Chapter #8 FINA 447

According to the International Fisher Effect (IFE)....

home country investors will earn the same return on foreign investments as on domestic investments foreign country investors will earn the same return on foreign investments than on domestic investments.

Assume that the New Zealand inflation rate is higher than the U.S. inflation rate. This will cause U.S. consumers to ________ their imports from New Zealand and New Zealand consumers to ________ their imports from the U.S. According to purchasing power parity (PPP), this will results in a(n) ________ of the New Zealand dollar (NZ$).

reduce; increase; depreciation

Under purchasing power parity, the future spot exchange rate is a function of the initial spot rate in equilibrium and

the inflation differential.

The inflation rate in the U.S. is 4%, while the inflation rate in Japan is 1.5%. The current exchange rate for the Japanese yen (¥) is $0.0080. After supply and demand for the Japanese yen has adjusted according to purchasing power parity, the new exchange rate for the yen will be

$0.0082 (1.04)/(1.015)-1 = 0.000197 0.000197 + .008 = $0.008197

The interest rate in the United Kingdom is 7 percent, while the interest rate in the United States is 5 percent. The spot rate for the British pound is $1.50. According to the international Fisher effect (IFE), the British pound should adjust to a new level of

$1.47 (1.05 / 1.07) -1 = - 1.87% $1.50 (1 - 0.0187) = $1.47

Real rate of Interest US - 2% Mexico - 2% Nominal Interest US - 11% Mexico - 15% Spot Rate $0.20 One Yr Fwd $0.19 Use the forward rate to forecast the percentage change in the Mexican peso over the next year. Use the differential in expected inflation to forecast the percentage change in the Mexican peso over the next year Use the spot rate to forecast the percentage change in the Mexican peso over the next year.

($0.19 - 0.20) / 0.20 = -.05 0r -5% (1.09)/(1.13) - 1 = -.0353 or -3.53% Zero Percent Change

Assume that the spot exchange rate of the British pound is $1.73. How will this spot rate adjust according to PPP if the United Kingdom experiences an inflation rate of 7 percent while the United States experiences an inflation rate of 2 percent?

(1.02/1.07) - 1 = -4.67% $1.73 x (1 + (-4.67%)) = $1.649

Assume that the spot exchange rate of the Singapore dollar is $.70. The one-year interest rate is 11 percent in the United States and 7 percent in Singapore. What will the spot rate be in one year according to the IFE? What is the force that causes the spot rate to change according to the IFE?

(1.11 / 1.07) - 1 = 3.74% $0.70 x (1 + 3.74%) = $0.7262 The force that causes this expected effect on the spot rate is the inflation differential. The anticipated inflation differential can be derived from interest rate differential.

Reasons that purchasing power parity (PPP) does not consistently occur are

-Exchange rates are affected by interest rate differentials -Supply and Demand may not adjust if no substitutable goods are available -Exchange rates are affected by national income differentials and government controls

PPP - the relative form... - focuses on the relationship between -absolute form suggests...

-accounts for the possibility of market imperfections -exchange rate and inflation -prices of similar products of two different countries should be equal when measured in a common currency.

You have an opportunity to invest in Australia at an interest rate of 8%. Moreover, you expect the Australian dollar (A$) to appreciate by 2%. Your effective return from this investment is

10.16% (1.08)*(1.02) -1 = 0.1016

If investors in the United States and Canada require the same real interest rate, and the nominal rate of interest is 2 percent higher in Canada, what does this imply about expectations of U.S. inflation and Canadian inflation? What do these inflationary expectations suggest about future exchange rates?

Expected inflation in Canada is 2 percent above expected inflation in the U.S. If these inflationary expectations come true, PPP would suggest that the value of the Canadian dollar should depreciate by 2 percent against the U.S. dollar.

T/F: PPP theory cannot be tested for countries on which inflation information is available.

False

T/F: The Fisher effect states that real risk-free interest rates contain a nominal rate of return and anticipated inflation.

False

T/F: Purchasing power parity (PPP) focuses on the relationship between nominal interest rates and exchange rates between two countries.

