1. International financial managementHARISHA.B.VAIP(FINANCE AND CONTROL)IIM BANGALOREHarisha.B.V. (Associate) finance and control, IIMB 1

2. Module 1 International financial environment. Nature of international risk exposure International Monetary system Determination of Exchange rates Balance of payments Interest parity International fisher effect Harisha.B.V. (Associate) finance andcontrol, IIMB 2 3. International FinancialEnvironment No country is literally having any controlonce they crosses their nations border. The restrictions and freedom varies fromone country to another in respect ofborrowing ,repayments, debt equity ,taxation policy, production and mfgpolicies,sales markets etc. Harisha.B.V. (Associate) finance andcontrol, IIMB 3 4. Though there are no particular characteristic featureof business economics in any country,developedcountries reflects the market mechanism andindividual choice is having greater freedom andimportance.The tendency of post world war II has been tomultilateral agreement and many internationalorganizations have been created to facilitate themultilateral format.e.g. IMF,IBRD,GATT,BIS,OECD,OPEC , etc.Harisha.B.V. (Associate) finance and control, IIMB 4 5. Therefore it is described as being comprisedof a number of sovereign nation states withdistinct internal organizational structurescompeting against one another according to aset of guidelines determined by multilateralnegotiations ,and which is monitored by themoral authority of the internationalorganization created for this purpose Harisha.B.V. (Associate) finance andcontrol, IIMB 5 6. FINANCE FUNCTIONTREASURERECONTOLLERFINACIALCASHFINANCIAL EXTERNALPLANNINGMANAGEMENT& MGT REPORTINGANALYSISACCOUNTINGFUNDINVESTMENT TAX PLANDECISIONS BUDGET ANDACQUISITION PLANNING MANGTCONTROLINVESTMENTRISK FINANCINGACCOUNTSMANAGEMENT MISRECEIVABLE Harisha.B.V. (Associate) finance andcontrol, IIMB6 source.APTE P.G. 7. IMPORTANCE /SCOPE OF IFM MNCs AND CFO: International eventswhich affect the firm and steps can be takento gain through development or insulateagainst harmful ones. Exchange rate behavior Interest rate behavior Economy Assets value Harisha.B.V. (Associate) finance andcontrol, IIMB 7 8. The emerging challenges To keep update with significantenvironmental changes and analyze theirimplications for the firm. To understand and analyze the complexinterrelationships between relevantenvironmental variables and corporateresponses-own and competitive-to thechanges in them.Harisha.B.V. (Associate) finance and control, IIMB 8 9. To be able to adapt the finance function tosignificant changes in the firms own strategicposture.A firms major change in the product marketmix,funding strategies,dividend policies,cash mgtetc.To take in stride past failures and mistakes tominimize their adverse impact.- a wrong takeover,large foreign loans etcTo design and implement effective solutions to takeadvantage of the opportunities offered by the marketand advances in financial theory.