Multinational Finance Dipresentasikan oleh Kelompok 1 Fiona Fitriyanto Tassya Andini

The foreign exchange (FX) market Basic questions and definitions Four theories
Purchasing Power Parity Interest Rate Parity

Fisher condition for capital market equilibrium

Expectations theory of forward rates
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Some currency rates as of November 29, 2012:

Per IDR:
Currency
AUD EUR GBP HKD JPY SGD THB

Value
1.00 1.00 1.00 1.00 100.00 1.00 1.00

Sell
10,104.20 12,511.94 15,469.22 1,246.24 11,765.14 7,903.44 314.59

Buy
10,002.81 12,385.66 15,310.67 1,233.77 11,645.35 7,823.60 311.06

USD

1.00

9,658.00

9,562.00

Some forward currency rates as of May 24, 2004:

U.S. dollars per Euro (bid prices):
Spot rate One-month forward 3 months forward 6 months forward 12 months forward 24 months forward 1.2017 1.20062 1.19898 1.19789 1.19854 1.19804

Why arent FX rates all equal to one? Why do FX rates change over time? Why dont all FX rates change in the same direction? What drives forward rates the rates at which you can trade currencies at some future date?
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Difference in interest rates 1 + r 1 + r$

Interest Rate parity

Fisher Theory

Exp. difference in inflation rates 1 + iSFr 1 + i$

Relative PPP

Difference between forward & spot rates F/$ Exp. Theory s/$ of forward
rates

Expected change in spot rate E(s/$) S/$

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Law of One Price Versions of PURCHASING POWER PARITY

Absolute PPP

Relative PPP

A commodity will have the same price in terms of common currency in every country
In the absence of frictions (e.g. shipping costs,

tariffs,..)
P = s/$ P$

Example Price of wheat in France (per bushel): P Price of wheat in U.S. (per bushel): P$ S/$ = spot exchange rate
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Example:
Price of wheat in France per bushel (p) = 3.45 Price of wheat in U.S. per bushel (p$) = $4.15 S/$ = 0.83215 (s$/ = 1.2017)

Dollar equivalent price of wheat in France

= s$/ x p

= 1.2017 $/ x 3.45 = $4.15

When law of one price does not hold, supply and demand forces help restore the equality As the supply of product A increases relative to others, the price of product A must decrease relative to others
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Extension of law of one price to a basket of goods: States that equilibrium exchange rate between the domestic and the foreign currencies equals the ratio between the domestic and foreign price levels.

Absolute PPP examines price levels

Apply the law of one price to a basket of goods with price P and

PUS (use upper-case P for the price of the basket):

where

P = i (wFR,i p,i ) PUS = i (wUS,i pUS,i )

S/$ = P / PUS
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If the price of the basket in the U.S. rises relative to the price in Euros, the U.S. dollar depreciates:
May 21 : s/$ = P / PUS

= 1235.75 / $1482.07 = 0.8338 /$

May 24: s/$ = 1235.75 / $1485.01 = 0.83215 /$

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Britain, Big Mac: 1.99 pound/3.41 USD , Implies a PPP exchange rate of: 0.58 pound The actual exchange rate is 0.50 Pound was 16% overvalued. Big Mac is not objective because its price containing local tax, location, local service, etc.
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Using Tall Latte index, the purchasing power of each individual national currency can be reflected in the U.S.-dollar cost of a latte in that country. In theory, if currency markets function with proper efficiency, the price of an identical product, such as a Starbucks latte, should have an identical U.S.-dollar cost in any country. Therefore, if a latte costs significantly less in one country than another, this suggests that the country with the cheaper latte price has an undervalued currency.
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Main idea The difference between (expected) inflation rates equals the (expected) rate of change in exchange rates:
1 + i = E(s/$) 1 + i$ s/$

The currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation adjustment of various rates and prices to inflations
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The German hyperinflation (192023) and the lessons thereof. Inflation peaked at 200 billion percent in 1923. In 1922, Germanys highest currency denomination was 50,000 mark. By 1923, the highest denomination was 100,000,000,000,000 mark. In December of 1923 one US dollar was equal to 4,000,000,000,000 marks!.

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Yugoslavia, 1993 (500 billion dinar for a gallon of milk!)

Yugoslavias Central Bank introduced a 500 billion dinar bank note around Christmas 1993. It marked another milestone in the countrys descent into economic chaos.

In November 1993, inflation topped 600,000 %.

In 1992, the U.S dollar was worth 1,000 dinar. By Christmas 1993, it took 180 trillion of the same 1,000 dinar notes to equal one dollar!

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The Law of One Price frequently does not hold. Absolute PPP does not hold, at least in the short run.
See The Economists Big McCurrencies

The data largely are consistent with Relative PPP, at least over longer periods.
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Simplistic model Why does PPP not hold?