False; exchange rates and inflation

T/F: The absolute form of purchasing power parity (PPP) states that the rate of change in the prices of products should be similar (but not identical) when measured in a common currency.

False; it should be the same

T/F: Assume that a regression of exchange rate changes on the expected exchange rate changes according to purchasing power parity (PPP) produced a coefficient of 2. This strongly indicates that PPP holds.

False; this indicates that they underestimated the exchange rate change during the period under examination

How is it possible for PPP to hold if the IFE does not?

For the IFE to hold, the following conditions are necessary: (1) investors across countries require the same real returns (2) the expected inflation rate embedded in the nominal interest rate occurs (3) the exchange rate adjusts to the inflation rate differential according to PPP. If conditions (1) or (2) do not hold, PPP may still hold, but investors may achieve consistently higher returns when investing in a foreign country's securities. Thus, IFE would be refuted.

Japan has typically had lower inflation than the United States. How would one expect this to affect the Japanese yen's value? Why does this expected relationship not always occur?

Japan's low inflation should place upward pressure on the yen's value. Yet, other factors can sometimes offset this pressure. For example, Japan heavily invests in U.S. securities, which places downward pressure on the yen's value.

Regression Analysis of exchange rate indicates that a= 0 and a=2 implies...

PPP underestimated the exchange rate change during the period under examination

Inflation differentials between the U.S. and other industrialized countries have typically been a few percentage points in any given year. Yet, in many years annual exchange rates between the corresponding currencies have changed by 10 percent or more. What does this information suggest about PPP?

The information suggests that there are other factors besides inflation differentials that influence exchange rate movements. Thus, the exchange rate movements will not necessarily conform to inflation differentials, and therefore PPP will not necessarily hold.

T/F: A theory relating exchange rate changes to the nominal interest rate differential between two countries is the international Fisher effect (IFE).

True

T/F: Assume a statistical test is run, where actual exchange rate changes are regressed on the hypothesized exchange rate changes according to the IFE. The hypothesized values of the intercept and coefficient are 0.0 and 1.0, respectively.

True

T/F: Points lying below the PPP line represent purchasing power disparity; in this case, home country goods are cheaper from the foreign consumers' perspective.

True

T/F: Research in finance indicates that when an exchange rate deviates far from the value that would have been expected according to purchasing power parity (PPP), it moves towards that value.

True

T/F: The relative form of purchasing power parity (PPP) accounts for the possibility of market imperfections such as transportation costs, tariffs, and quotas in establishing a relationship between inflation rates and exchange rate changes.

True

Relative form PPP

accounts for market imperfections like transportation costs, tariffs, and quotas. It states that the rate of price changes should be similar

If nominal Canadian interest rates are 2% and nominal U.S. interest rates are 6%, then the Canadian dollar (C$) is expected to ________ by about ________%, according to the international Fisher effect (IFE)

appreciate; 3.92 (1.06/1.02) - 1 = 0.0392

Assume that the inflation rate in Singapore is 3 percent, while the inflation rate in the United States is 8 percent. According to PPP, the Singapore dollar should ____ by ____percent.

appreciate; 4.85 (1.08 / 1.03) - 1 = 4.85%

According to ___________, a country with a higher interest rate will have higher expected inflation.

b. the international Fisher effect (IFE)

According to the IFE, if British interest rates are lower than U.S. interest rates

d. the British pound will appreciate against the dollar.

Purchasing Power Parity (PPP) Line

diagonal line on a graph that reflects points at which the inflation differential between two countries is equal to the % change int he exchange rate between the two respective currencies.

