international parity session- v

7/27/2019 International Parity Session- V

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International Parity

Demand/Supply

of currency- Equilibrium, Factors

affecting exchange rate, Parity Theories

and their Interrelationship

Int

ernationalfinanc

ialManagement

MBA2012, August 2013Mohanamani


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Int

ernationalfinanc

ialManagement

MBA2012, Sep 2013Mohanamani

Exchange Rate Determination

The exchange rate is the price of onecountrys currency in terms of

anothercountrys currency1.Demand for CurrencyA countrys currency is in demand when foreigners buy the goodsand services exported by that country

When they desire to buy financial assets denominated in that

currency

2.Supply of currencyA countrys currency is supplied in the course of paying for that

countrys importsThrough 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


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Int

ernationalfinanc

ialManagement


Exchange Rate Determination

Demand and Supply of Currency

Supply

Demand

Supply and demand for foreign currency

E

xchangeRate


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Int

ernationalfinanc

ialManagement


Factors Affecting Exchange Rate

Inflation RatesThe Economic growth Rates

Interest rates

Political factors

Social Factors

Government Controls


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ernationalfinanc

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BoP Theory of Exchange rates

A statement of receipts and payments of foreignexchange based on the concept of double entry

book keeping

Represents the demand for and supply of foreign

currenciesAssumption 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


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Int

ernationalfinanc

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The Purchasing Power Parity Theory

Developed by a Swedish Economist Gutsav CassellDescribes 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 thespot exchange rate , is the same in all countries across the

world

A unit of home currency should have

the same purchasing power in allcountries


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Internationalfinanc

ialManagement


The Purchasing Power Parity Theory -

The Law of One PriceIf 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 costsThere 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


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Internationalfinanc

ialManagement


Forms of PPP

The absolute formThe 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 marketsIf 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


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Internationalfinanc

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Forms of PPP

The Relative FormThe 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.


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Internationalfinanc

ialManagement


Forms of PPP

The Expectation FormIt 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


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Internationalfinanc

ialManagement


Departures from PPP

It is free trade which can equalize prices in acommon currency across the countries

Non-traded items , highly perishable commodities

and hospitality services may cause departures from

PPPLimitations of price indices as a measure of price-

level changes- different countries may use different

basket of goods and services in the construction of

the price indexThere are many other factors other than prices of

goods and services which influence exchange rates

PPP holds only in the long run


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Internationalfinanc

ialManagement


The real exchange rate

It is the nominal exchange rate adjusted for inflationdifferential 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 toanother

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 inthe international market and realize increased exports


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Internationalfinanc

ialManagement


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 rateThe exchange rate can be 1.nominal effective exchange

rate 2.real effective exchange rate


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Internationalfinanc

ialManagement


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.


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InternationalfinancialManagement


Fisher Effect

Is the relationship between the nominal interestrate, 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 realrate 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


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Fisher Effect(+)

(+)(-)

(-)

Parity line

Interest rate

differential (%)

Inflation

differential (%)


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The international Fisher relation

The nominal interest rate differential reflects theexpected 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 thecountry 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


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Interrelationship of parity conditions(+)

(+)(-)

(-)

Parity line

Expected change

in spot rate (%)

Interest

differential (%)


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Interrelationship of parity conditions

Ft / So

E(St)/ So(1+kh)t /(1+kf)t

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

IRP FRP

PPP

IFR


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Exchange Rate Forecasting

It is used in making hedging decisions, investmentdecisions 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


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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


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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


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MBA2012 Sep 2013Mohanamani

Exchange Rate Forecasting The

Portfolio Balance ModelIt 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 riskThree assets are involved in this model

-money(M)

-domestic bonds denominated in the home

currency(B)-Foreign currency bonds(FB)

international parity session- v

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