International Finance chapter 4
IFE is a combination of ______ and ___
PPP, FE
FE formula =
R = a + i
The international Fisher Effect or IFE states =
States that the spot rate adjusts to the interest rate differential between two countries
IFE formula
_ e/ e0 = ( (1 + rh)^t) / (1 + rf)^t )
THE LAW OF ONE PRICE: If the prices after exchange-rate adjustment were not equal,
arbitrage ensures that they eventually will be.
ABSOLUTE PPP: Price levels adjusted for exchange rates should be
equal between countries.
Real rates of interest: Fisher effects asserts that real returns tend toward _______________________________
equality across countries through arbitrage.
PPP formula=
et = e0 x ( (1 + ih)^t / (1 + if)^t )
et = e0 = ih = if = t =
et = future spot rate e0 = spot rate, $/€ H/F ih = home inflation rate if = foreign inflation rate t = the time period
Forward premium
exists if the forward rate is above the spot rate.
Interest Rate Parity (IRP).
forward exchange rate & Interest rate
Unbiased Forward Rate (UFR).
forward exchange rate & spot exchange rate
(UFR) Stated as:
ft = et
FE States that nominal interest rates (r) are a __________ of the real interest rate (a) and a __________ (i) for inflation expectations
function, premium
ABSOLUTE PPP: One unit of currency has same purchasing power ______________
globally
IFE = Expected rates of return are equal in the absence of
government intervention.
According to the Fisher Effect Countries with higher inflation rates have __________________________________
higher interest rates. (but nominal higher than real)
THE LAW OF ONE PRICE: States that
identical goods sell for the same price worldwide, if sold in a competitive market.
THE UNBIASED FORWARD RATE (UFR) States that,
if the forward rate (ft) is unbiased, then it should reflect the expected future spot rate (et).
PPP: Foreign exchange rate must change by the difference between domestic and foreign rates of ____________
inflation
The International Fisher Effect (IFE)
inflation rate & interest rate
Purchasing Power Parity (PPP)
inflation rates & exchange rates
Due to capital market integration globally,
interest rate differentials are eroding. But if differences exist must due to either currency risk or political risk.
forward exchange rate
refers to an exchange rate that is quoted today but for delivery and payment on a specific future date.
spot exchange rate
refers to the current exchange rate
Simplified IFE equation
rh - rf = (e1 - e0) / e0
ABSOLUTE PPP:It ignores___________, _____________, and ___________________
transportation costs, tariffs, product differentiation
Real rates of interest: With no government interference nominal rates ___________________________________________
vary by the inflation differential or rh - rf = ih - if
A unit of home currency should have the same purchasing power worldwide: 1$ buys a pen in USA, then ___ buys a pen in Britain.
$1
Interest rate parity states
1. Higher interest rates on a currency are offset by forward discounts. and 2.Lower interest rates are offset by forward premiums.
Covered interest arbitrage Conditions required:
1. Interest rate differential does not equal the forward premium or discount. 2. Funds will move to a country with a more attractive rate.
RELATIVE PPP:
The exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries
ARBITRAGE
The simultaneous purchase and sale of the same assets on different markets to profit from price discrepancies.
ABSOLUTE PPP: Big Mac index:
is the exchange rate that leaves hamburgers costing the same overseas as in the USA
Forward discount
is when the forward rate expressed in dollars is below the spot rate.
Empirical evidence is consistent with the Fisher Effect theory =
most nominal rates across countries can be attributed(caused by) to differences in inflationary expectations
In equilibrium, returns on currencies will be the same, that is
no profit will be realized and interest parity exists
The Fisher Effect (FE).
nominal interest rate & real (spot exchange rate)
Real interest rate
rate at which current goods are being converted into future goods
Five parity conditions result from
the arbitrage activities and emphasize the link among prices, inflation rates, spot and forward exchange rates
PPP states:
the currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation
The interest rate parity theory (IRP) states
the forward rate (𝑓1) differs from the spot rate (𝑒0) at equilibrium by an amount equal to the interest differential (𝑟ℎ - 𝑟𝑓) between two countries.
IFE = The nominal interest rate differential should reflect .
the inflation rate differential
Nominal Interest rate
the rate of exchange between current and future dollars