Which of the following is not true about the IFE line. a. Any point lying on the IFE indicates that the international Fisher effect holds. b. Any point lying to the left of the IFE line represents opportunities for home country investors to earn higher returns than those available domestically. c. Any point lying to the right of the PPP line indicates that returns from foreign investments will be lower than those from those available at home. d. All of these choices are true. e. [Any point lying to the left of the IFE line represents opportunities for home country investors to earn higher returns than those available domestically.] and [Any point lying to the right of the PPP line indicates that returns from foreign investments will be lower than those from those available at home.] are not true.

e. Any point lying to the left of the IFE represents opportunities for home country investors to earn higher returns than those available domestically & Any point lying to the right of the PPP line indicates that returns from foreign investments will be lower than those available at home are not true

Regression results indicate that a0 = 0 and a1 = 0.4 for the inflation rate information and exchange rate. Therefore

purchasing power parity overestimated the exchange rate change during the period under examination.

PPP suggests that a currency's _________ will change according to _____.

spot rate; inflation differentials

IFE suggests that a currency's _____ will change according to

spot rate; interest rate differentials

Assume that the U.S. one-year interest rate is 3 percent and the one-year interest rate on Australian dollars is 6 percent. The U.S. expected annual inflation is 5 percent, while the Australian inflation is expected to be 7 percent. You have $100,000 to invest for one year and you believe that PPP holds. The spot exchange rate of an Australian dollar is $0.689. What will be the yield on your investment if you invest in the Australian market?

4% (1.05 / 1.07) x $0.689 = $0.676 $100,000 / $0.689 = A$145,137.88 A$145,137.88 (1.06) = A$153,846.15 A$153,846.15 x $0.676 = $104,000 Yield = $104,000 - 100,000 / 100,000 x100 = 4%

Shouldn't the IFE discourage investors from attempting to capitalize on higher foreign interest rates? Why do some investors continue to invest overseas, even when they have no other transactions overseas?

According to the IFE, higher foreign interest rates should not attract investors because these rates imply high expected inflation rates, which in turn imply potential depreciation of these currencies. Yet, some investors still invest in foreign countries where nominal interest rates are high. This may suggest that some investors believe that (1) the anticipated inflation rate embedded in a high nominal interest rate is overestimated, or (2) the potentially high inflation will not cause substantial depreciation of the foreign currency (which could occur if adequate substitute products were not available elsewhere), or (3) there are other factors that can offset the possible impact of inflation on the foreign currency's value.

The nominal interest rate in Fiji is 3%, while the nominal interest rate in the U.S. is 5%. Real interest rates in both countries are 2%. According to purchasing power parity (PPP), the Fijian dollar (F$) may be expected to ________ by ________%.

Appreciate; 1.98% Fiji rate = 3% - 2% => 1% US rate = 5% - 2% => 3% (1.03 / 1.01) - 1 = 1.98%

Russia commonly experiences a high rate of inflation. Explain why the high Russian inflation typically places severe downward pressure on the value of the Russian ruble. In some periods, the Russian government intervenes in the foreign exchange market and imposes some restrictions on international trade. Why might these conditions prevent purchasing power parity (PPP)? Will the effects of the high Russian inflation and the decline in the ruble offset each other for U.S. importers? That is, how will U.S. importers of Russian products be affected by the conditions?

As Russian prices were increasing, the purchasing power of Russian consumers was declining. This would encourage them to purchase products in the U.S. and elsewhere, which results in a large supply of rubles for sale. Given the high Russian inflation, foreign demand for rubles to purchase Russian products would be low. Thus, the ruble's value should depreciate against the dollar, and against other currencies. The general relationship suggested by PPP is supported, but the ruble's value will not normally move exactly as specified by PPP. The political conditions that could restrict trade or currency convertibility can prevent Russian consumers from shifting to foreign products. Thus, the ruble may not decline by the full degree to offset the inflation differential between Russia and the U.S. Furthermore, the government may not allow the ruble to float freely to its proper equilibrium level. U.S. importers will likely experience higher prices, because the Russian inflation may not be completely offset by the decline in the ruble's value. This may cause a reduction in the U.S. demand for Russian products.

Assume that the inflation rate in Brazil is expected to increase substantially. How will this affect Brazil's nominal interest rates and the value of its currency (called the real)? If the IFE holds, how will the nominal return to U.S. investors who invest in Brazil be affected by the higher inflation in Brazil? Explain.

