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International Financial Management: INBU 4200 Fall Semester 2004

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International Financial Management: INBU 4200Fall Semester 2004

Lecture 4: Part 4

International Parity Relationships: The International Fisher Effect (Chapter 5)

- Purchasing Power Parity
- Exchange rate between two countries should be equal to the ratio of the two countries price level.
- The change in the exchange rate will be equal to, but opposite in sign to, the difference in inflation.

- International Fisher Effect
- The change in the exchange rate will be equal to, but opposite in sign to, the difference in the nominal interest rate between two countries.

- Both of these models are regarded as longer term forecasting models.
- Not concerned with where spot rates will be in a couple of minutes, hours, days or weeks.

- The last major foreign exchange parity model is the International Fisher Effect.
- This model begins with the Fisher interest rate model:
- Attributed to the economist Irving Fisher (see next slide)
- Explanation of the market (nominal) interest rate.
- Market interest rate is made up of two critical components:
- Real rate requirement; relates to the real growth rate in the economy.
- Inflationary expectations premium; the markets expectations regarding future rates of inflation

1867-1947.

One of the earliest American neo-classical economists

Noted for:

The Quantity Theory of Money (MV = PT)

Theory of Interest

Just days before the October 1929 Wall Street crash, he was quoted as saying that stock prices were not over inflated but, rather, had achieved a “new, permanent plateau.”

- The Fisher model assumes:
- Real rate requirement relatively stable over time.
- Inflationary expectations subject to wide swings over time.
- Thus, the inflationary expectations premium is subject to large changes over time.

- Thus, changes in market interest rates occur primarily because of changes in expected inflation!

- The Fisher Effect is best stated as:
- A change in the expected rate of inflation will result in a direct and proportionate change in the market rate of interest.

- Assume the following:
- real rate requirement is 3.0%
- Expected rate of inflation is 1.0%

- Under these conditions, the market interest rate would be 4%
- If the expected rate of inflation increases to 2.0%, the market interest rate would rise to 5%.

CPI Forecast2 Year Gov’t

Country20042005Bond Rate

Australia+2.2% +2.5%5.27%

U.S.+1.9% +1.8%2.45%

Switzerland+0.7% +0.4%1.13%

Japan-0.1% nil0.14%

Forecast: The Economist Poll, May 29, 2004

Conclusion: Higher expected rate of inflation counties are associated with higher market interest rates.

- Model assumes that the real rate requirement is the same across major industrial countries.
- Thus observed market interest rate differences between counties is accounted for on the basis of differences in inflation expectations.
- Example:
- If the United States 1 year interest rate is 5% in the United Kingdom 1 year interest rate is 7%, then:
- The expected rate of inflation is 2% higher in the U.K. over the next 12 months.

- International Fisher effect parity model suggests that:
- Changes in exchange rates will be driven by differences in market interest rates between countries.

- Relationship to Exchange Rates
- The currencies of high interest rate countries will weaken (depreciate).
- The currencies of low interest rate countries will strengthen (appreciate)

- Why?
- Because differences in interest rates capture (incorporate) differences in expected inflation.

- Relatively high interest rate countries have high inflationary “expectations” conditions.
- Relatively high inflation causes a currency to weaken (depreciate): see PPP model.

- Relatively low interest rate countries have low inflationary “expectations” conditions.
- Relatively low inflation causes a currency to strengthen (appreciate): see PPP model

- Assumptions:
- The exchange rate will change by a percentage amount equal to the observed market interest rate difference.
- Exchange rate will move opposite to the observed interest rate difference.

- Data to be used:
- Use (National) Government securities
- Use yields to maturities (not coupon yields)
- Match maturity of securities with forecasted time period
- Very Important

- Using interest rate data from Bloomberg’s web site (rates and bonds):
- http://www.bloomberg.com/markets/index.html

- 2 year U.S. Government rate: 2.65%
- 2 year Japanese Government rate: 0.14%
- Higher U.S. interest rate is accounted for on the basis of higher expected U.S. inflation:
= 2.65% – 0.14% = 2.51%

- Forecast: Yen over the next two years.

- Given the expected inflation differences, the yen will appreciate 2.51% per year.
- Current spot rate JPY110.44/USD.
- Spot rate 1 year from now: 107.67
= 110.44 - (110.44 x .0251) = 110.44 – 2.77 = 107.67\

- Spot rate 2 years from now: 104.97
= 107.67 – (107.67 x .0251) = 107.67 – 2.70 = 104.97

Note: Yen is quoted in European terms, hence the minus sign in the above calculation.

The minus sign represents an appreciation of the yen.

- Using interest rate data from Bloomberg’s web site (rates and bonds):
- http://www.bloomberg.com/markets/index.html

- 2 year U.S. Government rate: 2.65%
- 2 year Australian Government rate: 5.13%
- Higher Australian interest rate is accounted for on the basis of higher expected inflation in Australia:
= 2.65% – 5.13% = -2.48%

- Forecast: Australian dollar over the next two years.

- Given the expected inflation differences, the Australian dollar will depreciate 2.48% per year.
- Current spot rate USD.7262/AUD.
- Spot rate 1 year from now: .7569
= .7762 - (.7762 x .0248) = .7762 - .0193 = .7569

- Spot rate 2 years from now: 3.09
= .7569 - (.7569 x .0248) = .7569 - .0188 = .7381

- Note: The Australian dollar is quoted in American terms; hence the minus sign in the above calculation
- The minus sign represents a depreciation of the Australian dollar.