Sponsored By ELIAS J. LUBENGO.

CURRENT OVERVIEW OF INTERNATIONAL BUSINESS

IN TANZANIA

CONTEXT

FOREIGN DIRECT INVESTMENT

INTRODUCTION

FDI stands for Foreign Direct Investment, a component of a country’s national financial
accounts. Foreign Direct Investment is investment of foreign assets into domestic structures,
equipment, and organizations. It does not include foreign investment into the stock markets.
Foreign Direct Investment is more useful to a country than investments in the equity of its
companies because equity investments are potentially “hot money” which can leave at the first
sign of trouble, whereas FDI is durable and generally useful whether things go well or badly.
Foreign Direct Investment (FDI) is the key driver of economic growth in any developing
economy. The purpose of FDI is to stimulate economic growth, and in particular, FDI positively
affects the country’s balance of Payments position.

Conflicting interest of MNC’S AND African Governments

MNC’s have different objectives for investing outside their countries of origin. Their objectives
are likely to be contrary to the expectations of host countries. These conflicts of interest feature
more in less developed countries than in the developed countries. The need to address these is
important at early stage before MNC’s embark on investing huge amount of capital sums in any
country especially if the prospective country of investment has high political risks.

Host country expectations from Multinational Corporations are more on the positive benefits,
which these companies will bring such as promotion of national development, introduction of
new technology, promoting domestic industrial competition. They would like to see that there
is higher protection, which benefits the host country’s infant industries. These objectives and
expectations of the host countries are completely different from MNC’s expectations.

MNC’s expect that investments in other countries should help them to enhance global
competitiveness, achieve lower taxes and benefit from higher protection due to tariffs. Despite

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the benefits that MNC’s are likely to bring to host countries, these conflicting objectives create
relationship problems and misunderstanding with host governments.

Major Determinants of Foreign Direct Investments.

Multinational corporations have different motives of diversifying their investments

internationally. These motives are not likely to be the same from one corporation to another.
However, the following motives are more common in all MNCs. They include the following:

1. Market
Multinationals corporations’ motives of investing abroad are the causes of a desire to
obtain markets for their products. African and Asian countries’ population provides a big
market for these corporations. The selection of the market by MNC’s is the result of
combinations of various factors such as the type of the product and cultural climate of
the host countries. Consider for example a toy manufacturing company located in the
USA, which may want to open a production plant in Uganda, it may be difficult for this
company to open a production plant in Uganda, as it is likely to have no market for the
toys especially in the rural areas.

2. Raw Materials
Africa has comparative advantages over other continent in terms of natural resources,
which provide raw materials for multinational corporations from developed countries.
MNCs from developed countries have opened productions plants in different parts of
Africa simply because these countries are rich in natural resources. Typical examples of
these companies are the mining and oil prospecting companies in Uganda and Tanzania
respectively.

3. Labour
Availability of labour in host countries is another incentive as to why MNCs decide to
open production units outside their countries of origin. Skilled labour is considered
cheaper in Asian countries by MNC’s which is a reason as to why many corporations
from USA and Europe open production plants in these countries which is not the case in
African countries. Again, on one side we see that some types of investments by MNC’s
cannot be feasible in Africa because there are low numbers of skilled labours to work for
them especially where the MNCs are more inclined to use sophisticated technology.

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 4. Good infrastructure
Availability of good infrastructure in a host country might influence the decisions of the
MNCs’ in investing abroad. Africa has poor economic infrastructure. In major parts of
Africa, there are poor road networks, poor communications systems, poor or
inadequate power generations plants, which discourages MNCs that wish to set up
production plants.

Importance of Foreign Direct Investment to Africa

Foreign direct investments, in different ways, play a great role in most African countries. In fact,
there is a greater relationship between foreign direct investment and development of African
countries. Most countries, which have well utilized the FDIs, have highly benefited and their
economies have improved to a certain degree. The importance of FDI’s includes the following;

1. Provision of Additional Capital.

Countries enjoy additional capital brought in by multinationals, which may not be available
from local sources. The existence of foreign banks in Africa countries like the Standard Charter
Bank, supermarkets like shoprite and other international hotels like holidays inn, Sheraton
Hotel and many others is a typical example of extra funds brought in through FDI’s.