Brazil's nominal interest rate would likely increase to maintain the real return required by Brazilian investors. The Brazilian real would be expected to depreciate according to the IFE. If the IFE holds, the return to U.S. investors who invest in Brazil would not be affected. Even though they now earn a higher nominal interest rate, the expected decline in the Brazilian real offsets the additional interest to be earned.

Would PPP be more likely to hold between the United States and Hungary if trade barriers were completely removed and if Hungary's currency were allowed to float without any government intervention? Would the IFE be more likely to hold between the United States and Hungary if trade barriers were completely removed and if Hungary's currency were allowed to float without any government intervention? Explain.

Changes in international trade result from inflation differences and affects the exchange rate (by affecting the demand for the currency and the supply of the currency for sale). The effect on the exchange rate is more likely to occur if (a) free trade is allowed and (b) the currency's exchange rate is allowed to fluctuate without any government intervention. The underlying force of IFE is the differential in expected inflation between two countries, which can affect trade and capital flows. The effects on the exchange rate are more likely to occur if (a) free trade is allowed, and (b) the currency's exchange rate is allowed to fluctuate without government intervention.

Brazil commonly has a much higher nominal interest rate than the U.S. Yet, some large institutional investors do not invest in Brazilian money market securities, even when they believe the securities have no credit (default) risk. Use the international Fisher effect (IFE) to explain why the Brazilian money market securities may not be a good investment for U.S. investors.

If investors believed in the IFE, the high nominal interest rate in Brazil should reflect a high level of expected inflation. According to purchasing power parity (PPP), the higher interest rate should result in a weaker currency because of the implied market expectations of high inflation. The high expected inflation can cause concerns that the Brazilian real will depreciate to offset the interest rate advantage. Consequently, the return to U.S. investors might be no better than what they can earn on domestic investments.

Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in the United States is 8 percent for one-year securities that are free from default risk. What does the IFE suggest about the differential in expected inflation in these two countries? Using this information and the PPP theory, describe the expected nominal return to U.S. investors who invest in Mexico.

If investors from the U.S. and Mexico required the same real (inflation-adjusted) return, then any difference in nominal interest rates is due to differences in expected inflation. Thus, the inflation rate in Mexico is expected to be about 40 percent above the U.S. inflation rate. According to PPP, the Mexican peso should depreciate by the amount of the differential between U.S. and Mexican inflation rates. Using a 40 percent differential, the Mexican peso should depreciate by about 40 percent. Given a 48 percent nominal interest rate in Mexico and expected depreciation of the peso of 40 percent, U.S. investors will earn about 8 percent. (This answer used the inexact formula, since the concept is stressed here more than precision.)

Compare and contrast interest rate parity (discussed in the previous chapter), purchasing power parity (PPP), and the international Fisher effect (IFE).

Interest rate parity can be evaluated using data at any one point in time to determine the relationship between the interest rate differential of two countries and the forward premium (or discount). PPP suggests a relationship between the inflation differential of two countries and the percentage change in the spot exchange rate over time. IFE suggests a relationship between the interest rate differential of two countries and the percentage change in the spot exchange rate over time. IFE is based on nominal interest rate differentials, which are influenced by expected inflation. Thus, the IFE is closely related to PPP.

Explain how you could determine whether PPP exists. Describe a limitation in testing whether PPP holds.

One method is to choose two countries and compare the inflation differential to the exchange rate change for several different periods. Then, determine whether the exchange rate changes were similar to what would have been expected under PPP theory. A second method is to choose a variety of countries and compare the inflation differential of each foreign country relative to the home country for a given period. Then, determine whether the exchange rate changes of each foreign currency were what would have been expected based on the inflation differentials under PPP theory. A limitation in testing PPP is that the results will vary with the base period chosen. The base period should reflect an equilibrium position, but it is difficult to determine when such a period exists.

Explain why PPP does not hold.

PPP does not consistently hold because there are other factors besides inflation that influences exchange rates. Thus, exchange rates will not move in perfect tandem with inflation differentials. In addition, there may not be substitutes for traded products. Therefore, even when a country's inflation increases, the foreign demand for its products will not necessarily decrease (in the manner suggested by PPP) if substitutes are not available.

