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PowerPoint

to accompany

Multinational
Business Finance
(2nd Edition)

Chapter 06

David Eiteman | Kevin Daly


Subhrendu Rath | Arthur Stonehill
| Michael Moffett

INTERNATIONAL PARITY
CONDITIONS

International Parity
Conditions (IPC)

The economic theories that link


exchange rates, price levels, and
interest rates together are called
international parity conditions.

These parity conditions form the


core of the financial theory that is
unique to international finance.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

International Parity
Conditions

Parity theories help to 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.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

The law of one price

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.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

A primary principle of competitive markets is that


prices will equalise across markets if frictions do
not exist.

Comparing prices then, would require only a


conversion from one currency to the other:
PAUD x S = P
Where the product price in Australian dollars is
(PAUD), the spot exchange rate is (S) and the
price in Yen is (P).

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

Law of one price

Big Mac Index

it serves as one form for comparison of whether


currencies are currently trading at market rates that are
close to the exchange rate implied by Big Macs in local
currencies.

The index works by dividing the local price of a Big


Mac by the US price of a Big Mac. This gives the PPP
exchange rate.

One problem with the Big Mac index is that Big Macs
are not exchanged across country borders

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

Law of one price

CommSec iPod index

An alternative to the Big Mac Index

Compare the iPod prices across the boarders

The difference with the Big Mac index is that iPods


can indeed be exchanged across the globe.

If they are particularly cheap in one country, it could


cause tourists to buy their iPods when on holiday,
prompt people to buy iPods online in other countries
or encourage some companies to take advantage of
arbitrage opportunities

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

(Page 165)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

If the law of one price were true for all


goods and services,

By comparing the prices of identical products


denominated in different currencies,

the real or the purchasing power parity


(PPP) exchange rate that should exist, if
markets were efficient, can be determined.

This is called as the absolute version of


the PPP theory.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

Relative purchasing power parity (RPPP)


relaxed the assumptions of the absolute
version of the PPP theory

According to the RPPP, the relative


change in prices between two countries
over a period of time determines the
change in the exchange rate over that
period

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

More specifically, RPPP says


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.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Figure 6.1 Relative Purchasing Power


Parity (PPP) (Page 167)

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

Empirical tests of purchasing power parity


theory

Empirical tests has not proved PPP to be


accurate in predicting future exchange rates
and conclude that

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.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

Exchange rate indices: real and nominal

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.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

Exchange rate indices: real and nominal

The nominal effective exchange rate index

uses actual exchange rates to create an index, on a


weighted average basis, of the value of the subject
currency over time.

does not really indicate anything about the true


value of the currency, or anything related to PPP.

calculates how the currency value relates to some


arbitrarily chosen base period, but it is used in the
formation of the real effective exchange rate index.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

Exchange rate indices: real and nominal

The real effective exchange rate index


indicates

how the weighted-average purchasing power


of the currency has changed relative to some
arbitrarily selected base period

The real effective exchange rate index for the


Australian dollar

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

The real effective exchange rate index for the Australian dollar

Prices and Exchange Rates

Exchange rate indices: real and nominal

The real effective exchange rate index indicates

how the weighted-average purchasing power of the currency


has changed relative to some arbitrarily selected base period

The real effective exchange rate index for the Australian dollar
C$
E E FC
C
$
R

$
N

E R$ Re al effective rate
E N$ No min al effective rate
C $ Australian dollar cos t
C FC Foreign currency cos t

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

(Page 168)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

What is the exchange rate and why it important?

The exchange rate is the price of an Australian dollar


expressed in terms of another currency.

Two common measures of the exchange rate used in


Australia

the exchange rate against the US dollar

the trade-weighted index (TWI)

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

What is the exchange rate and why it important?

the trade-weighted index (TWI)

not a price in terms of a single overseas currency,


but a price in terms of a basket of currencies.

often a better measure of general trends in the


exchange rate than any one bilateral exchange rate

give a measure of whether the Australian dollar is


rising or falling on average.

is calculated on the basis of the rates for the US


dollar and other currencies.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

(Page 169)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

What is the exchange rate and why it important?

the trade-weighted index (TWI)

not a price in terms of a single overseas currency,


but a price in terms of a basket of currencies.

often a better measure of general trends in the


exchange rate than any one bilateral exchange rate

give a measure of whether the Australian dollar is


rising or falling on average.

is calculated on the basis of the rates for the US


dollar and other currencies.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

(Page 171)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

The determinants of the Australian exchange


rate

A higher or lower inflation rate than its trading


partners

The TWI (in Australia) depreciated due to the


cumulatively higher inflation Australia was experiencing.

The movement in the real exchange rate is a better


measure of changes in competitiveness than the
movement in the nominal exchange rate.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

(Page 173)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

(Page 173)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

The determinants of the Australian exchange rate


2. The terms of trade

The strong increase in commodity prices that began


in 2002 boosted the terms of trade and was
associated with an increase in the real TWI.

In the current global downturn, Australia has


benefited from a reorientation of our exports towards
Asia.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

The determinants of the Australian exchange rate


2. The terms of trade

(Page 174)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

The determinants of the Australian exchange rate


3.

The effect of capital transaction

Impact of factors such as relative rates of return on


Australian dollar assets and changes in investor
confidence in Australian dollar assets

The importance of relative rates of return

high levels of investment in the resources sector

Political stability, sound macroeconomic management and


microeconomic reform

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

The determinants of the Australian exchange rate

(Page 175)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Prices and Exchange Rates

Exchange rate pass-through

The degree to which the prices of imported and exported


goods change as a result of exchange rate changes.

