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PPP formula

(Actual Rate - PPP Rate) / PPP Rate remember that the actual rate has to be in the same terms

Exchange rate determination is complex, organized by the three major schools of thought

(parity conditions, balance of payments approach, asset market approach), and secondly by the individual drivers within those approaches. These are not competing theories but rather complementary theories.

BOP affects and is affected by such key macroeconomic factors as:

Gross Domestic Product (GDP) The exchange rate Interest rates Inflation rates

The International Monetary Fund is a key institution in the new international monetary system and was created to:

Help countries defend their currencies against cyclical, seasonal, or random occurrences Assist countries having structural trade problems if they promise to take adequate steps to correct these problems

There are three main elements of the actual process of measuring international economic activity:

Identifying what is and is not an international economic transaction Understanding how the flow of goods, services, assets, and money create debits and credits to the overall BOP Understanding the bookkeeping procedures for BOP accounting (It is a daunting task to measure all international transactions that take place in and out of a country over a year)

the absolute version of the PPP theory.

If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products denominated in different currencies, we could determine the "real" or PPP exchange rate that should exist if markets were efficient.

Two general conclusions can be made from these tests about PPP

PPP holds up well over the very long run but poorly for shorter time periods; and, the theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets.

RPPP holds that

PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period.

The rapid rise of the Chinese economy has been accompanied by a

10 fold increase in foreign exchange reserves (Exhibit 4.8) As a result, China's foreign exchange reserves are approximately 2.5 times larger than the next largest

Fundamentals of BOP Accounting

The BOP must balance It cannot be in disequilibrium unless something has not been counted or has been counted improperly Therefore it is incorrect to state that the BOP is in disequilibrium

The Greek/EU Debt Crisis

The EU established exchange rate stability and financial integration with the adoption of the euro but each country gave up monetary independence. However, each country still controls its own fiscal policy and sovereign debt is denominated in euros and thus impacts the entire Eurozone The ultimate outcome is still in question

Interest Rate Parity

The actual way forward rates are calculated from interest rate differentials

IRP

The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs. Interest Rate Parity (IRP) provides the linkage between the foreign exchange markets and the international money markets.

Trade Balances and Exchange Rates

A country's import and export of goods and services is affected by changes in exchange rates The transmission mechanism is in principle quite simple: changes in exchange rates change relative prices of imports and exports, and changing prices in turn result in changes in quantities demanded through the price elasticity of demand

Capital Flight

Although no single definition of capital flight exists, it has been characterized as occurring when capital transfers by residents conflict with political objectives. Many heavily indebted countries have suffered capital flight, compounding their debt service problems. Capital can be moved via international transfers, with physical currency, collectables or precious metals, money laundering or false invoicing of international trade transactions.

Possesses three attributes, often referred to as the Impossible Trinity:

Exchange rate stability Full financial integration Monetary independence

RPPP formula

FX1 * (1+i)^t / FX2 * (1+i)^t

Relative Purchasing Power Parity

Forecasting theory based upon forecast inflation differentials

International Fisher Effect

Forecasting theory based upon interest rate differentials (Forward rate is forecast of future spot.)

Forward Foreign Exchange Rates and Quotations

Forward rates in FX use interest rate differentials to calculate the cost of carry Forward rates have nothing to do with Forecasts Forward rates have everything to do with Cost of carry Forward rate equals spot rate plus interest cost (plus safekeeping fee)

In addition, a strong central bank, called the European Central Bank (ECB), was established

Frankfurt, Germany.

The current account consists of the following subcategories:

Goods trade and import of goods Services trade Income Current transfers

covered interest arbitrage (CIA)

The spot and forward exchange rates are not, however, constantly in the state of equilibrium described by interest rate parity. When the market is not in equilibrium, the potential for "risk-less" or arbitrage profit exists. The arbitrager will exploit the imbalance by investing in whichever currency offers the higher return on a covered basis.

International Parity Conditions

These theories do not always work out to be "true" when compared to what students and practitioners observe in the real world, but they are central to any understanding of how multinational business is conducted and funded in the world today. The mistake is often not with the theory itself, but with the interpretation and application of said theories.

Five broad categories of participants operate within these two tiers

bank and nonbank foreign exchange dealers, individuals and firms conducting commercial or investment transactions, speculators and arbitragers, central banks and treasuries, and foreign exchange brokers.

Thus, Bretton Woods Agreement was careful to promote free movement of capital for

current account transactions (e.g., foreign exchange or deposits) but less so for capital account transactions (e.g., foreign direct investment)

The general rule or premise is that

domestic land, assets and industry should be owned by residents of the country.

Empirical tests (using ex-post) national inflation rates have shown the Fisher effect usually exists

for short-maturity government securities (treasury bills and notes).

