International financial Management

International Parity Demand/Supply of currency- Equilibrium, Factors affecting exchange rate, Parity Theories and their Interrelationship

Mohanamani

MBA2012, August 2013

Exchange Rate Determination

International financial Management

The exchange rate is the price of one countrys currency in terms of 1.Demand currency for Currency another countrys A countrys currency is in demand when foreigners buy the goods
and services exported by that country When they desire to buy financial assets denominated in that currency

2.Supply of currency
A countrys currency is supplied in the course of paying for that countrys imports Through receipts in the current account through export and remittances Inflows in the capital account through FDI, Portfolio investment and ECBs Bank deposits made by foreigners including NRIs Mohanamani MBA2012, Sep 2013

Exchange Rate Determination

Demand and Supply of Currency

International financial Management

Supply
Exchange Rate

Demand

Supply and demand for foreign currency

Mohanamani

MBA2012, Sep 2013

Factors Affecting Exchange Rate Inflation Rates The Economic growth Rates Interest rates Political factors Social Factors Government Controls

International financial Management

Mohanamani

MBA2012, Sep 2013

BoP Theory of Exchange rates A statement of receipts and payments of foreign exchange based on the concept of double entry book keeping Represents the demand for and supply of foreign currencies Assumption is made a perfect foreign exchange market and perfect international market for goods and services Limitation BoP itself is a function of the exchange rate and cannot explain the determination of the exchange rate
Mohanamani MBA2012, Sep 2013

International financial Management

The Purchasing Power Parity Theory

Developed by a Swedish Economist Gutsav Cassell Describes the relationship between average price level in a country and its exchange rates The home currency price of a commodity in different countries, when converted into a common currency at the spot exchange rate , is the same in all countries across the world

International financial Management

A unit of home currency should have the same purchasing power in all countries
Mohanamani MBA2012, Sep 2013

The Purchasing Power Parity Theory The Law of One Price

If a commodity or product can be sold in two different markets, its price should be the same in both markets Assumptions: There are no transportation costs There are no transaction costs There are no tariffs There are no restrictions on the movement of products There is free flow of information There is no product differentiation

International financial Management

Mohanamani

MBA2012, Sep 2013

Forms of PPP The absolute form

The law of one price states that if a commodity or product can be sold in two different markets, its price in terms of a common currency should be the same in both the markets If the prices measured in a common currency are not the same, traders will engage in arbitraging to earn a profit until the price in different countries measured in a common currency equalizes

International financial Management

Mohanamani

MBA2012, Sep 2013

Forms of PPP The Relative Form The percentage change in the exchange rate between the domestic currency and the foreign currency should equal the percentage change in the ratio of price indices in the two countries.

International financial Management

Mohanamani

MBA2012, Sep 2013

Forms of PPP The Expectation Form It involves the exchange rate and inflation rates being expressed in terms It states that the expected percentage change in exchange rate equals the expected inflation differential in the two countries assuming the market participants are risk neutral and the markets are perfect

International financial Management

Mohanamani

MBA2012, Sep 2013

Departures from PPP

It is free trade which can equalize prices in a common currency across the countries Non-traded items , highly perishable commodities and hospitality services may cause departures from PPP Limitations of price indices as a measure of pricelevel changes- different countries may use different basket of goods and services in the construction of the price index There are many other factors other than prices of goods and services which influence exchange rates PPP holds only in the long run
Mohanamani MBA2012, Sep 2013

International financial Management

The real exchange rate

It is the nominal exchange rate adjusted for inflation differential between the two countries. It is a measure of change in the relative purchasing power of the two currencies concerned A change in the real exchange rate reflects the change in the purchasing power of one currency relative to another A real appreciation of domestic currency makes the countrys exports more expensive A depreciation of home currency relative to foreign currency enables the home currency to be competitive in the international market and realize increased exports

International financial Management

Mohanamani

MBA2012, Sep 2013

The real effective exchange rate

An overall measure of movement of the home currency against the countrys major trading partners currencies is of great significance. It is a weighted average rate that is calculated by weighing the exchange rates between the home currency and other major currencies As trade weights are used in the computation, the effective exchange rate is also called trade-weighted exchange rate The exchange rate can be 1.nominal effective exchange rate 2.real effective exchange rate
Mohanamani

International financial Management

MBA2012, Sep 2013

Interest Rate Parity

In an efficient market with no transaction costs, the currency of one country with the highest interest rate should be at a forward discount in terms of the currency of the country with a lower interest rate The spread between the spot rate and forward rate is influenced by the interest rate differential between the two countries.

International financial Management

Mohanamani

MBA2012, Sep 2013

Fisher Effect
Is the relationship between the nominal interest rate, the real interest rate and the expected rate of inflation in a country The expected rate of inflation is the difference between the nominal rate of interest and the real rate of interest 1+nominal rate of interest = (1+real rate of return)(1+expected rate of inflation) Nominal rate of return = Real rate of return + expected rate of inflation
Mohanamani

International financial Management

MBA2012, Sep 2013

Fisher Effect
(+) Interest rate differential (%)

Parity line

International financial Management

(-) Inflation differential (%)

(+)

(-)

Mohanamani

MBA2012, Sep 2013

The international Fisher relation

The nominal interest rate differential reflects the expected change in the spot rate A rise in the inflation rate in a country will be associated with a rise in the interest rate in the country and a fall in the countrys currency value It implies that the expected return on domestic investment should be equal to the expected return on foreign investment

International financial Management

Mohanamani

MBA2012, Sep 2013

Interrelationship of parity conditions

(+) Expected change in spot rate (%)

Parity line

International financial Management

(-) Interest differential (%)

(+)

(-)

Mohanamani

MBA2012, Sep 2013

Interrelationship of parity conditions

IRP
Ft / So

FRP

International financial Management

(1+kh)t /
(1+kf)t

E(St)/ So

IFR

(1+ih)t/(1+if)t

PPP

Mohanamani

MBA2012, Sep 2013

Exchange Rate Forecasting

It is used in making hedging decisions, investment decisions and financing decisions The forward rate is generally used as an unbiased estimate of the future spot rate But forward rates are available only for short maturities and their forecasting horizon ins limited to one year There are two approaches used in forecasting Technical Analysis and Fundamental Analysis

International financial Management

Mohanamani

MBA2012, Sep 2013

Exchange Rate Forecasting Monetary Model

It attempts to predict a proportional relationship between nominal exchange rates and relative supplies of money between nations Monetary model suggests that the exchange rate is determined by three independent variables: -Relative money supply -Relative interest rates -Relative national output

International financial Management

Mohanamani

MBA2012, Sep 2013

Exchange Rate Forecasting The Asset Market Model

An asset price consists of a fundamental value plus a term that reflects expectations of future changes in the asset price The foreign exchange is viewed as a financial asset and its price is determined by the demand and supply for the stock of foreign exchange As expectations changes rates also change

International financial Management

Mohanamani

MBA2012, Sep 2013

Exchange Rate Forecasting The Portfolio Balance Model

It is based on the premise that people divide their total wealth between domestic and foreign currency, domestic and foreign bonds, depending on their expected return and risk Three assets are involved in this model -money(M) -domestic bonds denominated in the home currency(B) -Foreign currency bonds(FB)

International financial Management

Mohanamani

MBA2012, Sep 2013