Transcript Financial Management in the International Corporation

REVIEW OF EXCHANGE RATE
TRANSACTIONS AND
INTERNATIONAL PARITIES
1
Parity conditions
Exchange rates, interest rates, and prices must
be linked
We start with prices...
2
Law of one price
In the absence of shipping costs, tariffs, and other
frictions, identical goods should trade for the same real
price in different economies:
Pi = s P*i
The Law of One Price holds perfectly for homogeneous
goods with low transaction costs
Why?
Examples: precious metals, wheat, oil
3
Purchasing power parity (PPP)
Purchasing Power Parity is simply the extension of the Law of
One Price to all products in two economies. It says that the
overall real price levels should be identical:
P = s P*
Example:
Costs $1400 to purchase a certain basket of U.S.
consumption goods
If Swiss Franc trades at 2 ($ per Franc), how many Swiss
Francs will the same basket cost in Geneva?
4
Relative purchasing power parity (RPPP)
Because overall economy price levels consist of different
goods in different countries, a more appropriate form of
PPP is the relative form
Relative Purchasing Power Parity asserts that relative
changes in price levels will be offset by changes in
exchange rates:
% DP - % DP* = % Ds
Or denoting inflation (%DP) as 
 - D * = %Ds
RPPP asserts that differences in inflation rates will be
offset by changes in the exchange rate
5
RPPP
Example:
A year ago, the Brazilian Real traded at $0.917/Real.
For 2011, Brazil’s inflation was 4.1% and the U.S. inflation
was 1.7%.
What should be the value of the Real today?
6
Exchange rates and asset prices
Exchange rates are determined by the relative supplies
and demands for currencies.
Since buyers and sellers are ultimately interested in
purchasing something with the currency - goods,
services, or investments - their prices and returns must
indirectly influence the demand for a given currency.
So, prices, exchange rates, and interest rates must be
linked….
7
Forward market basics
Forward Contract involves contracting today for the future
purchase or sale of foreign exchange.
8
Forward market basics
90 - day Swiss franc contract
You buy Swiss
Francs (long
position)
0
S90($/SF)
9
Forward market basics
90 - day Swiss franc contract
F90($/SF) = .8446
0
S90($/SF)
10
Forward market basics
Profit $
90 - day Swiss franc contract
Y -axes measures profits or losses
in $.
0
X- axes shows the spot price
on maturity date of the forward
contract
S90($/SF)
Forward price a buyer
will pay in dollars for
Swiss franc in 90 days
11
Forward market basics
Profit $
90 - day Swiss franc contract
Long Contract
0
S90($/SF)
F90($/SF) = .8446
If price drops to 0
then the buyer will
pay $.8446 while he could pay $0.
His loss then is -.8446
12
Forward market basics
Profit $
90 - day Swiss franc contract
Long Contract
If price is .8446
then his profit is then 0.
0
S90($/SF)
F90($/SF) = .8446
-F90($/SF)
13
Forward market basics
Profit $
90 - day Swiss franc contract
Long position
0
S90($/SF)
F90($/SF) = .8446
-F90($/SF)
14
Forward market basics
Profit $
90 - day Swiss franc contract
F90($/SF)
0
S90($/SF)
F90($/SF) = .8446
Short position
15
Law of One Price for assets
Absent frictions, identical goods must trade for identical
prices in different countries when converted into a
common currency.
The same condition should hold for assets.
One important difference between goods and assets:
Price is not paid immediately - it is paid over time in the
form of returns.
This introduces the primary friction for exchanging
assets - a friction not found in goods.
Risk.
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Law of One Price for assets
Hence, there must exist a corresponding version of LOP for
assets which requires returns to be identical across countries
once this friction has been removed:
Covered Interest Parity (CIP)
Exactly like the Law of One Price, Covered Interest Parity
requires frictionless markets to offer identical rates of returns for
identical assets.
How do make assets in two countries identical?
Eliminate risk:
1. Eliminate exchange rate risk with forward contracts.
2. Compare assets whose other risks are minimal (i.e. default).
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Law of One Price for assets
Arbitrageurs will guarantee that the following two
strategies will generate the exact same common-currency
return:
1. a. Purchasing $1 worth of U.S. short-term treasuries
(lend money).
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Law of One Price for assets
Arbitrageurs will guarantee that the following two strategies will
generate the exact same common-currency return:
1. a. Purchasing $1 worth of U.S. short-term treasuries.
b. Obtain an n-period return of 1+Rt,t+n.