Pass-through can also be partial as there are many


mechanisms by which companies can compartmentalise
or absorb the impact of exchange rate changes.

Price elasticity of demand p is an important factor when


determining pass-through levels.

ep

%Qd
%P

Where
Qd Quantity demand
P product price
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The Fisher Effect

Nominal interest rates in each country are equal to the required


real rate of return plus compensation for expected inflation.

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).

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

International Fisher effect

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

Fisher-open,

The spot exchange rate should change in an equal


amount but in the opposite direction to the
difference in interest rates between two countries

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

International Fisher effect (approximation)


S1 S 2
i A$ iSF
S2

Where
S= spot exchange rate using indirect quote
iA$ and iSF=respective national interest rate

International Fisher effect


S1 S 2 i A$ iSF

S2
1 iSF

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

International Fisher effect (approximation)

Justification

Investors must be rewarded or penalised to offset


the expected change in exchange rates

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The forward rate

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.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The forward rate

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

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The forward rate

Forward rate estimation

SF

Fn

Where

A$

n
SF
1

SF
360

S A$

A$ n
1

360

F= forward exchange rate using indirect quote


S= spot exchange rate using indirect quote
iA$ and iSF =respective eurocurrency interest rat

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

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.

spot forward 360


f

100
forward
n
Y

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

provides the linkage between the foreign


exchange markets and the international money
markets.

State that 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.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

(Page 181)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

Arbitrage opportunity?

Assume that an investor has A$1,000,000 and two


alternative investment opportunities
1. invest in an Australian dollar money market instrument and would
earn the Australian dollar rate of interest
or

1 i A$

2. exchange the Australian dollars for francs at the spot rate of


exchange and invest in a Swiss franc money market instrument
of identical risk and maturity for the same period

SF

A$

1 i SF

1
F

SF

A$

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

Arbitrage opportunity?
The comparison of the return

1 i S
A$

SF

A$

1 i

SF

1
F

SF

A$

Substituting in the spot rate =SF1.4800/A$ and forward rate =SF1.4655/A$


and respective interest rates iA$ = 0.02 and iSF = 0.01 in the equation can be
found the interest rate parity condition

1 0.02 1.4800

SF

A$

1 0.01

1
1.4655

SF

A$

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)


SF
1 0.02 1.4800 A$ 1 0.01

1.4655

The gross
return to the
investor would
earn by
investing in A$
money market

SF

A$

The gross return to the Australian


investor

Exchange A$ for SF at the spot rate,


Invest the CHF proceeds in the CHF
money market
simultaneously sell the principal plus
interest in Swiss francs forward for dollars
at the current 90-day forward rate

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)


SF
1 0.02 1.4800 A$ 1 0.01

1.4655

SF

A$

Ignoring transaction costs, if the returns


in A$ are equal between the two
alternative money market investments,
the spot and forward rates are
considered to be at IRP

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

In order for the two alternatives to be equal, any


differences in interest rates must be offset by the
difference between the spot and forward exchange
rates

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

(Page 182)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

Covered interest arbitrage (CIA)

The spot and forward exchange markets are not constantly in the state
of equilibrium described by interest rate parity.

The potential for risk-less or arbitrage profit exists when the market is
not in equilibrium,.

The arbitrager will exploit the imbalance by investing in whichever


currency offers the higher return on a covered basis.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

Covered interest rate arbitrage

(Page 183)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

Covered interest arbitrage (CIA)

Arbitrage rule of thumb:


If the difference in interest rates is greater than the forward
premium (or expected change in the spot rate), invest in
the higher interest yielding currency.
If the difference in interest rates is less than the forward
premium (or expected change in the spot rate), invest in
the lower yielding currency.

Covered interest arbitrage opportunities continue


until interest rate parity is re-established

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

uncovered interest arbitrage (UIA)

A deviation of covered interest arbitrage

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 remain


uncovered and accept the currency risk of exchanging the
higher yield currency into the lower yielding currency at the
end of the period.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

(Page 185)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

The exhibit 6.13 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.

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

(Page 186)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

Forward exchange rates as an 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 means that the forward rate will, on


average, overestimate and underestimate the actual future
spot rate in equal frequency and degree.

The rationale for this relationship is based on the


hypothesis that the foreign exchange market is reasonably
efficient

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

Forward exchange rates as an unbiased predictors of future


spot exchange rates

Market efficiency assumes that


all relevant information is quickly reflected in both the spot and forward
exchange markets;
transaction costs are low; and
instruments denominated in different currencies are perfect substitutes
for one another.

Empirical studies of the efficient foreign exchange market hypothesis


have yielded conflicting results.

It appears that the forward rate is not an unbiased predictor of the


future spot rate and that it does pay to use resources to attempt to
forecast exchange rates

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Interest Rates and Exchange Rates

The of Interest Rate Parity (IRP)

(Page 187)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

International Parity Conditions

(Page 189)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

Mini-Case Questions: Porsche

Clearly, at some point sooner or later, Porsche


must raise the U.S. dollar price of this model
and all product models (particularly if the euro
continues to strengthen and maintains this
strength compared to the dollar). But when
must this step occur?

What would it take to convince Porsches


management that now is the time to passthrough more of the exchange rate change in
the price?

Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition

PowerPoint

to accompany

Additional
Chapter
Figures

(Page 176)
Copyright 2011 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442525894/Eiteman/Multinational Finance/2nd edition