International financial management inbu 4200 fall semester 2004
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International Financial Management: INBU 4200 Fall Semester 2004. Lecture 4: Part 4 International Parity Relationships: The International Fisher Effect (Chapter 5). Recall: Two Long Run Parity Models. Purchasing Power Parity

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International financial management inbu 4200 fall semester 2004

International Financial Management: INBU 4200Fall Semester 2004

Lecture 4: Part 4

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


Recall two long run parity models

Recall: Two Long Run Parity Models

  • 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.


International fisher effect

International Fisher Effect

  • 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


Irving fisher

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.”

Irving Fisher


Fisher interest rate model

Fisher Interest Rate Model

  • 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

The Fisher Effect

  • 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%.


Fisher effect data

Fisher Effect Data

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.


Fisher effect cross border assumptions

Fisher Effect Cross Border Assumptions

  • 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 effect1

International Fisher Effect

  • 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.


Summary exchange rate interest rate relationship

Summary: Exchange Rate – Interest Rate Relationship

  • 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


Forecasting with the international fisher effect

Forecasting With the International Fisher Effect

  • 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


Japanese yen example

Japanese Yen Example

  • 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.


Yen exchange rate change

Yen Exchange Rate Change

  • 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.


Australian dollar example

Australian Dollar Example

  • 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.


Exchange rate change

Exchange Rate Change

  • 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.


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