International

Financial
Management
Alan Shapiro & Peter Moles
Adapted by Dr. Jayanta Kumar Seal

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
Seal
 CHAPTER 4

Currencies: Expectations,
Parities, and Forecasting

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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ARBITRAGE AND THE LAW OF
ONE PRICE
I. THE LAW OF ONE PRICE

A. States that identical goods sell for

the same price worldwide.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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ARBITRAGE AND THE LAW OF
ONE PRICE
B. Theoretical basis
If the prices after exchange-rate adjustment were
not equal, arbitrage for the goods worldwide ensures
that eventually they will be.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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ARBITRAGE AND THE LAW OF
ONE PRICE
C. Five parity conditions result from these
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).

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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ARBITRAGE AND THE LAW OF
ONE PRICE
D. Five parity conditions linked by

1. The adjustment of various rates and

prices to inflation.

2. The notion that money should have

no effect on real variables (since
they have been adjusted for price
changes).

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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ARBITRAGE AND THE LAW OF
ONE PRICE
E. Inflation and home currency depreciation

1. Jointly determined by the growth of

domestic money supply.

2. Relative to the growth of domestic

money demand.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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ARBITRAGE AND THE LAW OF
ONE PRICE

F. The Law of One Price

‒ enforced by international arbitrage.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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PURCHASING POWER PARITY
I. THE THEORY OF PURCHASING
POWER PARITY
States that spot exchange rates between
currencies will change to the differential in inflation
rates between countries.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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PURCHASING POWER PARITY

II. ABSOLUTE PURCHASING POWER PARITY

A. Price levels adjusted for

exchange rates should be equal
between countries.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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PURCHASING POWER PARITY

II. ABSOLUTE PURCHASING POWER

PARITY

B. One unit of currency has same

purchasing power globally.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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PURCHASING POWER PARITY

III. RELATIVE PURCHASING POWER PARITY

A. States that the exchange rate of one

currency against another will adjust to
reflect changes in the price levels of
the two countries.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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PURCHASING POWER PARITY
1. In mathematical terms:

where et = future spot rate

e0 = spot rate
ih = home inflation
if = foreign inflation
t = the time period

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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PURCHASING POWER PARITY
2. If purchasing power parity is expected to hold,
then the best prediction for the one-period spot rate
should be written as:

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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PURCHASING POWER PARITY
3. A more simplified but less precise relationship is
written:
et
 ih  i f
e0
that is, the percentage change should be
approximately equal to the inflation rate
differential.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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PURCHASING POWER PARITY
4. PPP states:
the currency with the higher inflation rate is
expected to depreciate relative to the currency with the
lower rate of inflation.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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PURCHASING POWER PARITY
B. Real exchange rates
The quoted or nominal rate adjusted for a
country’s inflation rate is:

(1  i f ) t

e '
t  et
(1  ih ) t

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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PURCHASING POWER PARITY
C. Real exchange rates

1. If exchange rates adjust to inflation

differential, PPP states that real exchange rates
stay the same.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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PURCHASING POWER PARITY
C. Real exchange rates (cont’d)

2. Competitive positions:
domestic and foreign firms are unaffected.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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THE FISHER EFFECT (FE)
I. THE FISHER EFFECT (FE)
A. Definition:
States that nominal interest rates (r) are a
function of the real interest rate (a) and a premium (i)
for inflation expectations.

R = a + i

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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THE FISHER EFFECT
B. Real rates of interest

1. Should tend toward equality

everywhere through arbitrage.

2. With no government interference

nominal rates vary by the inflation
differential or
rh - r f = i h - i f

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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THE FISHER EFFECT
C. According to the Fisher Effect
Countries with higher inflation rates have
higher interest rates.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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THE FISHER EFFECT

Due to capital market integration globally,

interest rate differentials are eroding.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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THE INTERNATIONAL FISHER EFFECT
(IFE)

I. IFE

A. States that the spot rate adjusts to the interest

rate differential between two countries.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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THE INTERNATIONAL FISHER EFFECT

IFE = PPP + FE

et (1  rh ) t

e0 (1  r f ) t

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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THE INTERNATIONAL FISHER EFFECT

B. Fisher postulated:

1. The nominal interest rate differential

should
reflect the inflation rate differential.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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THE INTERNATIONAL FISHER EFFECT

B. Fisher also postulated:

2. Expected rates of return are equal in

the absence of government intervention.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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THE INTERNATIONAL FISHER EFFECT

C. Simplified IFE equation:

(if rf is relatively small)

e1  e0
rh  rf 
e0

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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THE INTERNATIONAL FISHER EFFECT

D. Implications of IFE

1. Currency with the lower interest rate is

expected to appreciate relative to the one
with a higher rate.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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THE INTERNATIONAL FISHER EFFECT

D. Implications of IFE (cont’d)

2. Financial market arbitrage:
insures interest rate differential is an unbiased
predictor of change in future spot rate.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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INTEREST RATE PARITY THEORY
I. INTRODUCTION

A. The theory states:

the forward rate (F) differs from the spot rate
(S) at equilibrium by an amount equal to the
interest differential (rh - rf) between two
countries.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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INTEREST RATE PARITY THEORY
1. The forward premium or discount equals the
interest rate differential.

where rh = the home interest rate

rf = the foreign interest rate

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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INTEREST RATE PARITY THEORY
2. In equilibrium, returns on currencies will be the
same

i.e. no profit will be realized and interest parity

exists which can be written:

F 1  rh 

S 1  rf 
INTEREST RATE PARITY THEORY
B. Covered interest arbitrage

1. Conditions required:
Interest rate differential does not equal the
forward premium or discount.

2. Funds will move to a country with a more

attractive rate.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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INTEREST RATE PARITY THEORY
3. Market pressures develop:

a. As one currency is more demanded spot

and sold forward.

b. Inflow of funds depresses interest rates.

c. Parity eventually reached.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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INTEREST RATE PARITY THEORY
C. Summary

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.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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THE FORWARD RATE AND THE
FUTURE SPOT RATE
I. THE UNBIASED FORWARD RATE

A. States that, if the forward rate (f t) is

unbiased, then it should reflect the
expected future spot rate (et).

B. Stated as:
ft = e t

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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CURRENCY FORECASTING
I. FORECASTING MODELS

A. Created to forecast exchange rates in

addition to parity conditions.

B. Two types of forecast:

1. Market-based.
2. Model-based.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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CURRENCY FORECASTING
1. Market-based forecasts
– derived from market indicators.
a. The current forward rate contains
implicit information about exchange
rate changes for one year.
b. Interest rate differentials may be used
to predict exchange rates beyond one
year.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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CURRENCY FORECASTING
2. Model-based forecasts
‒ include fundamental and technical analysis.

a. Fundamental analysis relies on key

macroeconomic variables and
policies which are most likely to
affect exchange rates.

b. Technical analysis relies on use of

1. Historical volume and price data.
2. Charting and trend analysis.

“International Financial Management” by Alan Shapiro and Peter Moles adapted by Jayanta
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