Multinational Financial

Management

Alan Shapiro

7th Edition

Power Points by

J.Wiley

&

Sons

Joseph F. Greco, Ph.D.

California State University, Fullerton

1

CHAPTER 4

PARITY CONDITIONS

AND

CURRENCY

FORECASTING

2

CHAPTER OVERVIEW

I.

ARBITRAGE AND THE LAW OF

ONE PRICE

II. PURCHASING POWER PARITY

III. THE FISHER EFFECT

IV. THE INTERNATIONAL FISHER EFFECT

V. INTEREST RATE PARITY THEORY

VI. THE RELATIONSHIP BETWEEN THE

FORWARD AND FUTURE SPOT RATE

VII. CURRENCY FORECASTING

3

PART I. ARBITRAGE AND THE LAW OF

ONE PRICE

I.

THE LAW OF ONE PRICE

A. Law states:

Identical goods sell for the

same price worldwide.

4

ARBITRAGE AND THE LAW OF ONE

PRICE

B. Theoretical basis:

If the price after exchange-rate

adjustment were not equal,

arbitrage in the goods worldwide

ensures eventually it will.

5

ARBITRAGE AND THE LAW OF ONE

PRICE

C. Five Parity Conditions Result

From These Arbitrage Activities

1. Purchasing Power Parity (PPP)

2. The Fisher Effect (FE)

3. The International Fisher Effect

(IFE)

4. Interest Rate Parity (IRP)

5. Unbiased Forward Rate (UFR)

6

ARBITRAGE AND THE LAW OF ONE

PRICE

D. Five Parity Conditions Linked

by

1. The adjustment of

various

rates and prices to

inflation.

7

ARBITRAGE AND THE LAW OF ONE

PRICE

2.

The notion that money

should have no effect on

real variables (since they

have been adjusted for

price changes).

8

ARBITRAGE AND THE LAW OF ONE

PRICE

E. Inflation and home currency

depreciation:

1. jointly determined by the

growth of domestic money

supply;

2. Relative to the growth of

domestic money demand.

9

ARBITRAGE AND THE LAW OF ONE

PRICE

F. THE LAW OF ONE PRICE

- enforced by

international

arbitrage.

10

PART II. PURCHASING POWER

PARITY

I. THE THEORY OF PURCHASING

POWER PARITY:

states that spot exchange rates

between currencies will change

to the differential in inflation

rates between countries.

11

PURCHASING POWER PARITY

II.

ABSOLUTE PURCHASING

POWER PARITY

A. Price levels adjusted for

exchange rates should be

equal between countries

12

PURCHASING POWER PARITY

II.

ABSOLUTE PURCHASING

POWER PARITY

B. One unit of currency has

same purchasing power

globally.

13

PURCHASING POWER PARITY

III. RELATIVE PURCHASING

POWER PARITY

A. states that the exchange

rate of one currency against

another will adjust to reflect

changes in the price levels

the two countries.

of

14

PURCHASING POWER PARITY

1.In mathematical terms:

et

e0

where

e0 =

ih =

if =

t =

(1 +

ih

=

(1 + i f

)

)

t

t

et = future spot rate

spot rate

home inflation

foreign inflation

the time period

15

PURCHASING POWER PARITY

2. If purchasing power parity is

expected to hold, then the best

prediction for the one-period

spot rate should be

et = e0

(1 + ih )

(1 + i )

t

t

f

16

PURCHASING POWER PARITY

3. A more simplified but less precise

relationship is

et

= ih − i f

e0

that is, the percentage change should be

approximately equal to the inflation rate

differential.

17

PURCHASING POWER PARITY

4.

PPP says

the currency with the higher

inflation rate is

expected to

depreciate

relative to the

currency

with the lower rate of inflation.

18

PURCHASING POWER PARITY

B. Real Exchange Rates:

the quoted or nominal rate

adjusted for a country’s

inflation rate is

et' = et

(1 + i f ) t

(1 + ih ) t

19

PURCHASING POWER PARITY

C. Real exchange rates

1. If exchange rates adjust to

inflation differential, PPP

states that real exchange

rates stay the same.

20

PURCHASING POWER PARITY

C. Real exchange rates

2.

Competitive positions:

domestic and foreign

firms

are unaffected.

21

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

22

THE FISHER EFFECT

B. 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

23

THE FISHER EFFECT

C. According to the Fisher

Effect,

countries with higher

inflation rates have higher

interest rates.

24

THE FISHER EFFECT

D. Due to capital market

integration globally, interest

rate differentials are

eroding.

25

Management

Alan Shapiro

7th Edition

Power Points by

J.Wiley

&

Sons

Joseph F. Greco, Ph.D.

California State University, Fullerton

1

CHAPTER 4

PARITY CONDITIONS

AND

CURRENCY

FORECASTING

2

CHAPTER OVERVIEW

I.

