Multinational Financial

Management
Alan Shapiro
7th Edition
J.Wiley & Sons
Adapted from the Power Points by
Joseph F. Greco, Ph.D.
California State University, Fullerton
 CHAPTER 4
PARITY CONDITIONS AND
CURRENCY FORECASTING
(Part 2)
 CHAPTER OVERVIEW

• The fisher effect

• The international fisher effect
• Interest rate parity theory
• The relationship between the forward and future
spot rate
• Currency forecasting
Example 1

Assume you are a U.S. citizen.

Suppose the current U.S price level is at 112 and the Swiss price level is
at 107, relative to the base price levels of 100. Given initial value of the
Swiss Franc was $0.98, then, the real exchange rate ?

= $0.98/CHF * 112 = $1.0258

107
2) How much is the appreciation of the U.S. Dollar value of the Swiss
Franc according to the PPP?
= 1.0258 - 0.98 *100 = 4.67%
0.98
Example 2

Assume you are a U.S. citizen.

Between 1982 and 2006, the ¥/$ exchange rate moved from
¥249.05/$ to ¥116.34./$ During this same 25-year period, the
consumer price index (CPI) in Japan rose from 80.75 to 97.72 and
the U.S. CPI rose from 56.06 to 117.07 .

1)If PPP had held over this period, what would the ¥/$ exchange
rate have been in 2006?

2)What had happened to the $ value of ¥?

Example 3

Assume you are a U.S. citizen.

The real exchange rate between $ and ₹ was, ₹45.70/$ on January

2011 and that on December 2014 was ₹62.85/$. During the same
period the CPI in India rose from 107.1 to 146.6 and CPI in U.S.
moved from 126.143 to 133.926.

1)If PPP had held over the period, what should be $/ ₹ exchange rate
in December 2014?

2) What had happened to the $ value of ₹ ?

 PART III.
THE FISHER EFFECT (FE)
I. THE FISHER EFFECT states that nominal interest rates (r) are
a function of the real interest rate (a) and a premium (i) for
inflation expectations.
R = a + i
Real Rates of Interest
1. Should tend toward equality everywhere through
arbitrage.
2. With no government interference nominal rates vary by
inflation differential or
rh - r f = i h - i f
 THE FISHER EFFECT
C. According to the Fisher Effect, countries with higher inflation
rates have higher interest rates.

D. Due to capital market integration globally, interest rate

differentials are eroding.
PART IV. THE INTERNATIONAL
FISHER EFFECT (IFE)
I. IFE STATES:
A. the spot rate adjusts to the interest rate differential
between two countries.

IFE = PPP + FE

et (1  rh ) t

e0 (1  r f ) t
 THE INTERNATIONAL FISHER
EFFECT
B. Fisher postulated
1. The nominal interest rate differential should reflect the
inflation rate differential.

2. Expected rates of return are equal in the absence of

government intervention.
THE INTERNATIONAL FISHER
EFFECT
C. Simplified IFE equation: (if rf is relatively small)

e1  e0
rh  rf 
e0
 THE INTERNATIONAL FISHER
EFFECT
D. Implications of IFE
1. Currency with the lower interest rate expected
to appreciate relative to one with a higher rate.

2. Financial market arbitrage: insures interest rate

differential is an unbiased predictor of change in future spot
rate.
Example 4

Assume you are a U.S. citizen.

In July, the one-year interest rate is 2% on Swiss franc and 7% on

U.S Dollars.

1.If the current interest rate is CHF1=$0.91, what is the expected

future exchange rate in one year?

et (1  rh ) t

e0 (1  r f ) t
Example 5

Assume you are a U.S. citizen.

In July, the one-year interest rate is 7.25% on Indian rupees and

0.25% on U.S Dollars.

1.If the current interest rate is ₹65.60 = $1, what is the expected
future exchange rate in one year?

et (1  rh ) t

e0 (1  r f ) t
 PART VI. INTEREST RATE PARITY
THEORY
I. INTRODUCTION

A. The Theory states:

the forward rate (F) differs from the spot rate (S) at equilibrium by an
amount equal to the interest differential (r h - rf) between two countries.
 INTEREST RATE PARITY
THEORY
2. The forward premium or discount equals the
interest rate differential.
(F - S)/S = (rh - rf)
where rh = the home rate
rf = the foreign rate
3. In equilibrium, returns on currencies will be the same i. e. No
profit will be realized and interest parity exists which can be
written
(1 + rh) = F
(1 + rf) S
 INTEREST RATE PARITY THEORY
B. Covered Interest Arbitrage
1. Conditions required: interest rate differential does
not equal the forward premium or discount.
2. Funds will move to a country with a more attractive rate.
3. Market pressures develop:
a. As one currency is more demanded spot and sold forward.
b. Inflow of fund depresses interest rates.
c. Parity eventually reached.
 INTEREST RATE PARITY
THEORY
C. Summary:
Interest Rate Parity states:
1. Higher interest rates on a currency offset by
forward discounts.
2. Lower interest rates are offset by forward
premiums.
 PART VI. THE RELATIONSHIP BETWEEN THE

FORWARD AND THE FUTURE SPOT RATE

I. 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 = e t
 PART VI. CURRENCYFORECASTING
I. FORECASTING MODELS
A. Created to forecast exchange rates in addition to parity
conditions.
B. Two types of forecast:
1. Market-based
2. Model-based
 CURRENCY FORECASTING
MARKET-BASED FORECASTS:

derived from market indicators.

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.
 CURRENCY FORECASTING
MODEL-BASED FORECASTS:

include fundamental and technical analysis.

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