A nation's choice as to which currency regime to follow reflects national priorities about all facets of the economy, including:

inflation, unemployment, interest rate levels, trade balances, and economic growth.

The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the

international Fisher effect.

The Current Account includes

international economic transactions with income or payment flows occurring within one year, the current period.

The economic theories that link exchange rates, price levels, and interest rates together are called

international parity conditions.

foreign exchange transaction

is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified date.

A capital control

is any restriction that limits or alters the rate or direction of capital movement into or out of a country Free movement of capital is more the exception than the rule

The single largest threat to maintaining purchasing power

is inflation, so the job of the EU has been to prevent inflationary forces from undermining the euro.

The primary driver of a currency's value

is its ability to maintain its purchasing power.

The Official Reserves Account

is the total reserves held by official monetary authorities within the country. These reserves are normally composed of the major currencies used in international trade and financial transactions (hard currencies). The significance of official reserves depends generally on whether the country is operating under a fixed exchange rate regime or a floating exchange rate system.

If the euro is to be successful,

it must have a solid economic foundation.

Methods of intervention are determined by

magnitude of a country's economy, magnitude of trading in it's currency, and the country's financial market development Direct Intervention the active buying and selling of the domestic currency against foreign currencies If the goal is to increase the value, then the central bank buys its own currency If the goal is to decrease the value, then the central bank sells its own currency

Foreign exchange

means the money of a foreign country; that is, foreign currency bank balances, banknotes, checks and drafts.

Whereas forecasting for the long run must depend

on the economic fundamentals of exchange rate determination, many of the forecast needs of the firm are short to medium term in their time horizon and can be addressed with less theoretical approaches.

The forecasting inadequacies of fundamental theories has led to the growth and popularity of

technical analysis, the belief that the study of past price behavior provides insights into future price movements The primary assumption is that any market driven price (i.e. exchange rates) follows trends.

The asset market approach argues

that exchange rates are determined by the supply and demand for a wide variety of financial assets: Shifts in the supply and demand for financial assets alter exchange rates. Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter exchange rates.

The monetary approach in its simplest form states

that the exchange rate is determined by the supply and demand for national monetary stocks, as well as the expected future levels and rates of growth of monetary stocks. Other financial assets, such as bonds are not considered relevant for exchange rate determination, as both domestic and foreign bonds are viewed as perfect substitutes.

The asset market approach assumes

that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (among others): Prospects for economic growth Capital market liquidity A country's economic and social infrastructure Political safety Corporate governance practices Contagion (spread of a crisis within a region) Speculation

The BOP is composed of two primary sub accounts

the Current Account and the Capital/Financial Account

A fourth account

the Net Errors and Omissions account is produced to preserve the balance of the BOP

Foreign currency intervention is

the active management, manipulation, or intervention in the market's valuation of a country's currency. Why Intervene? Fight inflation (strong currency) Fight slow economic growth (weak currency)

In addition to gaining an understanding of the basic theories, it is equally important to gain a working knowledge of:

the complexities of international political economy; societal and economic infrastructures; and, random political, economic, or social events that affect the exchange rate markets.

foreign exchange market consists of two tiers

the interbank or wholesale market (multiples of $1MM US or equivalent in transaction size), and the client or retail market (specific, smaller amounts).

The longer the time horizon of the forecast

the more inaccurate the forecast is likely to be.

The theory of purchasing power parity is

the most widely accepted theory of all exchange rate determination theories: PPP is the oldest and most widely followed of the exchange rate theories. Most exchange rate determination theories have PPP elements embedded within their frameworks. PPP calculations and forecasts are however plagued with structural differences across countries and significant data challenges in estimation.

Apart from the use of interest rates to intervene in the foreign exchange market,

the overall level of a country's interest rates compared to other countries does have and impact on the financial account of the BOP

Foreign exchange market

the physical and institutional structure through which the money of one country is exchanged for that of another country; the determination rate of exchange between currencies; and is where foreign exchange transactions are physically completed.

the Official Reserves account

tracks government currency transactions

Technical analysts

traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future. The single most important element of technical analysis is that future exchange rates are based on the current exchange rate. Exchange rate movements can be subdivided into three periods: Day-to-day Short-term (several days to several months) Long-term

Functions of the Foreign Exchange Market

transfer purchasing power between countries; obtain or provide credit for international trade transactions; and minimize exposure to the risks of exchange rate changes.

