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Session 8

Session 8. Vocabulary : Convergence Empirical The efficient market hypothesis (EFH) – all products (securities, commodities) in a market are fairly valued. Important Terms. Purchasing power parity (PPP) The fisher effect The international fisher effect Market efficiency

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Session 8

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  1. Session 8 • Vocabulary : • Convergence • Empirical • The efficient market hypothesis (EFH) – all products (securities, commodities) in a market are fairly valued

  2. Important Terms • Purchasing power parity (PPP) • The fisher effect • The international fisher effect • Market efficiency • Law of one price • Nominal interest rate • Real interest rates

  3. Inflation • We once again consider inflation and how it affects international financial management. Inflation is the overall general upward price movement of goods and services in an economy, usually as measured by the consumer price index and the producer price index. Opposite of deflation.

  4. The CPI(Consumer Price Index) • An inflationaryindicator that measures the change in the cost of a fixed basket of products and services, including housing, electricity, food, and transportation. The CPI is published monthly.

  5. Measuring the Cost of Living • In determining the cost of living, the bureau of labor statistics (BLS) first identifies a “market basket” of goods and services the typical consumer buys. . • Annually, the BLS surveys consumers to determine what they buy and the overall cost of the goods and services they buy.

  6. The CPI –Measuring the Cost of Living • The consumer price index (CPI) is used to monitor changes in the cost of living (i.E. The selected market basket) over time.  When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living. • The goal of the CPI is to measure changes in the cost of living. It reports the movement of prices not in dollar amounts, but with an index number.

  7. What Is an Index Number? • An Index Number is developed with an arbitrary base (usually starting with 100) that indicates a change in magnitude relative to its value at a specified point in time.

  8. Calculating the Consumer Price Index and the Inflation Rate • Base Year is 2000 • Bundle of goods in 2000 = $1,200 • The same bundle in 2001 cost = $1,236 • CPI = ($1,236 ÷ $1,200) X 100 = 103 • Prices between 2000 & 2001 increased 3%

  9. CPI Examples CPI1950=24.1 ……. CPI2001=177.2 Total inflation = 635% ……. Avg. annual inflation = 4% $50,000 salary in 2001 buys the same as $6,800 did in 1950. A 51-year bond purchased in 1950 with a 4% YTM earned a real return of zero.

  10. CPI Examples CPI2000=172.3 ……. CPI2001=177.2 Total inflation = 2.84% … Avg. annual inflation = 2.84% You invested $1,000 in 2000 at 5% for one year (compounded annually). In 2001, the investment is worth: Inflation stole $29.03 from you. (Who actually pocketed the $29.03?)

  11. CPI’s Significance • When comparing dollar values from different times, it is necessary to keep in mind that a dollar today is not the same as a dollar in the past. • The CPI illustrates one way that prices are measured and how to make adjustments for these price changes.

  12. Example: Even moderate deflation or inflation over a long period distorts stock prices. 12-31-2001 1145 80.5 Inflation Deflation

  13. Example: About 1/2 of the average annual increase in the S&P 500 since 1970 was simply inflation. Total nominal increase: 1,168% Avg. annual increase: 7.9% 12-31-2001 1145 245 Inflation Total real increase: 170% Avg. annual increase: 3.9%

  14. Real and Nominal Interest Rates • Interest represents a payment in the future for a transfer of money in the past. • Real interest rate = Nominal – Inflation • If Inflation = zero, then Real Rate = Nominal Rate

  15. Nominal Interest Rate • The rate that the bank pays in current value • Not adjusted for inflation.

  16. Real interest rate • The interest rate corrected for inflation. • Adjusted for inflation.

  17. Example • Assume you borrow $1,000 for one year. • Nominal interest rate was 15%. • During the year inflation was 10%. • The (approximate) real interest rate is: • 5% = 15% - 10% • The real interest rate is: • 4.5% = (15%-10%)/(1+10%)=.05/1.10

  18. Example • Lend a friend $100 for one year at 0% interest when inflation is 0%. What happens to your ability to consume goods in one year? • Suppose inflation is 10%. What happens to amount you can consume in one year? • The increase in $ amount represents the nominal interest rate. • The increase in your ability to consume is the real interest rate.

  19. Nominal and Real Indexes • Based on the “CPI” model, we have: • Nominal Effective Exchange Rate Index • Real Effective Exchange Rate Index IMF Index: • shows the degree to which PPP has held

  20. Purchasing Power Parity • The theory that, in the long run, identical products and services in different countries should cost the same in different countries. • This is based on the belief that exchange rates will adjust to eliminate the arbitrage opportunity of buying a product or service in one country and selling it in another. • The theory makes some assumptions that don't hold in the real world, such as ignoring the effects of transportation costs and tariffs..