-derivatives etc. Harisha.B.V. (Associate) finance andcontrol, IIMB 9 10. Rewards of IFM International trade & theory of Absoluteadvantage,comparative advantage,limitation.Adams smiths theory of AbsoluteadvantageDavid Ricardos comparative advantageposners theory of limitationproduct life cycle theorytheory of intra-industry trade Harisha.B.V. (Associate) finance andcontrol, IIMB 10 11. INTUTIVE THINKING NO INTERNATIONAL TRADE, NOINTERNATIONAL FINANCEHarisha.B.V. (Associate) finance and control, IIMB 11 12. Investment enhancing and consumptionsmoothing.Investment enhancingGain from return differential.Gain of moving from a lower marginalefficiency (production without transportfacility)Diversification(increasing returns withoutincreasing risks or reducing risks withoutreducing returns.) control, IIMBfinance andHarisha.B.V. (Associate)12 13. CONSUMPTION SMOOTHINGE.g.:- 75 UNITS OF CONUMPTIONREQUIRMENT IN A COUNTRY.YEARLY PRODUCE VARIES FROM50 UNITS TO 100 UNITS.SO WHENEVER 50 UNITS AREPRODUCED BORROW 25 UNITS.WHENEVER 100 UNITS AREPRODUCED LEND 25 UNITS.Harisha.B.V. (Associate) finance and control, IIMB 13 14. INTERNATIONAL RISKEXPOSURE RISK CAN BE BROADLY CLASSIFIEDINTO TWO,NAMELY CORE BUSINESS RISKS ENVIRONMENTAL RISKSHarisha.B.V. (Associate) finance and control, IIMB 14 15. RISK Core business risks are operational riskssuch as an unsuccessful new productlaunch,interruptions in raw materialsuppliers,labor problems, Environmental risks arise out ofunpredictable fluctuations in financialvariables such as exchange rates,interestrates and stock prices,rise in prices of rawmaterials.government policies. Harisha.B.V. (Associate) finance andcontrol, IIMB 15 16. FINANCIAL RISK FINANCIAL RISK THUS CAN BECLEARLY SAID AS SUBSET OFENVIRONMENTAL RISKS. Core business risks are peculiar to particularfirm, but environmental risks are pervasiveand affect all firms in a given industry. Harisha.B.V. (Associate) finance andcontrol, IIMB 16 17. Difference b/w risk and exposure Exposure is a measure of the sensitivity ofthe firms performance-however-measured-to fluctuations in the relevant risk factor . Risk is a measure of the extent of variabilityof the performance measure attributable tothe risk factor. Harisha.B.V. (Associate) finance andcontrol, IIMB 17 18. EXAMPLE FOREIGN CURRENCYFLUCTUATIONS.THE MAGNITUTE OF RISK ISDETERMINED BY MAGNITUDE OFEXPOSURE.Harisha.B.V. (Associate) finance and control, IIMB 18 19. Numerical example Exposure firm with 90 days payable of$500,000. Spot rate 42.90 Forward rate 43.10 Depreciation = RS .20/$1 Therefore the loss will be Rs 100,000 Exposure =change in value ofpayable/unanticipated change in exchange rate =100000/.20=500,000 Harisha.B.V. (Associate) finance andcontrol, IIMB 19 20. Explanation for the example The change in the value of the payable perunit change in the exchange rate. Exposure answers the question: by howmuch will the value of the payable change ifthe rupee dollar rate changes by one rupeeper dollar?. Harisha.B.V. (Associate) finance andcontrol, IIMB 20 21. Example for Risk Suppose a financial consulting firm givesthe following forecast of the value of thespot exchange rate three months from now. 3 months forward rate is Rs 45/$ But it may go up to 45.50 or come down to44.50 also. Therefore exposure is .50 on either side butthe