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Law of One Price for assets
Arbitrageurs will guarantee that the following two strategies will
generate the exact same common-currency return:
1. a. Purchasing $1 worth of U.S. short-term treasuries.
b. Obtain an n-period return of 1+Rt,t+n.
2. a. Convert $1 into foreign currency at rate 1/st (FC/$).
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Law of One Price for assets
Arbitrageurs will guarantee that the following two strategies will
generate the exact same common-currency return:
1. a. Purchasing $1 worth of U.S. short-term treasuries.
b. Obtain an n-period return of 1+Rt,t+n.
2. a. Convert $1 into foreign currency at rate 1/st (FC/$).
b. Purchase corresponding foreign short-term treasuries
(borrow money in foreign currency).
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Law of One Price for assets
Arbitrageurs will guarantee that the following two strategies will
generate the exact same common-currency return:
1. a. Purchasing $1 worth of U.S. short-term treasuries.
b. Obtain an n-period return of 1+Rt,t+n.
2. a. Convert $1 into foreign currency at rate 1/st (FC/$).
b. Purchase corresponding foreign short-term treasuries.
c. Receive an n-period foreign currency return of 1+R*t,t+n.
22
Law of One Price for assets
Arbitrageurs will guarantee that the following two strategies will
generate the exact same common-currency return:
1. a. Purchasing $1 worth of U.S. short-term treasuries.
b. Obtain an n-period return of 1+Rt,t+n.
2. a. Convert $1 into foreign currency at rate 1/st (FC/$).
b. Purchase corresponding foreign short-term treasuries.
c. Receive an n-period foreign currency return of 1+R*t,t+n.
d. Eliminate the currency risk of the foreign return by
locking in an exchange rate of Ft,t+n ($/FC).
23
Law of One Price for assets
Arbitrageurs will guarantee that the following two strategies will
generate the exact same common-currency return:
1. a. Purchasing $1 worth of U.S. short-term treasuries.
b. Obtain an n-period return of 1+Rt,t+n.
2. a. Convert $1 into foreign currency at rate 1/st (FC/$).
b. Purchase corresponding foreign short-term treasuries.
c. Receive an n-period foreign currency return of 1+R*t,t+n.
d. Eliminate the currency risk of the foreign return by
locking in an exchange rate of Ft,t+n ($/FC).
e. Obtain an overall n-period return of:
Ft,t+n (1+R*t,t+n) / st
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Synthetic forward contract
Another way to derive the forward price of FC is replicate it
synthetically:
1. Borrow $
2. Convert to FC (at St)
3. Lend the FC.
I now effectively have a forward contract. I have committed to pay a
certain quantity of $ in the future in return for receiving a certain
quantity of FC in the future.
Through exchange rate and money markets, we can synthetically
deposit, lend, exchange currency spot, or exchange currency
forward.
We just need to keep proper track of differences between bid and
ask prices and borrowing and lending rates.
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Spot, forward, and money market relationships
Time Dimension
A
D
B
C
Sell FC Forward at bid
$
Borrow at $ loan rate
t+n
Buy FC Spot at ask
Currency Dimension
t
FC
Lend at FC deposit rate
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Spot, forward, and money market relationships
t+n
A
D
Lend at $ deposit rate
FC
B
Borrow at FC loan rate
Buy FC Forward at ask
$
t
Sell FC Spot at bid
Currency Dimension
Time Dimension
C
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Spot, forward, and money market relationships
Time Dimension
Borrow at $ loan rate
A
D
Sell FC Spot at bid
Borrow at FC loan rate
B
Sell FC Forward at bid
Lend at $ deposit rate
FC
t+n
Buy FC Forward at ask
$
Buy FC Spot at ask
Currency Dimension
t
C
Lend at FC deposit rate
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Spot, forward, and money market relationships
Time Dimension
t+n
A
D
B
C
B
Ft,t+n
$
1/(1+Rt,t+n)
L
1/sAt
Currency Dimension
t
FC
D
(1+R*t,t+n
)
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Spot, forward, and money market relationships
$
t
t+n
A
D
A
1/Ft,t+n
(1+RDt,t+n)
stB
Currency Dimension
Time Dimension
L
1/(1+R*t,t+n
)
FC
B
C
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Spot, forward, and money market relationships
Time Dimension
$
1/(1+Rt,t+n)
L
t+n
A
D
B
Ft,t+n
stB
A
1/Ft,t+n
(1+RDt,t+n)
1/sAt
Currency Dimension
t
L
1/(1+R*t,t+n
)
FC
B
C
D
(1+R*t,t+n
)
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(1) An arrow from FC to $, can be thought of
as SELLING FC or BUYING $.