2. Increased competition in terms of price, Quality and wider products choices.

A monopolistic type of businesses has characterized African countries over a long time. The
liberalization trade policies introduce from the beginning of the eighties has allowed MNC has
to do business in these countries thus bringing competition in terms of prices, quality and wider
choice of products. Local companies no longer have monopoly in businesses.

3. Access to international markets.

MNCs have a wider access to international markets than local companies such that their
involvement in host countries can create markets of local products which are produced by
these companies in a host country. The operations of the MNC’ s in developing countries helps
these countries gain access to international markets. We have typical examples in East Africa
where there are industries, which now are producing different products for export to
international markets, which could not be possible without the existence of the MNCs

4. Contribution to GNP
Foreign direct investment contributes to the increase of production of goods and services
which in the end has greater contributions to the growth of the national Gross Domestic

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Product. Foreign direct investments have the potential to increase the flow of business capital
in the economy that helps to increase economy productivity in a nation.

5. Introduction of new products

The diverse business type brought by the growth of the economy due to increase of FDIs will
result in increased variety of products, which could not be possible before.

6. Widening the tax base.

FDIs increase or widen the areas in which the government can collect taxes. This is the result
of creation of more business organizations leading to increased income generation activities,
which leads to a wider tax base in the economy. In the end, this is likely to increase government
revenues.

7. Employment creation
When multinationals come and invest in a country, they help to create more opportunities
for employment and this improves the living standards of the citizens. Most MNCs that have
moved from developed countries to less developed countries and the developing countries
have created a number of employment positions to the indigenous populations. Typical
examples are companies like Serena Hotel, MTN, Vodacom and other telecommunication
companies.

The Impairing Factors of FDIs in LDCs

1. Inadequate infrastructure
The infrastructure in less developed countries such as those in Africa is inadequate such that
it limits the capital inflows of funds from outside.
There are very poor roads, small airports, outdated technology and poor capacities to generate
power.

2. High level of corruption in all sectors

The level of corruption in Africa is still very high which creates many bureaucratic problems
for business registration and growth. In some parts of Africa, it takes many days and months for
foreign companies to obtain business registrations. This indicates poor governance of most
African countries, which has contributed to the FDIs relocated.

3. Political instability

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 In other parts of Africa, political instability creates insecurities to foreign investors. Political
instability has contributed to wars and conflicts. Typical examples of African countries with
political instability are Sudan, Chad and Somalia. The wars have impaired the growth of foreign
direct investments in these parts of Africa.

4. Inability of African countries to enforce contracts

This happens when new governments come into power and they fail to honour the
agreements reached by their predecessors. Non-honouring of agreements reached by investors
with the previous governments will discourage future investors.

5. Inadequate number of trained human resources

In most African countries, the human capacity is still under developed. The level of
education is still low. Most foreign investors would prefer employing staff who have the
knowledge and skills to do the work.

6. Economic Sanctions
Economic sanctions on some African countries create a negative factor for inflow of foreign
direct investment into a country. In Africa, Zimbabwe is one of those countries where sanctions
from developed countries and international financial institutions affected the foreign direct
investments. Investors will always shy away from economics that are high risky.
In Zimbabwe, foreign Direct Inflows increased significantly from an average of US$8 million
in the 1980s to an average of US$95 million in the 1990s. Due to the negative impact of
sanctions, FDIs declined to averages of US$20.4 million in the new millennium. Reflecting this,
most multinational corporations such as Anglo-American were strongly discouraged from
investing in Zimbabwe by their home countries. This adversely affected investment levels into
the country, thus, accentuating the foreign exchange shortages leading to shortages of fuel and
imported raw materials.

7. High costs of energy

Due to increased costs of power and sometimes lack of electricity because of high
dependence on water filling of dams during rains seasons, productivity of industries is impaired.
Dry seasons in Africa have tremendous effect on electricity production, thus many African
countries have not managed to attract FDIs.