risk is different Harisha.B.V. (Associate) finance andcontrol, IIMB 21 22. TYPES OF RISKS ECONOMICAL AND POLITICAL RISKS GOVERNMENT AND TAXATION EXCHANGE RATE RISK INTEREST RATE RISK MARKET IMPERFECTIONS AGENCY PROBLEMS(conflict of interestbetween decision makers and the owners ofthe MNC)Harisha.B.V. (Associate) finance and control, IIMB 22 23. Goals of MNCs To protect and increase the shareholders value Exploit the global resources Understand the IF environment Use taxation tool effectively Balancing between the holding and subsidiarycompanys interests. Market expansion diversification Harisha.B.V. (Associate) finance andcontrol, IIMB 23 24. INTERNATIONAL MONETARY SYSTMEM EXCHANGE RATE REGIMES. MULTILATERAL FINANCIALINSTITUTIONS CURRENCY BLOCKS SUCH AS THEECONOMIC AND MONETARYUNION(EMU) IN EUROPE.Harisha.B.V. (Associate) finance and control, IIMB 24 25. EXCHANGE RATE REGIMES Gold standard system(1870-1913) Inter country war period (1914-1944) Bretton wood agreement (1945-1973) Fluctuating currency system (1973onwards)Harisha.B.V. (Associate) finance and control, IIMB 25 26. GOLD STANDARD SYSTEM IN THE EARLY DAYS GOLD WAS USED ASA STORAGE OF WEALTH AND AS AMEDIUM OF EXCHAGE. EACH COUNTRY SHOULD SET A PARVALUE FOR ITS CURRENCY IN TERMSOF GOLD AND THEN TRY TO MAINTAINTHIS VALUE. GOLD WAS MEASURED AS PER OUNCE 1OUNCE =31.1035GMS Harisha.B.V. (Associate) finance andcontrol, IIMB 26 27. THREE IMPORTANT FEATURES OF GOLDSTANDARD GOVERNMENT OF EACH COUNTRYDEFINES ITS NATIONAL MONETARY UNITIN TERMS OF GOLD FREE IMPORT OR EXPORT OF GOLD TWO WAY CONVERTIBILITY BETWEENGOLD AND NATIONAL CURRENCIES AT ASTABLE RATIO.Harisha.B.V. (Associate) finance and control, IIMB 27 28. EXAMPLE UNITED STATES DECLARED-$20.67/OUNCE OF GOLD. BRITISH POUND WAS AT4.2474/OUNCE OF GOLD. THERE FORE EXCHANGE RATE WILLBE 20.67USD/4.2474GBP=$4.86656/GBP Harisha.B.V. (Associate) finance andcontrol, IIMB 28 29. DRAW BACKS WHEN INFLATION INCREAES INPARTICULAR COUNTRY THE CURRENCYLOSES THE COMPETITIVENESS IN THEWORLD MARKET. IMPORTS BEING GREATER THAN EXPORTSLET TO A DECLINE IN THE CONFIDENCEOF THE CURRENCY. MANY TIMES GOLD WAS WITHDRAWNFROM RESERVES AND SHIPPED ABROADTO PAY FOR IMPORTS. WITH LESS GOLD AT HOME,THE COUNTRYWAS FORCED TO REDUCE ITS MONEYSUPPLY Harisha.B.V. (Associate) finance and control, IIMB29 30. CONTINUEDTHIS RESULTED IN A SLOW DOWN INECONOMIC ACTIVITY ,HIGH INTERESTRATES,RECESSION,REDUCED NATIONALINCOME AND INCREASEDUNEMPLOYMENT.THIS LED TO CHAOS IN MANYCOUNTRIES INCLUDING US AND UKBECAUSE OF HIGHER INFLATION.Harisha.B.V. (Associate) finance and control, IIMB 30 31. THE INTER WAR YEARS WORLD WAR I DISTURBED THESTABILITY OF EXCHANGE RATESFOR CURRENCIES OF MAJORCOUNTRIES. THE ROLE OF GREAT BRITAIN ASTHE WORLDS MAJOR CREDITORNATION ALSO CAME TO AN ENDAFTER WORLD WAR IHarisha.B.V. (Associate) finance and control, IIMB 31 32. THE UNITED STATES BEGAN TO ASSUMETHE ROLE OF THE LEADING CREDITORNATION.AFTER RECOVERING FROM WAR SOMECOUNTRIES TRIED TO RETURN TO THEGOLD STANDARD SYSTEM,AND FEWCOUNTRIES LIKE US ,UK, SWISS,FRANCE,SCANDINAVIAN COUNTRIES EVENRESTORED GOLD SYSTEM. and Harisha.B.V. (Associate) financecontrol, IIMB 32 33. THE