  21. “PPP” • States that spot exchange rates between currencies will change to the differential in inflation rates between countries. • One unit of currency has same purchasing power globally. • Price levels adjusted for exchange rates should be equal between countries. • Exchange rates between different currencies are in equilibrium when their purchasing power is the same in two countries. • If the price level of one country increases (i.E. The country experiences inflation), its currency must depreciate in order to maintain PPP.

  22. “PPP” • A more simplified relationship is that the percentage change should be approximately equal to the inflation rate differential. • PPP assumes efficiency.

  23. “PPP” Example • The price of wheat in Canadian and U.S. Markets should trade at the same price (after adjusting for the exchange rate). If the price of wheat is lower in Canada, then purchasers will buy wheat in Canada as long as the price is cheaper (after accounting for transportation costs). • Thus, demand will fall in the U.S. And increase in Canada to bring prices back into equilibrium.

  24. THE LAW OF ONE PRICEThe Absolute Form of PPP • Identical goods sell for the same price worldwide. • Theoretical basis: if the price after exchange-rate adjustment were not equal, arbitrage in the goods worldwide ensures eventually it will. • It suggests that similar products in different countries should be equally priced when measured in the same currency.

  25. Law of One Price: S simply says that an identical item. Simply says that an identical item. Must have an identical price in all. Countries when that price is. Expressed in the same currency. an identical price in all. Countries when that price is. Expressed in the same currency. Imply says that an identical item. Must have an identical price in all. Countries when that price is. Expressed in the same currency.

  26. The Relative Form of PPP • Accounts for market imperfections like transportation costs, tariffs, and quotas. • PPP may not occur consistently due to: • The existence of other influential factors like differentials in income levels and risk, as well as government controls; And. • The lack of substitutes for traded goods.

  27. “PPP” • ABSOLUTE PPP –states that the exchange rates is determined by relative prices of similar goods. • RELATIVE PPP – relaxes the standards of absolute PPP. States that if the spot exchange rate between two countries starts at equilibrium, any change in the rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate.

  28. The Fisher Effect • Named after economist, Irving fisher. • States that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations OR: R = a + I. • According to the fisher effect, countries with higher inflation rates have higher interest rates.

  29. The Fisher Effect • The fisher effect predicts upward adjustments in nominal interest rates as borrowers and lenders compensate for expected inflation. This effect may take place with a lag. • It requires a forecast of future inflation rates, NOT what inflation has been.

  30. THE INTERNATIONAL FISHER EFFECT • THEORY THAT THE SPOT EXCHANGE RATE SHOULD CHANGE BY AN AMOUNT EQUAL TO THE DIFFERENCE IN INTEREST RATES BETWEEN TWO COUNTRIES.

  31. The international fisher effect (IFE) theory suggests that currencies with higher interest rates will depreciate because the higher rates reflect higher expected inflation. The spot rate of one currency with respect to another currency will change in accordance with the differential in interest rates between two countries.

  32. Interest-rate Parity • Suggests that if interest rates are higher in one country than they are in another, the former’s currency will sell at a discount in the forward market. • Remember that the fisher effect implies that the nominal rate of interest equals the real rate of interest plus the expected rate of inflation. • The international fisher effect suggests that differences in interest rates between two countries serve as a proxy for differences in expected inflation.

  33. Value of PPP • Emphasizes the importance of inflation on currencies • May be valuable as a long-term indicator of exchange rate direction • Important if there exists wide inflation differential

  34. Correlations between % and inflation

  35. So What Happens If These Theories Don’t Hold? • Arbitrage opportunities exist • Empirical evidence suggests that neither PPP theory nor the international fisher effect are particularly good at explaining short term movements in exchange rates.

  36. “PPP” in Reality • Empirical tests have shown that PPP does not holdup well in the short run, but better in the long run ( like EFH). • Holds up better for countries with relatively high rates of inflation & underdeveloped capital markets. • These tests may be flawed due to. • Dissimilarity in baskets. • Dissimilarity in quality of products. • Other factors of taste, government intervention and deregulation.

  37. Big Mac Index • Using such an index we can gauge. Whether a currency is overvalued or. Undervalued. • Page 199-200 of Shapiro text.

  38. Big Mac Example • A big Mac in Sweden cost 24.00 Kr • A big Mac in the US costs $2.43 • So, 24.00/2.43 = Kr 9.8765/$ • However: • On the same date the actual exchange rate was: • Kr8.32/$ • So, kr9.8765/kr8.32 =1.187 • Meaning the Krona is overvalued by 18.7% according to the big Mac standard

  39. General Conclusions • Theories hold up well in the long run, but poor in the short run • Theories are just that – ideas – til someone comes up with something better • Inflation is an important consideration in both domestic and global business

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