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International Financial Markets: Exchange Rates, Interest Rates and Inflation Rates. Exchange Rates. Price of a unit of one currency in terms of another; e.g. £/$, €/$ People care about what a currency can bring in terms of goods & services or a rate of return - PowerPoint PPT Presentation
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International Financial Markets:Exchange Rates, Interest Rates
and Inflation Rates
Exchange Rates
• Price of a unit of one currency in terms of another; e.g. £/$, €/$
• People care about what a currency can bring in terms of goods & services or a rate of return
• How one currency trades against another depends on how each trades against goods and services or financial instruments
Parity Relationships
• In equilibrium, the same product or financial instrument should cost the same (in terms of a given currency) in any country
• Otherwise, there is an incentive to trade• How strong are the barriers to trade?
Purchasing Power Parity (PPP)
• S0, the spot exchange rate, is measured as €/$
• If the same good sells for P$ in the U.S. and Peuro in Europe, then in equilibrium:
$0$0 P
PSPSP euro
euro
Checking PPP for the Big Mac
• Suppose the spot exchange rate is .7569 €/$
• In Paris, you can buy a Big Mac for €2.84, the equivalent of $3.75
• However, a Big Mac in NYC costs $3.00
• Let’s take a trip
• The secret to arbitrage: do it big
Paris To-Do List
1. Borrow €1 billion (@2.08375% annualized rate per day)
2. Convert to €1bil/.7569 = $1,321,178,491
3. Board plane to NYC
NYC To-Do List
1. Rent fleet of 18-wheelers
2. Buy $1,321,178,491/3.00 = 440,392,830 Big Macs
3. Return to airport and board cargo planes to Paris
Paris Return To-Do List
1. Sell 440,392,830 Big Macs @ €2.84: €1,250,715,637
2. Pay bank €1,000,114,181 (principal plus int.)
3. End day, tired but happy with €250,601,456 (=$331,089.253.50)
Relative PPP
If transaction costs prevent $ prices for every single good from being equated across countries, maybe the average $ price of a general market basket of goods will be equated
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Relative PPP and Expected Exchange Rates
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Expected depreciation of ¥ relative to $ is related to amount by which Japanese inflation rate exceed that in U.S.
General Relative PPP Over Time
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Interest Rate Parity (IRP)
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• F1 is the one-period forward exchange rate (say, £/$)
• If IRP doesn’t hold there is a relatively easy and low-cost arbitrage opportunity
Arbitrage Opportunity
• Ability to buy and sell perfect substitutes at different prices in 2 markets
• Earn profit with no risk and without putting up any of your own money
• Arbitrage opportunities will be driven out in an efficient capital market
General IRP Over Time
t
US
UKt
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• Suppose Ft = E(St); e.g., assume forward rates are unbiased predictors of future spot rates
• Combine IRP with PPP
IRP + Relative PPP
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• Relation between nominal interest rates in different countries and their relative inflation rates
• Cross-multiply (1+RUS)t and (1+hUK)t
International Fisher Effect
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• In equilibrium, real interest rates tend to be equated across countries
International Capital Budgeting:Home Currency Approach
• Translate all foreign cash flows into $ using spot and expected future exchange rates; discount at $ discount rate
• S0 and E(St) measured as for. curr./$
TT
T
RSEC
RSEC
S
INPV
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International Capital Budgeting:Foreign Currency Approach
• Discount foreign currency (FC) cash flows at FC discount rate to find FC in FC terms
• Translate the result into $ using the spot exchange rate
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FC
T
FC R
C
R
CI
SNPV
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0
The Role of Interest Rate Parity
• If IRP holds, the relationship between RFC and R$ is given by:
tFC
t
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SR )1(
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Equivalence of the Two Approaches
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FC
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TFC
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FC
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SERS
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INPV
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