PARITY CONDITIONS IN

INTERNATIONAL FINANCE
AND CURRENCY
FORECASTING
INTERNATIONAL FINANCIAL
MANAGEMENT

BY GROUP 4
 BEST TEAM

Nabila Khairunnisa Adinda Salma Nadhira Revellin Rizki Prameswari

2010532040 2010532019 2010532023
TABLE OF CONTENT
Arbitrage and The Law of One Price
Purchasing Power Parity
The Fisher Effect
The International Fisher Effect
Interrest Rate Parity Theory
The Relationship Between The Forward
Rate and The Future Spot Rate
Currency Forecasting
ARBITRAGE AND THE
LAW OF ONE PRICE
ARBITRAGE PRICING THEORY is a way to determined the prices of some
asset based on law of one price. identical goods sell for the same price
wordlwide

WHY ARBITRAGE IS NEEDED?

Arbitrage arbitrage is necessary because of the existence of security
prices caused by price inaccuracies. this occurs when the price of one
asset differs from the price predicted using the valuation model

BASIC ASSUMPTIONS IN USING ARBITRAGE PRICING THOERY

Capital markets in perfect competition conditions
Investors always prefer more wealth than less with certainty
Asset income can be raised following the K factor model
THE FISHER EFFECT
 THE FISHER EFFECT
to determined relationship between inflation and interest rates
(nominal and real). The increase in the inflation rate causes a
proportionate increase in interest rates in the country

nominal interest rate : refers to the pre-

inflation rate, also refers to the stated
interest rate on loans without taking into
additional interest
real interest rate : the interest rate
received by saving investors or lenders
after inflation
 THE FISHER EFFECT

Benefit of the Fisher Effect

provide information about the wishes of investors and borrowers
provide information about the position of power of a person or a
company
provide information about the growth of business profits and
others
THE INTERNATIONAL
FISHER EFFECT
 THE INTERNATIONAL FISHER EFFECT
IFE is the currency of a country with low interest rates is expected to increase than
the currency of a country with high interest rates. high interest rates will be
compensated by a decrease in the exchange rate of the country's currency or vice
versa.

if there is no compensation through the mechanism of increasing and decreasing

the currency, there will be a flow of capital from countries with low interest rates to
countries with high interest rates.

IMPLICATIONS OF IFE
Currency with the lower interest rate expected to appreciate relative to one
with a higher rate.
Financial market arbitrage: insures interest rate differential is an unbiased
predictor of change in future spot rate.
THE INTERNATIONAL FISHER EFFECT

example : suppose the interest rate on one

year insured U.S. bank deposit is 9% and the
rate on one year insured Birtish bank
deposit is 10%. what does the IFE predict
will happen to the exchange trate?
PURCHASING POWER
PARITY
 PURCHASING POWER PARITY

.Purchasing power parity (PPP) was first stated in a

rigorous manner by the Swedish economist Gustav
Cassel in 1918. He used it as the basis for recommending
a new set of official exchange rates at the end of World
War I that would allow for the resumption of normal trade
relations
Purchasing power parity states that price levels should
be equal worldwide when expressed in a common
currency. In other words, a unit of home currency should
have the same purchasing power around the world.
 The Big Mac PPP, put together by The Economist, is the exchange
rate that would leave hamburgers costing the same overseas as in
the United States.

However, the Big Mac standard is somewhat misleading because

you are buying not just the hamburger but also the location.
The relative version of purchasing power parity, which is used more
commonly now, states that the exchange rate between the home
currency and any foreign currency will adjust to reflect changes in
the price levels of the two countries.

For example, if inflation is 5% in the United States and 1% in Japan,

then the dollar value of the Japanese yen must rise by about 4% to
equalize the dollar price of goods in the two countries.
Purchasing power parity is often represented by the following
approximation of Equation:
THE LESSON OF PURCHASING POWER PARITY

Nominal exchange rate is the actual exchange rate, may

be of little significance in determining the true effects of
currency changes on a firm and a nation.
Real exchange rate is the nominal exchange rate
adjusted for changes in the relative purchasing power of
each currency since some base period
EXPECTED INFLATION AND EXCHANGE RATE CHANGES