Imperfect Markets

Statistical difficulties

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Simplistic model

Transportation costs Tariffs and taxes Consumption patterns differ Non-traded goods & services Sticky prices Markets dont work well

Imperfect Markets

Statistical difficulties

Construction of price indexes - Different goods - Goods of different qualities

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Exp. difference in inflation rates 1 + i 1 + i$

Relative PPP

Expected change in spot rate E(s/$) S/$

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Main idea: There is no fundamental advantage to borrowing or lending in one currency over another This establishes a relation between interest rates, spot exchange rates, and forward exchange rates
Forward market: Transaction occurs at some point in future BUY: Agree to purchase the underlying currency at a predetermined

exchange rate at a specific time in the future SELL: Agree to deliver the underlying currency at a predetermined exchange rate at a specific time in the future

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Suppose you will need 100,000 in one year Through a forward contract, you can commit to lock in the exchange rate f$/ : forward rate of exchange
Currently, f$/ = 1.19854 1 buys $1.19854 1 $ buys 0.83435

At this forward rate, you need to provide $119,854 in 12 months.

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START (today) $117,228

r$=2.24%
(Invest in $)

END (in one year)

$117,228 1.0224 = $119,854

s/$=0.83215

One year

f/$=0.83435

$117,228 0.83215 = 97,551

(Invest in ) r=2.51%

97,551 1.0251 = 100,000

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Main idea: Either strategy gets you the 100,000 when you need it. This implies that the difference in interest rates must reflect the difference between forward and spot exchange rates Interest Rate Parity:
1 + r = f/$ 1 + r$ s/$

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Generally, it holds Why would interest rate parity hold better than PPP?
Lower transactions costs in moving currencies

than real goods

Financial markets are more efficient that real

goods markets
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Difference in interest rates 1 + r 1 + r$

Interest Rate parity

Exp. difference in inflation rates 1 + i 1 + i$

Relative PPP

Difference between forward & spot rates fr/$ s/$

Expected change in spot rate E(s/$) s/$

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Main idea: Market forces tend to allocate resources to their most productive uses So all countries should have equal real rates of interest The difference in interest rates is equal to the expected difference in inflation rates. Nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations. R =a+I Relation between real and nominal interest rates: (1 + rNominal) = (1 + rReal)(1 + i ) (1 + rReal) = (1 + rNominal) / (1 + i )
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Fisher condition in U.S. and France: (1 + r$(Real)) = (1 + r$) / (1 + i$) (1 + r(Real)) = (1 + r) / (1 + i)

If real rates are equal, then the Fisher condition implies:
1 + r = 1 + r$ 1 + i 1 + i$
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Difference in interest rates 1 + r 1 + r$

Interest Rate parity

Fisher Theory

Exp. difference in inflation rates 1 + i 1 + i$

Relative PPP

Difference between forward & spot rates f/$ s/$

Expected change in spot rate E(s/$) s/$

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Main idea:
States that if the forward rate is unbiased, then

it should reflect the expected future spot rate. The forward rate equals expected spot exchange rate
f/$ = E(s/$)

Expectations theory of forward rates:

f/$ = E(s/$ ) s/$ s/$
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With risk, the forward rate may not equal the spot rate
Group 1: Receive in six months, want $ Wait six months and convert to $ Sell forward Group 2: Contracted to pay out in six months Wait six months and convert $ to Buy forward

or

or

If Group 1 predominates, then E(s/$) < f/$ If Group 2 predominates, then E(s/$) > f/$
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Difference in interest rates 1 + r 1 + r$

Interest Rate parity

Fisher Theory

Exp. difference in inflation rates 1 + i 1 + i$

Relative PPP

Difference between forward & spot rates f/$ Exp. Theory s/$ of forward
rates

Expected change in spot rate E(s/$) s/$

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When a parity condition fails to hold, the structure of international financial markets may influence investors strategy of borrowing, investing, hedging, speculating, or making investment location decisions. If absolute PPP does not hold, sellers have the power to price discriminate across countries and buyers have incentives to overcome barriers to access lower cost goods. If IRP does not hold, the cost of borrowing or return on investment (with forward cover) differs depending on which currency is used therefore it is possible to find superior investment or lower cost funds without incurring foreign exchange risk. If IFE does not hold, investments with higher expected returns and funds with lower expected costs are possible but these contain exposure to currency risk. Rational for the IFE is that a country with a higher interest rate will tend to have a higher inflation rate. This increased level of inflation should cause the currency in the country with the high interest rate to depreciate against that of a country with lower interest rate.

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I. II.

Balance-Of-Payment Categories The International Flow Of Goods, Services, And Capital Coping With Current Account Deficits

II.