ARBITRAGE AND THE LAW OF

ONE PRICE

II. PURCHASING POWER PARITY

III. THE FISHER EFFECT

IV. THE INTERNATIONAL FISHER EFFECT

V. INTEREST RATE PARITY THEORY

VI. THE RELATIONSHIP BETWEEN THE

FORWARD AND FUTURE SPOT RATE

VII. CURRENCY FORECASTING

3

PART I. ARBITRAGE AND THE LAW OF

ONE PRICE

I.

THE LAW OF ONE PRICE

A. Law states:

Identical goods sell for the

same price worldwide.

4

ARBITRAGE AND THE LAW OF ONE

PRICE

B. Theoretical basis:

If the price after exchange-rate

adjustment were not equal,

arbitrage in the goods worldwide

ensures eventually it will.

5

ARBITRAGE AND THE LAW OF ONE

PRICE

C. Five Parity Conditions Result

From These Arbitrage Activities

1. Purchasing Power Parity (PPP)

2. The Fisher Effect (FE)

3. The International Fisher Effect

(IFE)

4. Interest Rate Parity (IRP)

5. Unbiased Forward Rate (UFR)

6

ARBITRAGE AND THE LAW OF ONE

PRICE

D. Five Parity Conditions Linked

by

1. The adjustment of

various

rates and prices to

inflation.

7

ARBITRAGE AND THE LAW OF ONE

PRICE

2.

The notion that money

should have no effect on

real variables (since they

have been adjusted for

price changes).

8

ARBITRAGE AND THE LAW OF ONE

PRICE

E. Inflation and home currency

depreciation:

1. jointly determined by the

growth of domestic money

supply;

2. Relative to the growth of

domestic money demand.

9

ARBITRAGE AND THE LAW OF ONE

PRICE

F. THE LAW OF ONE PRICE

- enforced by

international

arbitrage.

10

PART II. PURCHASING POWER

PARITY

I. THE THEORY OF PURCHASING

POWER PARITY:

states that spot exchange rates

between currencies will change

to the differential in inflation

rates between countries.

11

PURCHASING POWER PARITY

II.

ABSOLUTE PURCHASING

POWER PARITY

A. Price levels adjusted for

exchange rates should be

equal between countries

12

PURCHASING POWER PARITY

II.

ABSOLUTE PURCHASING

POWER PARITY

B. One unit of currency has

same purchasing power

globally.

13

PURCHASING POWER PARITY

III. RELATIVE PURCHASING

POWER PARITY

A. states that the exchange

rate of one currency against

another will adjust to reflect

changes in the price levels

the two countries.

of

14

PURCHASING POWER PARITY

1.In mathematical terms:

et

e0

where

e0 =

ih =

if =

t =

(1 +

ih

=

(1 + i f

)

)

t

t

et = future spot rate

spot rate

home inflation

foreign inflation

the time period

15

PURCHASING POWER PARITY

2. If purchasing power parity is

expected to hold, then the best

prediction for the one-period

spot rate should be

et = e0

(1 + ih )

(1 + i )

t

t

f

16

PURCHASING POWER PARITY

3. A more simplified but less precise

relationship is

et

= ih − i f

e0

that is, the percentage change should be

approximately equal to the inflation rate

differential.

17

PURCHASING POWER PARITY

4.

PPP says

the currency with the higher

inflation rate is

expected to

depreciate

relative to the

currency

with the lower rate of inflation.

18

PURCHASING POWER PARITY

B. Real Exchange Rates:

the quoted or nominal rate

adjusted for a country’s

inflation rate is

et' = et

(1 + i f ) t

(1 + ih ) t

19

PURCHASING POWER PARITY

C. Real exchange rates

1. If exchange rates adjust to

inflation differential, PPP

states that real exchange

rates stay the same.

20

PURCHASING POWER PARITY

C. Real exchange rates

2.

Competitive positions:

domestic and foreign

firms

are unaffected.

21

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

22

THE FISHER EFFECT

B. 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

23

THE FISHER EFFECT

C. According to the Fisher

Effect,

countries with higher

inflation rates have higher

interest rates.

24

THE FISHER EFFECT

D. Due to capital market

integration globally, interest

rate differentials are

eroding.

25

## FM11 Ch 26 Multinational Financial Management

## Lecture multinational financial management chapter 1 ngo thi ngoc huyen

## Lecture multinational financial management chapter 2 ngo thi ngoc huyen

## Lecture multinational financial management chapter 3 ngo thi ngoc huyen

## Lecture multinational financial management chapter 4 ngo thi ngoc huyen

## Lecture multinational financial management chapter 5 ngo thi ngoc huyen

## Lecture multinational financial management chapter 6 ngo thi ngoc huyen

## Lecture multinational financial management chapter 7 ngo thi ngoc huyen

## BT thanh toan quoc te multinational financial management dap an

## Test bank Finance Management chapter 19 multinational financial management

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