Changes in expected, as well as actual, inflation will cause

exchange rate changes. An increase in a currency’s expected
rate of inflation, all other things being equal, makes that
currency more expensive to hold over time (because its
value is being eroded at a faster rate) and less in demand at
the same price. Consequently, the value of higher-inflation
currencies will tend to be depressed relative to the value of
lower-inflation currencies, other things being equal.
THE MONETARY APPROACH

Purchasing power parity has been reformulated into the

monetary approach to exchange rate determination.
M = National Money Supply
P = The general price level
y = GDP
v = Velocity of Money
PWe can rewrite above equation in terms of growth rates to
give the determinants of domestic inflation:

h = the domestic inflation rate

μh = the rate of domestic money supply expansion
gyh = the growth in real GDP
gvh = the change in the velocity of the domestic
EMPIRICAL EVIDENCE

The general conclusion from empirical studies of PPP is that

the theory holds up well in the long run, but not as well over
shorter time periods

In summary, despite often lengthy departures from PPP,

there is a clear correspondence between relative inflation
rates and changes in the nominal exchange rate. However,
for reasons that have nothing necessarily to do with market
disequilibrium, the correspondence is not perfect.
INTERREST RATE PARITY
THEORY
 THE THEORY STATES:
The IRP theory states that the difference in interest rates on
international money markets will tend to be the same as the
forward rate premium or discount.

Based on
IRP theory will determine/estimate how much the forward
rate (FR) exchange rate changes compared to the spot rate
(SR) if there is a change in interest rates, for example
between a home country and a foreign country.

According to the IRP, the magnitude of the change in FR to

SR is determined by the magnitude of the forward rate
premium or discount that arises as a result of the difference
in interest rates between home and foreign countries.
 THE THEORY STATES:

Thus the fund owner will determine in which currency or

foreign exchange the funds will be invested.

The Spot Rate is the exchange rate of a foreign currency

against a certain domestic currency at the time a transaction
occurs or the nominal exchange rate on that day.

Forward rate is the rate set now or when the transaction is

made to be completed or submitted at a later date
IILLUSTRATION:

Suppose an investor with $1,000,000 to invest for 90 days is trying to

decide between investing in U.S. dollars at 8% per annum (2% for 90
days) or in euros at 6% per annum (1.5% for 90 days). The current spot
rate is €0.74000/$, and the 90-day forward rate is €0.73637/$.

Specifically, $1,000,000 invested in dollars for 90 days will yield

$1,000,000×1.02 = $1,020,000.
IILLUSTRATION:
Alternatively, if the investor chooses to invest in euros on a hedged
basis, he will Convert the $1,000,000 to euros at the spot rate of
€0.74000/$.

This yields €740,000 available for investment.

1. Invest the principal of €740,000 at 1.5% for 90 days. At the end of

90 days, the investor will have €751,100.

2. Simultaneously with the other transactions, sell the €751,100 in

principal plus interest forward at a rate of €0.73637/$ for delivery in
90 days. This transaction will yield €751,100/0.73637 = $1,020,000 in
90 days.
If ih > if is then we will get p > 0 or positive, meaning forward rate
premium and FR > SR

• If ih < if, you will get p < 0 or negative, meaning forward rate
discount and FR < SR

• Thus, by taking into account the difference in interest rates

between the 2 countries, an investor will be able to determine in
what currency his funds should be invested.
THE RELATIONSHIP BETWEEN
THE FORWARD RATE AND THE
FUTURE SPOT RATE
THE UNBIASED FORWARD RATE

A. States that if the forward rate is unbiased,

then it should reflect the expected future
spot rate.

B. Stated as

ft = et

et is the expected future exchange rate at

time t (units of home currency per unit of
foreign currency) and

ft is the forward rate for settlement at time t.

CURRENCY FORECASTING
FORECASTING MODELS

Created to forecast exchange rates

in addition to parity conditions.
Two types of forecast:
1. Market-based
2. Model-based
 derived from market indicators.
MARKET-BASED
FORECASTS: A. The current forward rate contains
implicit information about exchange
rate changes for one year.

B. Interest rate differentials may be

used to predict exchange rates
beyond one year.

.
 include fundamental and technical
MODEL-BASED analysis.
FORECASTS
A. Fundamental relies on key
macroeconomic variables and
policies which most like affect
exchange rates.

B. Technical relies on use of

1.Historical volume and price data
2.Charting and trend analysis

.
THANK YOU