The role of African Government In promoting Foreign Direct Investments

Government can play a major role as monetary and fiscal policies with aim of promoting the
foreign direct investments. The strategies that have been common in Africa countries do not

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have greater variation from one country to another. There are common features that have
been used as a strategy to increase the FDIs, which some of these strategies are mentioned
below.

1. Set up One Investment Centre

One area of focus for African countries is on dismantling the bureaucracy that has stifled
business development as well the foreign direct investments. Africa governments have to take
steps to streamline the establishment of one-step-shop for investors to obtain the required
registration. Typicall examples of one stop center are in Zambia, Tanzania, Uganda and Kenya.

2. More Incentives for Investment

African countries need to ensure that there are continuous improvements to their
investment environment. There must be some more tax incentives, which aim toward
establishing a climate for increased domestic industrial growth, attracting foreign investment
and promoting exports and developing the private sector.

3. Building economic infrastructure

African countries need to review their capital expenditure budgets and provide more funds
to develop their economic infrastructure. There must be more effort to address the inadequacy
in roads, create capacities to build modern electricity, power generation plants and improve
and build airports and airports.

4. Promote and enhance law and order

In order to promote FDIs there is needto promote a proper regulatory framework that
enhances law and order and that can encourage foreign investments inflows. Where there are
no proper laws in a country, foreign investors are discouraged too.

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 FOREIGN EXCHANGE MARKET (FEM)

Foreign exchange means money of a foreign country.

Why FEM?

Any international transaction requires the use of foreign currency.

Where should one get foreign currencies?

Foreign currency can be obtained from a foreign exchange market (FEM).

What is a FEM?

• The foreign exchange market is the market in which participants are able to buy, sell,
exchange and speculate on currencies. Foreign exchange markets are made up of
banks, commercial companies, central banks, investment management firms, hedge
funds, and retail forex brokers and investors.
• The foreign exchange market is a global decentralized market for the trading
of currencies.
• It is a market where national currencies are bought and sold against one another.

It should be noted that the FEM is not a physical place; rather it is an electronically linked
network of banks, foreign exchange brokers, and dealers whose function is to bring together
buyers and sellers of foreign currency.

FEM provides the physical and institutional structure through which the money of one country
is exchanged for that of another country, the rate of exchange between currencies is
determined, and foreign exchange transactions are physically completed.

The FEM is not confined to any one country but it is dispersed throughout the leading financial
centers of the world such as a London, New York, Tokyo,Paris,Amsterdam and many other
centers. Ie geographically, the FEM spans the globe

Historically, trading in FEM has been done by telephone, telex, or the SWIFT system(Society for
Worldwide Interbank Financial Telecommunications) which is an international bank-
communications network connecting banks and broker-dealers in different countries .
However, there is currently a growing competition from Internet-based system that allow both
banks and non financial companies to connect to a secure payments network,

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Participants of FEM

i. Commercial Banks

These are the market makers as they actively deal in foreign exchange for their own accounts.
ie. They buy and sell currencies at the exchange rate they declare.

Commercial banks deal with both their customers, as well as the interbank market (ie with
other banks)

ii. Retail clients/commercial customers (businesses, MNCs, International investors)

These are the price takers as they always buy currencies at price determined by commercial
banks or dealers

IeThey are not direct participants

iii. Foreign exchange brokers

These are specialists in matching net supplier and demander banks (ie bringing buyers and
sellers together).

They receive a small commission on all trades eg in USA approximately $312.50 on a $1 million
trade.

Advantages of brokers

• They supply information (at which rates various banks will buy or sell a currency)
• They provide anonymity to the participants until a rate is agreed to
• They help banks minimize their contacts with other banks

However, there is a rising competition by electronic brokers.

iv. Central banks

These intervene in the market by buying and selling their currencies in order to smooth
exchange rate fluctuations or to maintain target (desired) exchange rates.

v. Foreign exchange dealers

These are participating in FEM (buying and selling) for their own account)g Bureau de change

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These participate in the FEM through the commercial banks; they are under the supervision of
the central banks.

vi. Other financial institutions

Eg investment banks

TYPES OF FOREIGN EXCHANGE MARKET

Two types: (The Spot market and the Forward Market)

