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 4200Fall Semester 2004

Lecture 4: Part 4

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

Recall: Two Long Run Parity Models
• 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
• 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.”

Irving Fisher
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 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

CPI Forecast 2 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% nil 0.14%

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
• 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
• 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
• 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
• 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
• 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
• 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
• 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
• 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.