Chapter Five International Parity Relationships forecasting Exchange rates Chapter objective This chapter examines several key international parity relationships, such as interest rate parity and purchasing power parity
INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Second Edition 5 Chapter Five International Parity Relationships & Forecasting Exchange Rates Chapter Objective: This chapter examines several key international parity relationships, such as interest rate parity and purchasing power parity
Chapter Outline ● Interest Rate Parity o Purchasing Power Parity The fisher effects o Forecasting Exchange rates McGraw-Hilylrwoin 5-1 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-1 Chapter Outline ⚫ Interest Rate Parity ⚫ Purchasing Power Parity ⚫ The Fisher Effects ⚫ Forecasting Exchange Rates
Chapter Outline ● Interest Rate parity Covered Interest Arbitrage IRP and Exchange Rate Determination Reasons for deviations from Irp o Purchasing Power Parity ● The Fisher effects o Forecasting Exchange Rates McGraw-Hilylrwoin 5-2 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-2 Chapter Outline ⚫ Interest Rate Parity ◼ Covered Interest Arbitrage ◼ IRP and Exchange Rate Determination ◼ Reasons for Deviations from IRP ⚫ Purchasing Power Parity ⚫ The Fisher Effects ⚫ Forecasting Exchange Rates
Chapter Outline ● Interest Rate Parity o Purchasing Power Parity PPP Deviations and the real exchange rate Evidence on Purchasing Power Parity ● The Fisher effects Forecasting Exchange Rates McGraw-Hilylrwoin 5-3 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-3 Chapter Outline ⚫ Interest Rate Parity ⚫ Purchasing Power Parity ◼ PPP Deviations and the Real Exchange Rate ◼ Evidence on Purchasing Power Parity ⚫ The Fisher Effects ⚫ Forecasting Exchange Rates
Chapter Outline ● Interest Rate Parity Purchasing Power Parity The fisher effects o Forecasting Exchange Rates McGraw-Hilylrwoin Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-4 Chapter Outline ⚫ Interest Rate Parity ⚫ Purchasing Power Parity ⚫ The Fisher Effects ⚫ Forecasting Exchange Rates
Chapter Outline ● Interest Rate Parity Purchasing Power Parity The Fisher effects o Forecasting Exchange rates Efficient Market Approach Fundamental Approach Technical Approach Performance of the forecasters McGraw-Hilylrwoin 5-5 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-5 Chapter Outline ⚫ Interest Rate Parity ⚫ Purchasing Power Parity ⚫ The Fisher Effects ⚫ Forecasting Exchange Rates ◼ Efficient Market Approach ◼ Fundamental Approach ◼ Technical Approach ◼ Performance of the Forecasters
Interest Rate Parity o Interest Rate Parity defined ●Coⅴ ered interest Arbitrage Interest Rate Parity exchange Rate Determination o Reasons for deviations from Interest Rate Parity McGraw-Hilylrwoin 5-6 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-6 Interest Rate Parity ⚫ Interest Rate Parity Defined ⚫ Covered Interest Arbitrage ⚫ Interest Rate Parity & Exchange Rate Determination ⚫ Reasons for Deviations from Interest Rate Parity
Interest Rate Parity Defined o IRP is an arbitrage condition o If irP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity Since we dont typically observe persistent arbitrage conditions, we can safely assume that IRP holds McGraw-Hilylrwoin 5-7 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-7 Interest Rate Parity Defined ⚫ IRP is an arbitrage condition. ⚫ If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. ⚫ Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds
Interest Rate Parity Defined Suppose you have $100,000 to invest for one year You can either 1. invest in the U.S. at is. Future value=$100, 000(1+ 2. trade your dollars for yen at the spot rate invest in japan at y and hedge your exchange rate risk by selling the future value of the Japanese investment forward. The future value $100000(7)(1+i) Since both of these investments have the same risk, they must have the same future value--otherwise an arbitrage would exist (F/S)(1+1)=(1+i1s McGraw-Hilylrwoin 5-8 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-8 Interest Rate Parity Defined Suppose you have $100,000 to invest for one year. You can either 1. invest in the U.S. at i$ . Future value = $100,000(1 + ius) 2. trade your dollars for yen at the spot rate, invest in Japan at i¥ and hedge your exchange rate risk by selling the future value of the Japanese investment forward. The future value = $100,000(F/S)(1 + i¥) Since both of these investments have the same risk, they must have the same future value—otherwise an arbitrage would exist. (F/S)(1 + i¥) = (1 + ius)
Interest Rate Parity Defined Formally, (F/S)(1+iy)=(1+is or If you prefer, 1+ F 1+ IRP is sometimes approximated as (F-S S McGraw-Hilylrwoin 5-9 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-9 Interest Rate Parity Defined Formally, (F/S)(1 + i¥) = (1 + ius) or if you prefer, S F i i = + + ¥ $ 1 1 IRP is sometimes approximated as S (F- S) (i -i ) $ ¥ =