➢ The Spot Market:this is the market in which currencies are traded for immediate
delivery, which is actually within two business days after the transaction has been
concluded

“Spot exchange rate” (spot rate)=the price of one currency in terms of another currency for
immediate delivery

➢ The Forward Market: this is the market in which contracts are made to buy or sell
currencies for future delivery

Forward exchange rate (forward rate)=the price of one currency in terms of another currency
fixed today for future delivery

The Spot Market

Spot Quotations: two ways ie direct quotation or indirect quotation

❖ Direct quotation: this is an exchange rate quote that states the number of units of home
currency needed to buy a single unit of the foreign currency:

EgTshs 2300/US $ or Tshs 2300=US$

Note that, this is a direct quotation of US$ in terms of TShs.

❖ Indirect quotation: this is an exchange rate quote that states the number of units of
foreign currency needed to buy a single unit of the home currency:

Eg US$ 00006/Tsh or US$ 00006= Tsh

Note that, this is indirect quotation of US$ in terms of TSh

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Quotes are always given in pairs (Pairwise Quotation)

❖ The first rate is the buy or bid price

❖ The second rate is the sell, or ask, or offer price

Eg suppose today the US$ is quoted at Tsh 2300-20: This quote means the banks are willing to
buy US$ at Tshs 2300 and sell them at Tshs 2320;

Cases:

What about a customer of the bank who wants to buy US$?

What about a customer of the bank who wants to sell US$?
What about a customer of the bank who wants to buy Tshs?
What about a customer of the bank who wants to sell Tshs?

The Bid-Ask Spread

This refers to a difference between the bid (buy) price and ask (sell) price that belongs to the
dealer as a profit (or margin). This profit (spread) is usually stated as a percentage.

Percent Spread= (Ask price – Bid price)/Ask price x 100

Example

Suppose today the US$ is quoted at Tsh 2300-20. What is the percent spread?

Cross Rate

This is the rate between two currencies calculated via a given common currency.

Formular: cross rate of “a” per “b” is the rate for “a” divided by the rate for “b”

NB. Before calculating cross rate, make sure the common currency is directly quoted

Example

Consider the following quotation:

• TShs 2200/US$
• KShs 220/US$

Required: what is the cross rates for TShs and KShs?

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Solution:

✓ NB. ; the common currency (ie US$) is directly quoted

✓ Formular: cross rate of “a” per “b” is the rate for a divided by the rate for b
✓ Thus Cross rate for TShs/KS= TShs 2200/US$D ÷KShs 220/US$
✓ The answer is Cross rate between TShs and KShs =TShs 10/KS

Case: what is the cross rates for Kshs/TShs?

Why calculating Cross rates?

i. Cross rates are used by arbitrageurs to detect opportunities of profit from “Inter-market
Arbitrage” or Triangular Currency Arbitrage.

NB:if cross rate and actual quotation differ opportunity for profit

ii. When information is not available on the exchange rates

Triangular Currency Arbitrage

Triangular arbitrage (also referred to as cross currency arbitrage or three-point arbitrage) is

the act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three
different currencies in the foreign exchange market.

Steps of the Triangular Currency Arbitrage

i. Use the undervalued currency to acquire the common currency

ii. Convert the common currency into the overvalued currency

iii. Convert the overvalued currencyinto the undervalued currency

NB:Profit = ending amount-starting amount

Example:

The following exchange rates are available:

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 • US$ 1.2223/ €
• US$ 1.8410/£
• €1.5100/ £

Required:

i. Check on opportunity to profit from triangular arbitrage

ii. Show how an astute trader with US$ 1,000,000 would benefit from that piece of
information.

The Forward Market

Forward rates can be expressed in two ways:

i. As an outright rate (actual rate)

ii. As a discount from or a premium on, the spot rate

Note:

A foreign currency is at premium when the forward rate is above the spot rate
A foreign currency is at discount when the forward rate is below the spot rate
A foreign currency is at par when the spot rate = forward rate

Forward differential on a foreign currency

Forward differential on a foreign currency (ieForward premium or discount on a foreign

currency) is normally expressed as an annualized percentage deviation of forward rate from the
spot rate.