Two types of business transactions dominate the balance of payments:

Exchange of Real Assets Exchange of Financial Assets

For a MNE, both home and host country BOP data is important as:

An indication of pressure on a country's foreign exchange rate A signal of the imposition or removal of controls in various sorts of payments (dividends, interest, license fees, royalties and other cash disbursements) A forecast of a country's market potential (especially in the short run)

The Current Account is typically dominated by the first component which is known as

Balance of Trade (BOT)

The Problem with PPP

Barriers to trade: imports, quotas, government policy Informal structural barriers: distribution, tastes, language, cultural, regulation, quality differences Taxation differences Currency restrictions/policies

The euro affects markets in three ways:

Cheaper transactions costs in the eurozone Currency risks and costs related to uncertainty are reduced All consumers and businesses both inside and outside the eurozone enjoy price transparency and increased price-based competition

The Russian Crisis of 1998

Contagion from Asian Crisis Commodity/energy prices fall (80% of Russian exports) Political problems Inflation goes to 84% Ruble loses 80% of its value Russia raises interest rates to 150% to defend the ruble Investors sell ruble bonds and yields soar to 200% Russian stock market loses 75% of its value Russian bonds default Global flight to quality

The Capital/Financial Account consists of two main components

Direct Investment - in which the investor exerts some explicit degree of control over the assets Portfolio Investment - in which the investor has no control over the assets

uncovered interest arbitrage (UIA).

In this case, investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceed into currencies that offer much higher interest rates. The transaction is "uncovered" because the investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period.

The Asian Financial Crisis of 1997

Local borrowing costs high US$ borrowing costs low Stable exchange rates The entire SE Asian market borrowed uncovered dollars. To not do so put you out of business. The roots of the Asian currency crisis extended from a fundamental change in the economics of the region, the transition of many Asian nations from being net exporters to net importers. The most visible roots of the crisis were the excess capital inflows into Thailand in 1996 and early 1997. As the investment "bubble" expanded, some market participants questioned the ability of the economy to repay the rising amount of debt and the Thai bhat came under attack. Hedge funds sell more than $15 billion in Thai baht Borrowers panic and start to buy back dollars, selling Thai baht The Thai government intervened directly (using up 90% of their currency reserves!!!) and indirectly by raising interest rates in support of the currency. Ultimately, the Thai central bank allowed the bhat to float. Thai investment markets and the economy ground to a halt. The bhat fell dramatically and soon other Asian currencies (Philippine peso, Malaysian ringgit and the Indonesian rupiah) came under attack.

To prepare for the EMU, a convergence criteria was laid out whereby each member country was responsible for managing the following to a specific level:

Nominal inflation rates Long-term interest rates Fiscal deficits Government debt

Portfolio Investment

This is the net balance of capital that flows in and out of the U.S. but does not reach the 10% threshold of direct investment. The purchase of debt securities across borders is classified as portfolio investment because debt securities by definition do not provide the buyer with ownership or control. Portfolio investment is motivated by a search for returns rather than to control or manage the investment. As illustrated in Exhibit 4.4, portfolio investment has shown much more volatile behavior than net foreign direct investment over the past decade

The measurement of all international economic transactions between the residents of a country and foreign residents is called the

balance of payments (BOP)

The spot exchange rate should (int'l fisher effect)

change in an equal amount but in the opposite direction to the difference in interest rates between two countries

The source of concern over foreign investment in any country focuses on two topics

control and profit.

Why is the US Portfolio Investment Account in surplus?

foreigners buy t-bills

There is, therefore, something of a_______ for a currency's value.

fundamental equilibrium path

BOP data is important for government policymakers and MNEs as it is

gauge of a nation's competitiveness or health (domestic and/or foreign)

The goods trade deficit saw the decline of

heavy traditional industries in the U.S. (steel, automobiles, automotive parts, textiles)

The International Bank for Reconstruction and Development (World Bank)

helped fund post-war reconstruction and has since then supported general economic development

The balance of payments approach is the

second most utilized theoretical approach in exchange rate determination: The basic approach argues that the equilibrium exchange rate is found when currency flows match up vis-à-vis current and financial account activities. This framework has wide appeal as BOP transaction data is readily available and widely reported. Critics may argue that this theory does not take into account stocks of money or financial assets.

Balance of trade excludes

services trade

law of one price.

sold in two different markets; and no restrictions exist on the sale; and transportation costs of moving the product between markets are equal, then the product's price should be the same in both markets.

The Fisher effect

states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation.

Relatively low real interest rates should normally

stimulate an outflow of capital seeking higher rates elsewhere However, in the case of the U.S., the opposite has occurred due to perceived growth opportunities and political stability - allowing it to finance its large fiscal deficit However, it is beginning to appear that the favorable inflow on the financial account is diminishing while the current account balance is worsening - making the U.S. a bigger debtor nation vis-à-vis the rest of the world

when doing cia prob

watch for the rates and do the conversions simply; make sure to end in dollars and convert correctly

The objective of PPP is to discover

whether a nation's exchange rate is "overvalued" or "undervalued" in terms of PPP.