International Parity Conditions

Ch 7
7-2
International Parity Conditions
Some fundamental questions managers of MNEs, 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.
7-3
International Parity Conditions
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.
7-4
Prices and Exchange Rates
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 products price should be the same in both
markets.
This is called the law of one price.
7-5
Prices and Exchange Rates
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:
P
$
x S = P


Where the product price in US dollars is (P
$
),
the spot exchange rate is (S) and the price in
Yen is (P

).

7-6
Prices and Exchange Rates
If the law of one price were true for all goods and services,
the purchasing power parity (PPP) 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 PPP
exchange rate that should exist if markets were efficient.
This is the absolute version of the PPP theory.
Exhibit 7.1 Selected Rates from the
Big Mac Index
7-8
Prices and Exchange Rates
If the assumptions of the absolute version of
the PPP theory are relaxed a bit more, we
observe what is termed relative purchasing
power parity (RPPP).
RPPP holds that PPP 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.
7-9
Prices and Exchange Rates
More specifically, with regard to RPPP:

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.
7-10
Exhibit 7.2 Relative Purchasing Power
Parity (PPP)
7-11
Prices and Exchange Rates
Empirical testing of PPP and the law of one price
has been done, but has not proved PPP to be
accurate in predicting future exchange rates.
Two general conclusions can be made from these
tests:
PPP holds up well over the very long run but poorly
for shorter time periods; and,
the theory holds better for countries with relatively
high rates of inflation and underdeveloped capital
markets.
7-12
Prices and Exchange Rates
Individual national currencies often need to
be evaluated against other currency values to
determine relative purchasing power.
The objective is to discover whether a nations
exchange rate is overvalued or
undervalued in terms of PPP.
This problem is often dealt with through the
calculation of exchange rate indices such as
the nominal effective exchange rate index.
Exhibit 7.3 IMFs Real Effective Exchange Rate Indexes for
the United States, Japan, and the Euro Area
7-14
Prices and Exchange Rates
Incomplete exchange rate pass-through is one reason that a countrys
real effective exchange rate index can deviate
The degree to which the prices of imported and exported goods change
as a result of exchange rate changes is termed pass-through.
Although PPP implies that all exchange rate changes are passed through
by equivalent changes in prices to trading partners, empirical research in
the 1980s questioned this long-held assumption.
For example, a car manufacturer may or may not adjust pricing of its cars
sold in a foreign country if exchange rates alter the manufacturers cost
structure in comparison to the foreign market.

7-15
Prices and Exchange Rates
Pass-through can also be partial as there are many
mechanisms by which companies can compartmentalize or
absorb the impact of exchange rate changes.
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 goods own price.

7-16
Exhibit 7.4 Exchange Rate Pass-
Through
7-17
Interest Rates and Exchange Rates
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):
i = r +
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).

7-18
Interest Rates and Exchange Rates
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.
7-19
Interest Rates and Exchange Rates
More formally:
S
1
S
2

Where i
$
and i

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.
S
2
= i
$
- i

7-20
Interest Rates and Exchange Rates
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.

7-21
Interest Rates and Exchange Rates
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/US
dollar exchange rate (F
SF
/$90) is found by multiplying the
current spot rate (S
SF
/$) by the ratio of the 90-day euro-Swiss
franc deposit rate (i
SF
) over the 90-day eurodollar deposit rate
(i
$
).

7-22
Interest Rates and Exchange Rates
Formulaic representation of the forward rate:
F
SF/$
90
= S
SF/$
x [1 + (i
SF
x 90/360)]


[1 + (i
$
x 90/360)]
7-23
Interest Rates and Exchange Rates
The forward premium or discount is the
percentage difference between the spot and
forward exchange rate, stated in annual
percentage terms.
f
SF
= Spot Forward

This is the case when the foreign currency
price of the home currency is used (SF/$).
Forward
360
days
100 x x
7-24
Interest Rates and Exchange Rates
The theory of Interest Rate Parity (IRP)
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.
7-25
Exhibit 7.5 Currency Yield Curves and
the Forward Premium
7-26
Exhibit 7.6 Interest Rate Parity (IRP)
7-27
Interest Rates
and Exchange Rates
The spot and forward exchange rates are not, however,
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.
This is known as covered interest arbitrage (CIA).
7-28
Exhibit 7.7 Covered Interest Arbitrage
(CIA)
7-29
Interest Rates
and Exchange Rates
A deviation from covered interest arbitrage is uncovered interest
arbitrage (UIA).
In this case, 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 no 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.
7-30
In the yen carry trade, the investor borrows Japanese yen at relatively low interest rates, converts the proceeds to another currency
such as the U.S. dollar where the funds are invested at a higher interest rate for a term. At the end of the period, the investor
exchanges the dollars back to yen to repay the loan, pocketing the difference as arbitrage profit. If the spot rate at the end of the
period is roughly the same as at the start, or the yen has fallen in value against the dollar, the investor profits. If, however, the yen
were to appreciate versus the dollar over the period, the investment may result in significant loss.
Exhibit 7.8 Uncovered Interest Arbitrage (UIA): The Yen
Carry Trade
7-31
Interest Rates
and Exchange Rates
The following exhibit 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.
7-32
Exhibit 7.9 Interest Rate Parity
(IRP) and Equilibrium
7-33
Interest Rates
and Exchange Rates
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.
7-34
Exhibit 7.10 Forward Rate as an Unbiased Predictor for Future
Spot Rate
7-35
Exhibit 7.11 International Parity Conditions in Equilibrium
(Approximate Form)
7-36
Mini-Case Questions: Currency Pass-
Through at Porsche
Which do you believe is most important for sustaining the sale
of the new Carrera model, maintaining a profit margin or
maintaining the U.S. dollar price?
Given the change in exchange rates and the strategy
employed by Porsche, would you say that the purchasing
power of the U.S. dollar customer has grown stronger or
weaker?
In the long run, what do most automobile manufacturers do
to avoid these large exchange rate squeezes?