Formula: Forward premium or discount on a foreign currency =

FR-SR x 12 x 100

SR months

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OR

FR-SRx 360 x 100

SR Fwd contract days

Where

FR =forward rate

SR=spot rate

A student should note the following:

The formula is applicable when the foreign currency is directly quoted

If the answer is positive, then the FR is at premium and if it is negative, then the forward
rate is at discount.
In calculating the % forward premium or discount you base on , either buying rate or
selling rate or sometimes you may calculate the average.

Example

Spot Japanese Yen (¥) on june 2005, sold at $ 0.009189, whereas 180-day forward Yen were
priced at $ 0.009360.

Required? What is the forward differential on Yen?

Solution:

Forward differential on Yen is= FR-SRx 360 x 100

SR Fwd contract days

=0.009360 -0.009189 x360 x100

0.009189 180

=3.72%

Ie this is the annualized forward premium on Yen (because the answer is positive) is 3.72%.

Ie yen is trading on premium on the forward market as compared to the spot market

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Conversion of Swap Quotations into Outright Quotations when Swap Quotation is in Point Form

Example of swap quotation in point form:

Spot Japanese Yen on June 22, 2005, sold at $0.009189, whereas 180-day forward Yen were
priced at $ 0.009360.

That quotation could be written as “On june 22,2005, the 180-day forward Yen was quoted as a
171-Point Premium.”

: Conversion rules

Rising points are added to the spot rate to arrive at the forward rate
Falling points are subtracted from the spot rate to arrive at the forward rate

Example

You have access to the following information

EURO

Spot 1 month 3 months

US $ 1.7510-90 7-9 5-3

Required

Convert the above swap quotation into outright quotation

Solution:

Note:

▪ The 7 point=1 month forward buying rate point for the EURO in terms of the US$
▪ The 5 point=3 months forward buying rate point for the EURO in terms of the US$
▪ The 9 point=1 month forward selling rate point for the EURO in terms of the US$
▪ The 3 point=3 months forward selling rate point for the EURO in terms of the US$

• 7-9 are the rising points

• 5-3 are the falling points

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Now given the information (data) above, 1 month forward rate (ie 1 month outright rate) and 3
months forward rate are arrived at as follows:

EURO (1 month forward rate)

Buying Selling
Spot: US $ 1.7510 1.7590
Add Points (since we have the rising points) 7 9
I month forward rate 1.7517 1.7599

I.e. the EURO is standing at Premium because the forward market is greater than the spot
market

EURO (3 months forward rate)

Buying Selling
Spot: US $ 1.7510 1.7590
Less Points (since we have the falling points) 5 3
3 months forward rate 1.7505 1.7587
Ie the EURO is standing at a discount

Challenges

Case I: a customer needs to buy EURO 1000 now. How many US$ will he be needed to pay?

Solution:

Trick: use selling rate in spot market

Ie US$ 1.7590/EURO x EURO 1000= US$ 1759

Case II: a customer needs to sell US $ 10,000 1 month forward. How many EURO will the
customer get?

Solution:

Trick: use the selling rate for EURO (why? Because the available information is on buying and
selling price of a single unit of EURO in terms of dollars)

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Ie

US $ 10,000

US $ 1.7599/EURO

=EURO 5682

Conversion of Swap Quotations into Outright Quotations when Swap Quotation is in Cent Form

Conversion rules

Premiums are subtracted from spot rates to arrive at the forward rates
Discounts are added to the spot rates to arrive at the forward rates

Example

You have access to the following information

Euro

Spot 1 month 3 months

US$ 1.7510 – 1.7590 2c – 10c disc 0.3c – 0.2 c pm

Required

Convert the above swap quotation into outright quotation

Solution:

Note:

▪ 2c= 1 month buying rate of the EURO in terms of US$

▪ 10c=1 month selling rate of the EURO in terms of US$
▪ 0.3c=3 months buying rate of the EURO in terms of US$
▪ 0.2c=3 months selling rate of the EURO in terms of US$

• C disc = cent discount

• C pm = cent premium

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Now given the information (data) above, I month forward rate (ie 1 month outright rate) and 3
months forward rate are arrived at as follows:

EURO (1 month forward rate)

Buying rate Selling rate

Spot: US $ 1.7510 1.7590
Add: discount 0.0200 0.1000
I month forward rate 1.7710 1.8590

Ie the EURO is standing at Premium because the forward market is greater than the spot
market

EURO (3 months forward rate)

Buying Selling
Spot: US $ 1.7510 1.7590
Less premium 0.0030 0.0020
3 months forward rate 1.7480 1.7470

Ie the EURO is standing at a discount

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 PARITY RELATIONSHIPS IN INTERNATIONAL FINANCE AND CURRENCY FORECASTING

Parity relationships (aka Parity conditions) are economic relationships between countries which
help to explain the exchange rate movements.

There are five basic Parity Relationships:

Purchasing Power Parity (PPP)

Fisher Effect (FE)
International Fisher Effect (IFE)
Interest Rate Parity (IRP)
Expectations Hypothesis (EH)

Purchasing Power Parity (PPP)

It is an idea that the exchange rates adjusts to keep purchasing power constant among
currencies.

There are two forms (versions) of PPP:-

i. Absolute PPP
ii. Relative PPP

Absolute PPP

It states that the spot rate is determined by the relative prices of similar baskets of goods.

This is basically an application of a Law of One Price (LOP) that states, “a commodity costs the
same regardless of what currency is used to purchase it or where it is selling”.

Now basing on this LOP and therefore absolute PPP, the exchange rate between two
currencies should be the ratio of price of a particular commodity in the two countries.

Formula: The algebraic expression of Absolute PPP is therefore:

EFt= PDt/(PFt)

Where;

EFt Exchange rate at time t (ie spot rate)

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PDt=Domestic currency price of a commodity at time t

PFt=Foreign currency price of a commodity at time t

NB;EFt= number of units of domestic currency needed to purchase a unit of foreign currency (ie
direct quotation of a foreign currency)

Example

Suppose a loaf of bread in Tanzania sells for TZS 600/= whereas in London the price is £0.4.
What is the “implied” spot exchange rate basing on absolute PPP or LOP?

Solution

✓ Absolute PPP implies that EFt= PDt /(PFt)

✓ Data given:

PDt=TZS 600

PFt=£0.4

EFt=?

✓ Workings

EFt=PDt/PFt =TZS 600/£0.4 =TZS 1500/£

Therefore: the implied (aka calculated) exchange rate=TZS 1500/£

NOTE: because of profit potential due to differences between equilibrium exchange rate and
the actual rate, forces are set in motion to change the exchange rate and/or to the price of
bread

Challenge

Suppose the actual exchange rate is TZS 2000/£, how could a trader benefit from this situation?
(i.e. commodity arbitrage)

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Solution:

Note that, a commodity arbitrageur will always purchase the commodity from the country
whose currency is undervalued in terms of the other country and ship and sell it in the other
country whose currency is overvalued.

Limitations of Absolute PPP

i. It ignores the effect of transportation cost, tariffs, quotas, and other restrictions
ii. It ignores the effect of free trade and product differentiation.

Relative PPP

It says that the change in the exchange rate is determined by the difference in the inflation
rates between two countries.

Put in other way, the exchange rate between the home currency and foreign currency will
adjust to reflect changes in price levels of the two countries.

The relative PPP simply says

et/eo= (1+ih)t/(1+if)t

Where:

et= expected exchange rate in t periods

eo= current(spot exchange rate)

ih= inflation rate in home currency

if= inflation rate in foreign currency

t= periods (in years)

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Example

The United States and Germany are having annual inflation rate of 5% and 3% respectively. The
initial exchange rate is DM 1=US $ 0.75.

Required:

Calculate the value of DM in 3 years assuming that the PPP holds

Solution:

E3/0.75 = (1+0.05)3/(1+0.03)3

E3= 0.75 × (1+0.05)3/(1+0.03)3 =US $ 0.7945

Therefore, the PPP rate for DM in three years should be US$ 0.7945

Note: Because we do not really expect absolute PPP to hold for most goods, when we refer to
PPP without further qualification, we mean relative PPP.

The Fisher Effect (FE)

The Fisher Effect (FE) relates interest rates to the expected inflation rates.