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Definition An accounting statement that summarizes all the economic transactions between residents of the home country and residents of all other countries. Purpose Measures all financial and economic transactions over a specified period of time. BoP is Double-entry bookkeeping i.e. a source of funds => credits a use of funds => debits

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Three Major Accounts (a/c): 1. Current a/c 2. Capital a/c 3. Financial a/c Total amount of Debit should equals to Credit; or

Current a/c balance + Finance a/c balance + Financial a/c balance = BoP = 0

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1. Current Account

To records net flow of goods, services, and unilateral transfers (Gifts, grants, both private and government.) . Export and Import is included. Often called The balance on current spending.

It tells whether we are spending more abroad than foreigners are spending in our country (ignoring investment flows and accommodating flows).
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2. Capital Account (minor a/c)

Record transactions that are undertaken, without exchange, in fixed assets or in their financing (such as: development aid). I.e. Migrants funds represent the shift of the migrants networth to or from US.

3. Financial Account

Records public and private investment and lending. Capital Inflows = credit; Outflows = debit
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3. Financial Account (cont.)

Classified as:
Portfolio Investments

Purchases of financial assets with maturity more than 1 year; and short-term investments involve securities with maturity less than one year. Direct Investments Investments where the management control is exerted. Government borrowing and lending are included. Other Investments
i.e. Gold, foreign currency by official monetary institutions, etc.

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The Balance-of-payment measures: I. Basic Balance

Focuses on transaction considered to be fundamental to

the economic health of currency. It indicates the extent to which long-term investments are affecting the balance of payments. Includes: Balance of current a/c and long-term capital. Emphasizes long-term trends & Excludes short-term capital flows that heavily depend on temporary factors.

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II. Net Liquidity Balance

Measures the change in private domestic borrowing or lending require to keep payments equal without adjusting official reserves.

III. Official Reserve Transactions Balance

Measures adjustments needed by official reserves to achieve BoP equilibrium. Assume that official transaction are different from private transaction.

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Set of basic macroeconomic identities which link domestic spending and production to current and capital accounts.
I. Domestic Savings and Investment and the Capital Account NI NS = S I
*NI NS S I = National income = National Spending = Saving = Investments

*If NI >NS, S > I which implies that surplus capital spent overseas*
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Background
NI = Consumption + S
NS = Consumption + I

NI NS = S - I

Implications
A nation which produces more than it spends will save more than it

invests domestically with a net capital outflow producing a capital account deficit. A nation which spends more than it produces has a net capital inflow producing a capital account surplus. A healthy economy will tend to run a current account deficit.
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II. The Link Between The Current And Capital Accounts

NFI = E - I

*NFI E I

= Net Foreign Investment = Export = Import

Background NI - NS = E - I S - Investment = E - I

S Investment = E - I
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Implications

If Current a/c is in surplus, the nation must be a net exporter of capital. If Current a/c is a deficit, the nation is a major capital importer. When NS > NI, the excess must be acquired through foreign trade.

Solutions for Improving CA deficits: 1. Raise national income (output) relative to domestic investment (I). 2. Increase (S) relative to domestic investment (I).

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III. Government Budgets And Current Account Deficits

CA = Saving Surplus Government budget deficit

CA Deficit The nation is not saving enough to finance (I) and the deficit. CA Surplus The nation is saving more than needed to finance its (I) and deficit.

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I. Currency Depreciation Many believes that devaluation can reduce the trade deficit. Based on US experience in 1980s, the trade deficit kept worsening on the other hand of US depreciation.

I. i. Lagged Effects The simplest explanation that time is needed for an exchange rate. I. ii. J-Curve Theory A decline in currency value will initially worsen the deficit before improvement.

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Net change in trade balance

0

Currency depreciation

Trade balance improves

TIME

Trade balance initially deteriorates

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I. iii. Devaluation and Inflation Weaker currency tend to result in higher domestic inflation. II. Protectionism The imposition of tariffs, quotas, or other forms of restraint against foreign imports. III. Ending Foreign Ownership of Domestic Assets If foreigners can not hold claims on the nation, they will export an amount equal in value only to what they are willing to import.

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IV. Boosting the Saving Rate Stimulating saving behavior. V. External Policy Better understanding of External Policy

Further Impact of Current a/c deficit Increasing unemployment rate??

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Helps forecast a country's market potential, especially in the short-run. A country experiencing a serious BOP deficit is not likely to import as much as if it were running a surplus. The BOP is an important indicator of pressure on a country's foreign exchange rate, unstable currency results in exchange gains or losses! Continuing deficit in a country's BOP may signal weak controls on outgoing capital movements, such as payment of dividends, fees, interest on foreign investment. Continuing surpluses in a country's BOP may indicate that country's strong international position, and therefore a potentially good location for an operating subsidiary, or portfolio investment.

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