(2) The reverse arrow from $ to FC represents
the reverse transaction, SELLING $ or BUYING FC.
(3) An arrow from right to left (from the future to the present),
can be thought of as borrowing - taking cash from the future
and bringing it to the present.
(4) The reverse arrow from left to right (from the present
to the future), can be thought of as investing - taking cash
that you have now and putting it away until the future.
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Exchange rate risk
Covered Interest Parity says that if we lock in the forward
rate to eliminate exchange rate risk, the common-currency
return to otherwise riskless deposits in two currencies will
be identical:
1+Rt,t+n = Ft,t+n (1+R*t,t+n) / st
What happens if we don’t lock in the forward rate?
How will the returns compare if we use an unhedged or
“uncovered” version and just convert returns at the future
spot rate?
1+Rt,t+n vs. st+n (1+R*t,t+n) / st
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Exchange rate risk
If exchange rate risk is not priced (if investors do not require
compensation for bearing exchange rate risk) then expected
returns are equal:
1+Rt,t+n vs. E [ st+n ] (1+R*t,t+n) / st
and, if those expectations are rational, on average they are
right:
1+Rt,t+n = st+n (1+R*t,t+n) / st
Alternatively, this says that on average the forward rate
equals the future spot rate:
Ft,t+n = st+n .
This is known as the unbiased forward hypothesis.
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Uncovered Interest Parity (UIP)
Put differently, if exchange rate risk is not priced, an
‘unhedged’ version of covered interest parity should
hold as well.
1+Rt,t+n = Ft,t+n (1+R*t,t+n)
st
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UIP
Put differently, if exchange rate risk is not priced, an
‘unhedged’ version of covered interest parity should
hold as well.
On average:
1+Rt,t+n = st+n (1+R*t,t+n)
st
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UIP
Put differently, if exchange rate risk is not priced, an
‘unhedged’ version of covered interest parity should
hold as well.
On average:
1+Rt,t+n = st+n (1+R*t,t+n)
st
Which can be closely approximated by the
Uncovered Interest Parity equation:
Rt,t+n - R*t,t+n = % D st,t+n.
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The Intuition of
CIP and UIP
(1) In CIP, if FC interest rates are low, how can we get US$
based investors to hold FC assets?
The answer is that we offer them a more favorable forward rate
(higher F in terms of $/FC) to offset the low FC interest rate.
So the market is working by pricing F to offset a known low FC
interest rate.
(2) In UIP, if we expect the US$ to be weaker in the future
(meaning more $ per FC) how would we get investors to
willingly hold US$ assets?
The answer is, we offer them an added bonus in the form of a
higher $ interest rate - just high enough to offset the loss of a
weaker US$. So the market is working by setting a high $
interest rate to offset an expected depreciation of the US$.
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UIP
High interest rate currencies don’t, on average, depreciate
sufficiently. There are 3 possible explanations:
1. Risk Premia: The high interest rates of discount
currencies are not only compensating investors for an
expected decline in the exchange rate, but also for the
bearing risks associated with that currency.
2. Peso Problem: Remember, UIP holds “on average.” We
may have difficulty observing the true average in the data.
High interest rate currencies may include the possibility of
extremely large depreciations which have not occurred
during the sample period.
3. Irrational Expectations: investors systematically get
the future exchange rate wrong.
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Key international relationships
40
Key international relationships
Relative
Inflation
Rates
Exchange
Rate
Change
41
Key international relationships
Relative
Inflation
Rates
RPPP:
P - P* = %Ds
Inflation differentials
are offset by changes
in spot exchange rate.