There are two versions of FE:

i. Formalized FE
ii. Generalized FE

i. The Formalised FE

It states that nominal interest rates in each country are equal to:

1) A real required rate of return “a”

PLUS
2) An inflation premium equal to the expected amount of inflation “i”

Formally, the FE is expressed as:

1+norminal rate= (1+Real rate) (1+ Expected inflation rate)

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I.e. 1+r= (1+a) (1+i)

Note: the equation is often approximated by the equation r=a+i

Example

If the required real return is 3% and the expected inflation is 10%, then FE says the nominal rate
of return will be:

1+r = (1+0.03) (1+0.1)

Nominal rate=1.33-1=13.3%

Generalized FE

The generalized FE asserts that real returns are equalized across countries through arbitrage

That is ah = af

Where;

ah= domestic country real rate

af= foreign country real rate

Why such an assertion? (that real returns are equalized across countries through arbitrage)

If expected real returns were higher in one currency than another, capital would flow from the
second to the first currency. This process of arbitrage would continue, in absence of the
government intervention, until expected real returns were equalized.

In equilibrium, then, with no government interference, it should follow that the nominal
interest rates differential will approximately equal the anticipated inflation differential between
the two countries.

In effect, the generalized FE says that currencies with high rates of inflation should bear higher
interest rates than currencies with lower rates of interest.I.e.rh-rf = ih-if

Where:

rh=nominal home currency interest rates

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rf= nominal foreign currency interest rates

ih= expected amount of inflation in home

if= expected amount of inflation in a foreign country

International Fisher Effect (IFE)

It states that the interest rate differential should be equal to exchange rate change during the
same period.

IFE is a combination of PPP and the generalized FE

Algebraically, IFE is expressed as follows:

(1+rh)t/(1+rf)t = ēt/eo

Where:

ēt= expected exchange rate in period t

eo= spot exchange rate

Note: In effect, the IFE says that currencies with low interest rates are expected to appreciate
relative to currencies with high interest rates, if the parity holds.

Example:

In July, the one-year interest rate is 4% on Swiss Francs and 13% on US$.

Required:

If the current exchange rate is SFr=$0.63, what is the expected future exchange rate in one
year?

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Solution:

According to IFE (make eta subject)

Et=eo× (1+rh)t/(1+rf)t

=0.63 × (1.13)/(1.04) = US$ 0.6845

Challenge:

If a change in expectations regarding future US$ inflation causes the expected future spot rate
to rise to $ 0.70, what should happen to the US interest rate?

Interest Rate Parity (IRP)

IRP says that the interest rate differential should equal the forward differential.

Thus IRP relates nominal interest rates to the forward rates.

NB; when IRP holds, there are no chances of making profit from “interest arbitrage”

IRP is expressed as f1/eo=1+rh/1+rf

Where:

F1=forward exchange rate at time 1

eo=spot exchange rate at time 0.

Therefore, according to IRP theory, the currency of a country with a lower interest rate should
be at a forward premium in terms of the currency of the country with the higher rate, and vice
versa.

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Covered Interest Arbitrage (CIA)

Interest arbitrage simply refers to a process involving borrowing in one currency and investing
in another and sell the investment proceeds at a profit.

Covered Interest Arbitrage refers to a process involving borrowing in one currency and
investing in another and sell the investment proceeds in a forward market at a risk free profit.

CIA means movement of short term funds between two currencies to take advantage of
interest differential with exchange risk eliminated by means of forward contract (Shapiro)

Nb: Uncovered Interest Arbitrage refers a process involving borrowing in one currency and
investing in another and sell the investment proceeds in a spot market at a profit.

When is CIA possible?

Note: opportunity for CIA will exist if IRP does not hold (ie when spot rate and forward rate are
in disequilibrium)i.e when interest rate differential is not equal to the forward differential.

When the spot and forward exchange rates are not in equilibrium state, an investor will take
advantage of such disequilibrium by investing in whichever currency that offers the higher
return on a “covered basis” I.e. by using forward contracts to take care of potential exchange
risk and therefore assuming himself of a “risk free” profit in future.

