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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 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
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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