A case study of how a euro-based cost structure must deal
with foreign currency pricing in target markets
Currency Pass-Through
at Porsche
Currency Pass-Through at Porsche
Based in Germany, and with manufacturing and assembly
exclusively located in Germany, Slovakia, and Finland,
Porsches entire cost base is the euro or Slovakian koruna
(which is managed by the Slovakian government to maintain
stability against the euro).
This means that all of the direct costs in its automobile
manufacturing are incurred (for practical purposes) in euro-
denominated operations (cost, markup, basic pricing).
The three different product lines (911, Boxster, Cayenne) are
then exported and distributed through distributors in the
major industrial country markets.
Porsche therefore has little local sourcing or local currency
costs in the non-European markets where it sells more than
half its total annual volumes.

Currency Pass-Through at Porsche
If Porsche were not actively managing this exchange rate
exposure, the company would see declining profitability or
at least declining rates of profitable growth as a result of
its euro-denominated products priced and sold in non-euro
currency environments like the US dollar.
Assuming there is a limit to the price consumers in US dollar
market are willing and able to pay for Porsche products, the
US price will hit a ceiling, and, if the euro continues to rise
against the dollar, this will result in declining margins, or
declining volumes, or both.
A simple numerical example using the following equation
can make the limitations of a dollar-price readily apparent.
Price
$
= Price

x Spot
$/

Pass-Through Analysis for the 911 Carrera 4S Cabriolet, 2003
Pricing NA Launch
Price Component Apr May Jun Jul Aug Sep Oct Nov Dec
Full cost 74,696 74,696 74,696 74,696 74,696 74,696 74,696 74,696 74,696
Margin (@ 15%) 11,204 11,204 11,204 11,204 11,204 11,204 11,204 11,204 11,204
European price 85,900 85,900 85,900 85,900 85,900 85,900 85,900 85,900 85,900
Spot rate ($/) 1.0862 1.1565 1.1676 1.1362 1.1286 1.1267 1.1714 1.1710 1.2298
Base price in US$ $93,305 $99,343 $100,297 $97,600 $96,947 $96,784 $100,623 $100,589 $105,640
if 100% pass-through
Target price in US$ $93,200 $93,200 $93,200 $93,200 $93,200 $93,200 $93,200 $93,200 $93,200
Spot rate ($/) 1.0862 1.1565 1.1676 1.1362 1.1286 1.1267 1.1714 1.1710 1.2298
Price received in euros 85,804 80,588 79,822 82,028 82,580 82,719 79,563 79,590 75,785
Less full cost ( 74,696) ( 74,696) ( 74,696) ( 74,696) ( 74,696) ( 74,696) ( 74,696) ( 74,696) ( 74,696)
Residual margin 11,108 5,892 5,126 7,332 7,885 8,024 4,867 4,894 1,089
Margin (%) 14.9% 7.9% 6.9% 9.8% 10.6% 10.7% 6.5% 6.6% 1.5%
Effective Margin on 4S Cabriolet With Capped US$ Price
Assume that Porsche established what it considered the target price in April 2003, when the exchange rate was $1.0862/. This allowed Porsche to price ni a
margin of approiximately 15% on a full-cost basis, with a European price of 85,900 and a target North American price of $93,200, which preserved the 15%
margin.
Actual North American launch of the 4S Cabriolet did not occur until July. By then, the spot ecxhange rate had effectively By then, the spot exchange rate
had effectively reduced the margin earned by Porsche on the new model. As 2003 continued, the margin continued to erode.
Currency Pass-Through at Porsche
Currency Pass-Through at Porsche: Case
Questions
1. Which do you believe is more important for sustaining the
sale of the new Carrera model, maintaining a profit margin
or maintaining the U.S. dollar price?
2. Given the change in exchange rates and the strategy
employed by Porsche, would you say that the purchasing
power of the U.S. dollar customer has gotten stronger or
weaker?
3. In the long run, what do most automobile manufacturers
do to avoid these large exchange rate squeezes?