Interest Arbitrage (U I A): The Yen Carry Trade For long description, see

46. Appendix 14

47. Equilibrium Between Interest Rates and Exchange Rates Exhibit 6.9 illustrates the conditions necessary for equilibrium between interest rates and exchange rates. The disequilibrium situation, denoted by point U, is located off the interest rate parity line. However, the situation represented by point U is unstable because all investors have an incentive to execute the same covered interest arbitrage, which is virtually risk-free.

48. Exhibit 6.9 Interest Rate Parity and Equilibrium For long description, see

49. Appendix 15

50. Forward Rate as an Unbiased Predictor of the Future Spot Rate Some forecasters believe that forward exchange rates are unbiased predictors of future spot exchange rates. Intuitively this means that the distribution of possible actual spot rates in the future is centered on the forward rate. Unbiased prediction simply means that the forward rate will, on average, overestimate and underestimate the actual future spot rate in equal frequency and degree. Exhibit 6.10 illustrates this theory.

51. Exhibit 6.10 Forward Rate as an Unbiased Predictor of Future Spot For long description, see

52. Appendix 1 6 The forward rate available “today” (F t ) for delivery at a future time ( t + 1) is used as a forecast or predictor of the spot rate at time t + 1. The difference between the spot rate which then occurs and the forward rate is the forecast error. When the forward rate is termed an “unbiased predictor of the future spot rate,” it means that the errors are normally distributed around the mean future spot rate (the sum of the errors equals zero).

53. Prices, Interest Rates, and Exchange Rates in Equilibrium Exhibit 6.11 illustrates all of the fundamental parity relations simultaneously, in equilibrium, using the U.S. dollar and the Japanese yen.

54. Exhibit 6.11 International Parity Conditions in Equilibrium (Approximate Form) For long description, see

55. Appendix 1 7

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57. Appendix 1 Long Description for a formula expresses a currency conversion from dollars to yen. P to the power of dollar sign, times S to the power of start expression Yen sign times dollar sign end expression equals P to the power of Yen sign. Return to presentation