Explain the theory of purchasing power parity (PPP). Based on this theory, what is a general forecast of the values of currencies in countries with high inflation?

PPP suggests that the purchasing power of a consumer will be similar when purchasing products in a foreign country or in the home country. If inflation in a foreign country differs from inflation in the home country, the exchange rate will adjust to maintain equal purchasing power. Currencies in countries with high inflation will be weak according to PPP, causing the purchasing power of products int he home country vs these countries to be similar.

Exact/Approximate representation of IFE

ef = (1 + ih)/(1 + if) -1 ef ~ ih - if

Assume that locational arbitrage ensures that spot exchange rates are properly aligned. Also assume that you believe in purchasing power parity. The spot rate of the British pound is $1.80. The spot rate of the Swiss franc is .3 pounds. You expect that the one-year inflation rate is 7 percent in the U.K., 5 percent in Switzerland, and 1 percent in the U.S. The one-year interest rate is 6% in the U.K., 2% in Switzerland, and 4% in the U.S. What is your expected spot rate of the Swiss franc in one year with respect to the U.S. dollar? Show your work.

SF spot rate in $ = 1.80 × .3 = $.54. Expected % change in SF in one year = (1.01)/(1.05) - 1 = -3.8% Expected spot rate of SF in one year = $.54 × (1 - .038) = $.5194

Explain the international Fisher effect (IFE). What is the rationale for the existence of the IFE? What are the implications of the IFE for firms with excess cash that consistently invest in foreign Treasury bills? Explain why the IFE may not hold.

The IFE suggests that a currency's value will adjust in accordance with the differential in interest rates between two countries. The rationale is that if a particular currency exhibits a high nominal interest rate, this may reflect a high anticipated inflation. Thus, the inflation will place downward pressure on the currency's value if it occurs. The implications are that a firm that consistently purchases foreign Treasury bills will on average earn a similar return as on domestic Treasury bills. The IFE may not hold because exchange rate movements react to other factors in addition to interest rate differentials. Therefore, an exchange rate will not necessarily adjust in accordance with the nominal interest rate differentials, so that IFE may not hold.

Assume U.S. interest rates are generally above foreign interest rates. What does this suggest about the future strength or weakness of the dollar based on the IFE? Should U.S. investors invest in foreign securities if they believe in the IFE? Should foreign investors invest in U.S. securities if they believe in the IFE?

The IFE would suggest that the U.S. dollar will depreciate over time if U.S. interest rates are currently higher than foreign interest rates. Consequently, foreign investors who purchased U.S. securities would on average receive a similar yield as what they receive in their own country, and U.S. investors that purchased foreign securities would on average receive a yield similar to U.S. rates.

You believe that interest rate parity and the international Fisher effect hold. Assume the U.S. interest rate is presently much higher than the New Zealand interest rate. You have receivables of 1 million New Zealand dollars that you will receive in one year. You could hedge the receivables with the one-year forward contract. Or you could decide to not hedge. Is your expected U.S. dollar amount of the receivables in one year from hedging higher, lower, or the same as your expected U.S. dollar amount of the receivables without hedging? Explain

The expected amount is the same, because the forward rate reflects the interest rate differential, and the expected spot rate (if you do not hedge) according to IFE reflects the interest rate differential.

The U.S. three-month interest rate (unannualized) is 1%. The Canadian three-month interest rate (unannualized) is 4%. Interest rate parity exists. The expected inflation over this period is 5% in the U.S. and 2% in Canada. A call option with a three-month expiration date on Canadian dollars is available for a premium of $.02 and a strike price of $.64. The spot rate of the Canadian dollar is $.65. Assume that you believe in purchasing power parity. -Determine the dollar amount of your profit or loss from buying a call option contract specifying C$100,000. -Determine the dollar amount of your profit or loss from buying a futures contract specifying C$100,000.