CIA Steps

i. Borrow the currency with the lower Covered Yield I.e. the currency whose Covered Yield
< the nominal rate of interest of the other currency.

How to determine Covered Yield of a currency?

• For a currency bearing the higher interest rate:

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 CY=nominal interest rate ̶ forward differential

• For a currency bearing the lower interest rate:

CY=nominal interest rate +forward differential

Nb: The period of borrowing should be equal to the length of the forward contract.

ii. Convert the borrowed amount into the second currency at the spot exchange rate
iii. Invest in an asset ( e.g. a financial security) denominated in the second currency at the
given investment interest rate for a period equal to the length of the forward contract.
iv. Simultaneously, sell the investment proceeds forward: hence the term “covered interest
arbitrage”
v. At the end of the investment period, collect the investment proceeds, fulfill the forward
contract and use the amount obtained to repay the loan (principal + interest)

Note: profit from arbitrage=investment proceeds-loan amount

Example

Suppose the interest rate on the Pound in London is 12% and the interest rate on the
comparable US$ investment in NewYork is 7%. The following information is also available:

• Pound spot rate = US$ 1.75/£

• One year forward rate US$ 1.68/£

Required

a) Are there opportunities for CIA

b) Illustrate the profit by showing the steps that an arbitrageur can take to earn profit from
the discrepancy in rates based on US$ 1,000,000 transaction. Assume that the
borrowing and lending rates are identical and the bid ask spread in the spot and forward
market is zero

Solution

a) To determine whether or not there are opportunities for profits on CIA, compare
interest rate differential with the forward differential on the Pound.

Thus,

✓ Interest rate differential= 12%-7%=5%

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 ✓ The one year forward differential on the £:

FR – SR ×12 × 100

SR n

=1.68 – 1.75× 12× 100=-4%

1.75 12

I.e. One year forward differential on Pound = 4% (iefwd discount)

✓ Now, comparing interest rate differential (5%) with the forward differential on the
Pound (4%), there exists opportunities for CIA since the two are different.

b) Steps that an arbitrageur can take to earn profit

Borrow the currency with the lower Covered Yield:
✓ Covered Yield on £= nominal interest rate - forward differential

=12% - 4%=8%

✓ Covered yield on US$= nominal interest rate +forward differential

=7% + 4% = 11%

✓ Compare CY on £ (ie 8%) with nominal interest rate on US$ (ie 7%):

CY on £> NIR on $

✓ Compare CY on US$ (ie 11%) with nominal interest rate on £ (ie 12%):

CY on $ < NIR on £

✓ Thus, US$ is a currency to borrow and automatically Pound is a currency to invest on.

To benefit from the arbitrage process the following steps will be taken:

i. Borrow US$ 1,000,000 in New York at an interest rate of 7% for one year.

Note: At the end of the year the arbitrageur must pay the principal plus the interest.

I,e. US$ 1,000,000 (1+0.07)=US$ 1,070,000.

ii. Immediately, convert $ 1,000,000 into £. This transaction will yield:

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 US$ 1,000,000/1.75=£571,428.57
iii. Invest the £ in London at 12% interest rate for one year. Ie investment proceeds at the
end of the year will be:
£571,428.57 (1+0.12) = 639,999.9 ≈ £ 640,000
iv. Simultaneously (ie with investing the £) , sell the £640,000 (investment proceeds) one
year forward using the one-year forward rate ($ 1.68/£). This transaction will yield:
£640,000 × $1.68/£ =$ 1,075,200 next year
v. At the end of the year, collect the £640,000; deliver the amount to the bank and receive
$ 1,075,200 and use $ 1,070,000 to repay the loan.
The arbitrageur will earn a profit amounting to:
Profit=investment proceeds-loan amount
$1,075,000 - $1,070,000=$5,200

Forward Expectation Hypothesis

It states that the forward rate should reflect the expected future spot rate on the date of
settlement of the forward contract.

Put this way, the current forward exchange rate is an unbiased predictor of the spot rate at that
point in the future.

The parity is expressed as follows:

F1=e1

Where:

e1=expected future spot rate at time 1

F1=forward rate for settlement at time 1

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