Exchange
Rate
Change
42
Key international relationships
Relative
Inflation
Rates
Purchasing
Power
Parity
Exchange
Rate
Change
43
Key international relationships
Relative
Inflation
Rates
Relative
Interest
Rates
Purchasing
Power
Parity
Exchange
Rate
Change
Forward
Exchange
Rates
44
Key international relationships
Relative
Inflation
Rates
Relative
Interest
Rates
Purchasing
Power
Parity
Exchange
Rate
Change
CIP:
Ft,t+n / st =(1+ R) /(1+ R*)
Forward differs from
spot by interest rate
differential
Forward
Exchange
Rates
45
Key international relationships
Relative
Inflation
Rates
Relative
Interest
Rates
Purchasing
Power
Parity
Exchange
Rate
Change
Covered
Interest
Parity
Forward
Exchange
Rates
46
Key international relationships
Relative
Inflation
Rates
Relative
Interest
Rates
Purchasing
Power
Parity
Exchange
Rate
Change
Covered
Interest
Parity
Forward
Exchange
Rates
47
Key international relationships
Relative
Inflation
Rates
Relative
Interest
Rates
Purchasing
Power
Parity
Exchange
Rate
Change
Covered
Interest
Parity
Forward
Exchange
Rates
Unbiased Forward:
Ft,t+n = E(st+n)
Forward is
expectation of spot
48
Key international relationships
Relative
Inflation
Rates
Purchasing
Power
Parity
Relative
Interest
Rates
Exchange
Rate
Change
Covered
Interest
Parity
Forward
Exchange
Rates
Unbiased
Forward
Rate
49
Key international relationships
Relative
Inflation
Rates
Purchasing
Power
Parity
Relative
Interest
Rates
Exchange
Rate
Change
Covered
Interest
Parity
Forward
Exchange
Rates
Unbiased
Forward
Rate
50
Key international relationships
Fisher Effect:
1+R = (1+r)(1+)
Interest rate equals
real rate plus
expected inflation
Relative
Inflation
Rates
Purchasing
Power
Parity
Relative
Interest
Rates
Exchange
Rate
Change
Covered
Interest
Parity
Forward
Exchange
Rates
Unbiased
Forward
Rate
51
Key international relationships
1+R = (1+r)(1+E())
R - R* =  - * With RIP,
interest rates reflect
expected inflation
differential.
Relative
Inflation
Rates
Purchasing
Power
Parity
Relative
Interest
Rates
Exchange
Rate
Change
Covered
Interest
Parity
Forward
Exchange
Rates
Unbiased
Forward
Rate
52
Key international relationships
Fisher Effect
and
Real Interest
Parity
Relative
Inflation
Rates
Purchasing
Power
Parity
Relative
Interest
Rates
Exchange
Rate
Change
Covered
Interest
Parity
Forward
Exchange
Rates
Unbiased
Forward
Rate
53
Key international relationships
Fisher Effect
and
Real Interest
Parity
Relative
Inflation
Rates
Purchasing
Power
Parity
Relative
Interest
Rates
Ft,t+n / st =(1+ R) /(1+ R*)
Exchange
Rate
Change
Forward
Exchange
Rates
Unbiased
Forward
Rate
54
Key international relationships
Fisher Effect
and
Real Interest
Parity
Relative
Inflation
Rates
Relative
Interest
Rates
Ft,t+n / st =(1+ R) /(1+ R*)
Purchasing
Power
Parity
Exchange
Rate
Change
Forward
Exchange
Rates
Ft,t+n = E(st+n)
55
Key international relationships
Fisher Effect
and
Real Interest
Parity
Relative
Interest
Rates
Relative
Inflation
Rates
Purchasing
Power
Parity
Uncovered Interest Parity:
R - R* = %Ds
Exchange rate changes
offset interest differentials
Ft,t+n / st =(1+ R) /(1+ R*)
Forward
Exchange
Rates
Exchange
Rate
Change
Ft,t+n = E(st+n)
56
Key international relationships
1+R = (1+r)(1+)
R - R* =  - *
Relative
Inflation
Rates
Purchasing
Power
Parity
Relative
Interest
Rates
Exchange
Rate
Change
Covered
Interest
Parity
Forward
Exchange
Rates
Unbiased
Forward
Rate
57
Key international relationships
1+R = (1+r)(1+)
R - R* =  - *
Relative
Inflation
Rates
 - * = %Ds
Relative
Interest
Rates
Exchange
Rate
Change
Covered
Interest
Parity
Forward
Exchange
Rates
Unbiased
Forward
Rate
58
Key international relationships
1+R = (1+r)(1+)
R - R* =  - *
Relative
Interest
Rates
Relative
Inflation
Rates
 -  * = %Ds
Uncovered Interest Parity:
R - R* = %Ds
Exchange rate changes
offset interest differentials
Covered
Interest
Parity
Forward
Exchange
Rates
Exchange
Rate
Change
Unbiased
Forward
Rate
59
Key international relationships
Fisher Effect
and
Real Interest
Parity
Relative
Interest
Rates
Relative
Inflation
Rates
Purchasing
Power
Parity
Exchange
Rate
Change
Uncovered Interest Parity
Covered
Interest
Parity
Forward
Exchange
Rates
Unbiased
Forward
Rate
60