The expected change in the Canadian dollar's spot rate is: (1.05)/(1.02) - 1 = 2.94%. Therefore, the expected spot rate in 3 months is $.65 × (1.0294) = $.66911. The net profit per unit on a call option is $.66911 - $.64 - $.02 = $.00911. For the contract, the net profit is $.00911 × 100,000 = $911. According to IRP, the futures rate premium should be (1.01)/(1.04) - 1 = -2.88% Therefore, the futures rate should be $.65 × (1 - .0288) = $.6313. Recall that the expected spot rate in 3 months is $.65 × (1.0294) = $.66911. The expected net profit per unit from buying a futures contract is $.66911 - $.6313 = $.03781. For the contract, the net profit is $.03781 × 100,000 = $4,341.

Assume that several European countries that use the euro as their currency experience higher inflation than the United States, while two other European countries that use the euro as their currency experience lower inflation than the United States. According to PPP, how will the euro's value against the dollar be affected?

The high European inflation overall would reduce the U.S. demand for European products, increase the European demand for U.S. products, and cause the euro to depreciate against the dollar. According to the PPP theory, the euro's value would adjust in response to the weighted inflation rates of the European countries that are represented by the euro relative to the inflation in the U.S. If the European inflation rises, while the U.S. inflation remains low, there would be downward pressure on the euro.

One assumption made in developing the IFE is that all investors in all countries have the same real interest rate. What does this mean?

The real return is the nominal return minus the inflation rate. If all investors require the same real return, then the differentials in nominal interest rates should be solely due to differentials in anticipated inflation among countries.

Explain the rationale of the PPP theory.

When inflation is high in a particular country, foreign demand for products in that country will decrease. In addition, that country's demand for foreign products should increase. Thus, the home currency of that country will weaken; this tendency should continue until the currency has weakened to the extend that a foreign country's products are no more attractive than the home country's products. Inflation differential are offset by exchange rate changes.

Assume that the Canadian inflation rate is expected to exceed the U.S. inflation rate over the next year. If interest rate parity and the international Fisher effect theories hold, then the one-year forward rate of the Canadian dollar will exhibit a _______, and the spot rate of the Canadian dollar will _____________ over the next year.

b. discount; depreciate

Assume that U.S. and Argentine investors require a real return of 2 percent. If the U.S. nominal interest rate is 5 percent, and Argentina's nominal interest rate is 7 percent, then according to the IFE, the Argentine inflation rate is expected to be about ____ the U.S. inflation rate, and the Argentine peso is expected to ____.

d. 2 percentage points above; depreciate by about 2 percent (1.05 / 1.07) - 1 = - 1.90% or -2%

Which of the following is not true about the PPP line? a. Any point lying on the PPP line represent purchasing power parity. b. Any point lying to the left of the PPP line represent higher home consumers' purchasing power with respect to foreign goods than home goods. c. Any point lying to the right of the PPP line represent cheaper foreign goods than home country goods from a foreign consumer's perspective. d. Any point lying to the left of the PPP line represent covered interest arbitrage opportunities for home country investors.

d. any point lying to the left of the PPP line represent covered interest arbitrage opportunities for home country investors.

Exact/Approximate Representations of PPP

ef = (1 + Ih)/(1 + If) -1 ef = Ph(1 + Ih)/Pf(1 + If) ef ~ Ih-If

If interest rates on the euro are consistently above U.S. interest rates, then for the international Fisher effect (IFE) to hold a. the value of the euro would remain constant most of the time. b. the value of the euro would appreciate in some periods and depreciate in other periods, but on average have a zero rate of appreciation. c. the value of the euro would often depreciate against the dollar. d. the value of the euro would often appreciate against the dollar.

the value of the euro would often depreciate against the dollar.

Purchasing Power Parity (PPP) Theory

theory suggesting that exchange rates will adjust over time to reflect the differential in inflation rates in the two countries; in this way, the purchasing power of consumers when purchasing domestic goods will be the same as that when they purchase foreign goods.

Absolute form of PPP

theory that explains how inflation differentials affect exchange rates. It suggests that prices of two products of different countries should be equal when measured bu a common currency. Not considering international barriers