MBA (Finance specialisation)

&

MBA – Banking and Finance

(Trimester)

Term VI

Module : – International Financial Management

Unit II: Foreign Exchange Markets

Lesson 2.3 (Theories of Exchange rate – Interest rate parity theory and International fisher effect )

Interest Rate Parity relationshipThis relationship links interest rates of two countries with spot and future exchange rates. It was made popular in 1920s by economists such as John M. Keynes. The theory underlying this relationship says that premium or discount of one currency against another should reflect interest rate differential between the two countries. In perfect market conditions, where there are no restrictions on the flow of money and there are no transaction costs, it should be possible to gain the same real value of one's monetary assets irrespective of the country (or currency) in which they are invested.

Interest Rate Parity relationshipFor example, an investor has one unit of pound sterling. He can invest it in the UK money market and earn an interest of it on it. The resulting value after one year will be:

£1 (1 +i£) Alternatively, he can buy So dollars (the current exchange rate being So dollars = 1 pound sterling) and invest this dollar amount in US money market. The end value after one year will be:

$So (1 + i$) The equilibrium condition demands that these two sums be equal. If the two sums were not equal, then the investor would invest in that currency where the end value of their monetary assets is going to be more.

Interest Rate Parity relationshipBut once this action is generalized by the similar expectations of all investors, equilibrium is going to be reestablished. Thus, inequilibrium situation,

$S0 (1 + i$) = £1(1 + i£) $S0 [ (1 + i$)/(1 + i£) ] = £1

This expression on the left side of the above equation is future exchange rate. We can write

S1 = S0 [ (1 + i$)/(1 + i£) ] This expression can be written for any two currencies, A and B, by replacing dollar and pound sterling. Thus,

S1 = S0 [ (1 + iA)/(1 + iB)].The above equation is known as Interest rate parity relationship.

Problems – Based on IRPProblem1 If the current exchange rate between US dollar and euro is $1.20/ € and , the interest rates are 4% p.a. on dollar and 3% p.a. on euro, respectively, what is expected rate after one year?

Problem2 Six – month interest rates on Indian rupees and pound sterling are 8% and 5% p.a. respectively. The current exchange rate is Rs 79/£.Estimate the exchange rate of 6 month later.

Problem3 Exchange rate between rupee and Swiss franc is Rs 33/SFr at the reference period and is found to be Rs 33.40/SFr after 9 months. Nine month interest rate on rupee is 8% p.a. What should have been corresponding interest on Swiss franc?

International Fisher effectAccording to relative form of purchasing parity theory Forward /premium discount = difference in inflation rate of two countriesAccording to interest rate parity theory Forward /premium discount = difference in interest rate of two countries.Combining the two , we have , Difference in inflation rate = Difference in interest rate , or

(rhome – rforeign ) = (ihome – iforeign )

(rhome – ihome ) = (rforeign – iforeign ) The above equation implies that , in the absence of restrictions on trade flows and capital flows the expected real rate of return on capital tends to equalise. The above equation is referred as Fisher Open Condition or International fisher effect.

Deviations from Purchasing Power Parity Relationship

Though this relationship has a sound theoretical base, in practice, it does not always give satisfactory results. There are differences between the exchange rate predicted by the PPP and the actual future rate. Several factors could be responsible for the deviation.

a) One factor could be inflation rates themselves that are used for calculating future exchange rates.

b) PPP takes into account only movement of goods and services. It does not factor in the capital flows.

c) Government intervention in the exchange market directly or through trade restrictions.

d) Speculative activity in the exchange market.

Deviations from IRP relationship

Reasons

a) Capital controlsb) Transaction costs.

Exchange Rate and Foreign exchange reserves

Foreign Exchange reserves have an impact on exchange rate. Though there is no direct mathematical relationship between the level of reserves and exchange rate, yet there is a logic that links the two. First, let us see what the reserves are meant for. Why does any country maintain foreign exchange reserves? A country has to meet its financial obligations to the outside world. These obligations are broadly in the form of debt service requirements and payments to be made for imports. Debt service includes both interest and installments of the principal falling due for payment. In case, the reserves are able to meet these obligations comfortably, the level of reserves going up or down slightly does not have nay visible impact on exchange rate.

Exchange Rate and Balance of Payment

It has been established through observation and empirical studies that a deficit in Balance of Payment (BOP) causes depreciation of the domestic currency. When a country is importing more than its exports, the demand for foreign currencies increases. This increasing demand can be met by increasing capital inflows. As a result, the trade deficit may not have very significant impact on the exchange rate. However, if the demand for foreign currency is met by drawing down the existing foreign exchange resources, then the adverse impact on exchange rate will be more pronounced. The foreign currency due to its increased demand will harden while the domestic currency will depreciate.

Exchange Rate and Technical Analysis

Technical analysis refers to the process of estimating exchange rate by extrapolating the past data. The technical analysts (or chartists as they are also called) use daily, weekly or monthly data to generate charts and then try to discern certain definite patterns. They believe that these patterns are likely to repeat for some time in future, enabling the chartists to predict exchange rates.

Practice ProblemsProblem 1: Given ( Home Country : India , Foreign Country : U.S.) Spot Rate (Rs/$) = 626 mths Forward rate = 62.5Interest rate in India = 12%Interest rate in U.S. = 8%Is there any arbitrage possibility in the above case ? If yes, how an arbitrager can benefit from the same.

Problem 2: Given Home Country : India , Foreign Country : U.S. Spot Rate (Rs/$) = 626 mths Forward rate = 63Interest rate in India = 12%Interest rate in U.S. = 10%Is there any arbitrage possibility in the above case ? If yes, how an arbitrager can benefit from the same.