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International financial management
Calculated as:
Where:
"E" represents the % change in the exchange rate
"i1" represents country A's interest rate
"i2" represents country B's interest rate
For example, if country A's interest rate is 10% and country B's interest rate
is 5%, country B's currency should appreciate roughly 5% compared to
country A's currency.
The rational for the IFE is that a country with a higher interest rate will also
tend to have a higher inflation rate. This increased amount of inflation
should cause the currency in the country with the high interest rate to
depreciate against a country with lower interest rates.
INTEREST RATE PARITY
A theory that the interest rate differential between two countries is equal to
the differential between the forward exchange rate and the spot exchange
rate. Interest rate parity plays an essential role in foreign exchange markets,
connecting interest rates, spot exchange rates and foreign exchange rates.
According to interest rate parity the difference between the (risk free)
interest rates paid on two currencies should be equal to the differences
between the spot and forward rates.
Assuming the arbitrage opportunity described above does not exist, then the
relationship for US dollars and pounds sterling is:
(1 + r£)/(1+r$) = (£/$f)/(£/$s)
Where r£ is the sterling interest rate (till the date of the forward),
r$ is the dollar interest rate,
£/$f is the forward sterling to dollar rate,
£/$s is the spot sterling to dollar rate
Unless interest rates are very high or the period considered is long, this is a
very good approximation:
r£ = r$ + f
r = r2 + E[ΔS]
As the forward rate will be the market expectation of the change in rates, this
is equivalent to covered interest rate parity - unless one is speculating on
market expectations being wrong.
History:
Therefore to measure the differences between the real prices of goods and
services across different countries, we need something to measure them on a
common scale. This is where Purchasing Power Parity (PPP) comes into
picture. Purchasing Power Parity converts local currencies to a common
currency and compares the buying power of different currencies. The
purchasing power parity is a method of measuring the effective purchasing
power of different countries’ currencies over the same types of goods and
services. It also states that, in ideally efficient markets, identical goods
should have similar price. While comparing the Purchasing Power Parities of
different countries, a standard single currency should be taken such as a US
dollar.
But goods and services have widely varying prices across countries when
converted to a common currency. You can find more differences in goods or
services, which are not traded with other countries on international platform
such as products that are sold locally, costs of labour, housing, construction,
and healthcare services. That is the reason we get more number of haircuts
in India compared to US with the same amount of money. This also one of
the reasons many foreign companies to set up their offices and operate from
India. PPP is the main thing that is making the off shoring possible.
The PPP’s law of one price states that all the prices of goods or services
should equalize in the absence of local taxes, distributors margin and
shipping charges. But the price differences are less for goods that are widely
traded in international markets like electronic goods, machinery and
equipment. The theory of PPP is not working here with countries like India.
This is the reason some of the electronic goods and high-end cars in India
are expensive than in US.
There are some differences in the prices of goods and services between India
and US. Local goods, labour, food, housing, healthcare etc. are cheap in
India but some items like electronic goods, and high-end cars are overpriced.
Therefore be aware of things that are expensive and make sensible
purchases.
PPP exchange rate (the "real exchange rate") fluctuations are mostly due to
different rates of inflation between the two economies. Aside from this
volatility, consistent deviations of the market and PPP exchange rates are
observed, for example (market exchange rate) prices of non-traded goods
and services are usually lower where incomes are lower. (A U.S. dollar
exchanged and spent in India will buy more haircuts than a dollar spent in
the United States). Basically, PPP deduces exchange rates between
currencies by finding goods available for purchase in both currencies and
comparing the total cost for those goods in each currency.
The exchange rate reflects transaction values for traded goods among
countries in contrast to non-traded goods, that is, goods produced for home-
country use. Also, currencies are traded for purposes other than trade in
goods and services, e.g., to buy capital assets whose prices vary more than
those of physical goods. Also, different interest rates, speculation, hedging
or interventions by central banks can influence the foreign-exchange market.
Difficulties:
PPP numbers can vary with the specific basket of goods used, making it a
rough estimate.
During the first two decades of its existence, two thirds of the assistance
provided by the Bank went to electric power and transportation projects.
Although these so-called infrastructure projects remain important, the Bank
has diversified its activities in recent years as it has gained experience with
and acquired new insights into the development process.
The Bank gives particular attention to projects that can directly benefit the
poorest people in developing countries. The direct involvement of the
poorest in economic activity is being promoted through lending for
agriculture and rural development, small-scale enterprises, and urban
development. The Bank is helping the poor to be more productive and to
gain access to such necessities as safe water and waste-disposal facilities,
health care, family-planning assistance, nutrition, education, and housing.
Within infrastructure projects there have also been changes. In transportation
projects, greater attention is given to constructing farm-to-market roads.
Rather than concentrating exclusively on cities, power projects increasingly
provide lighting and power for villages and small farms. Industrial projects
place greater emphasis on creating jobs in small enterprises. Labor-intensive
construction is used where practical. In addition to electric power, the Bank
is supporting development of oil, gas, coal, fuel wood, and biomass as
alternative sources of energy.
The range of the Bank's activities is far broader than its lending operations.
Since the Bank's lending decisions depend heavily on the economic
condition of the borrowing country, the Bank carefully studies its economy
and the needs of the sectors for which lending is contemplated. These
analyses help in formulating an appropriate long-term development
assistance strategy for the economy.
Graduation from the IBRD and IDA has occurred for many years. Of the 34
very poor countries that borrowed money from IDA during the earliest
years, more than two dozen have made enough progress for them no longer
to need IDA money, leaving that money available to other countries that
joined the Bank more recently. Similarly, about 20 countries that formerly
borrowed money from the IBRD no longer have to do so. An outstanding
example is Japan. For a period of 14 years, it borrowed from the IBRD.
Now, the IBRD borrows large sums in Japan.
Abstract:
The government of India has formulated the Foreign Exchange Management
Act (FEMA), which relates to the foreign direct investment in the country.
Foreign Exchange Management Act (FEMA) has helped the country by
encouraging external payment and trade.