GREATEST MISTAKE DONE BY GREATBRITAIN HERE IS THEY RETURNED BACKTO $4.87/POUND.DURING THIS PERIOD US WAS FACINGINFLATION AT A LESSER RATE THAN UK.THIS RESULTED IN INCRASEDUNEMPLOYMENT AND ECONOMICSTAGNATION IN BRITAIN.Harisha.B.V. (Associate) finance and control, IIMB 33 34. IN 1934IN 193 US DOLLAR WAS DEVALUED TO 35$/OUNCE OF GOLD.THIS SYSTME IS CALLEDAS MODIFIED GOLD STANDARD OR GOLDEXCHANGE STANDARD.AFTER WORLD WARII ONLY NATIONCONTINUED TO REMAIN CONVERTIBLEWAS THE DOLLAR.Harisha.B.V. (Associate) finance and control, IIMB 34 35. THE BRETTON WOOD SYSTEMTHE DEPRESSION FOLLOWED BY WARIN 1930 DIMINISHED COMMERCIALTRADE.REVIVAL OF SYSTEM BYRECONSTRUCTION BEGAN WITHBRETTON WOODS AGREEMENT INNEW HAMPSHIRE. US. Harisha.B.V. (Associate) finance andcontrol, IIMB 35 36. MAIN POINTSTHE GOLD STANDARD SYSTEM WASSCRAPPED.THE BRITISH WANTED A REDUCEDROLE FOR GOLD.THE AGREEMENT ESTABLISHED ADOLLAR BASED INTERNATIONALMONETARY SYSTEMHarisha.B.V. (Associate) finance and control, IIMB 36 37. TWO NEW INSTITUTIONS WERE CREATED ,IMF AND IBRD(WORLD BANK).DOLLAR REMAINED AT 35 PER OUNCE.EACH COUNTRY WAS OBLIGATED TODEFINE ITS MONETARY UNITS IN TERMS OFGOLD OR DOLLAR.EACH CURRENCY WAS PERMITTED TOFLUCTUATE WITHING PLUS OR MINUS 1%TEN PERCENT DEVALUATION WASALLOWED WITH APPROVAL OF IMFHarisha.B.V. (Associate) finance and control, IIMB 37 38. THE BREAKDOWN OF BWASOME OF THE DEVELOPED COUNTRIESCURRENCIES STARTED BECOMINGCONVERTIBLE BY 1971.THERE WAS MUCH IMBALANCEBETWEEN SURPLUS AND DEFICITNATIONS.US DOLLAR FELL IN VALUE AGAINST ANUMBER OF MAJOR IIMBfinance andCURRENCIES.Harisha.B.V. (Associate) control, 38 39. SMITHSONIAN AGREEMENTTHE WORLDS LEADING COUNTRIESCALLED THE G10 PRODUCED THESMITHSONIAN AGREEMENT ONDEC,18,1971.NEW SET OF RATES WERE FIXEDWITHOUT PERMISSION OF IMF.THE US $ WAS FURTHER DEVALUEDFROM 35 TO 38 PER OUNCE OF GOLD.THE FLUCTUATION OF 2.25% WASHarisha.B.V. (Associate) finance andALLOWED. control, IIMB 39 40. FLEXIBLE EXCHANGE RATE REGIME,1973-PRESENT AMERICA ABANDONED THE DOLLAR GOLD LINK IN 1971. PURE FLOAT THE EXCHANGE RATESARE PURELY DETERMINED BY FORCESOF DEMAND AND SUPPLY. DIRTY FLOAT =AUTHORITIES HAVEINTERVENED MORE OR LESS INTENSELYIN FOREIGN EXCHANGE MARKETS.Harisha.B.V. (Associate) finance and control, IIMB 40 41. AS OF NOW THERE IS NO CONSENSUSEITHER ACADEMIC ECONOMISTS ORAMONG POLICY MAKERS OR AMONGBUSINESSMEN AND BANKERS AS TO THEIDEAL EXCHANGE RATE REGIME.MACRO ECONOMIC POLICY WITHIN ANECONOMY HAS BECOME AN EXTREMELYCOMPLEX. Harisha.B.V. (Associate) finance andcontrol, IIMB 41 42. MULTILATERAL FINANCIAL INSTITUTIONS IMF International monetary fund. 29 countries signed in Bretton hood . Current membership is 182 countries. Each member contributes the reservesnamed quota Quotas depends from country to country. 25% will be paid in gold and balance incurrency.Harisha.B.V. (Associate) finance and control, IIMB 42 43. When the country faces a BOP deficit ,IMF willadvance the reserves.IMF was constituted to maintain the exchangerates.Devaluation of currency requres prior approval ofIMFCountries with chronic BOP deficits were allowedto depreciate their currencies.Harisha.B.V. (Associate) finance and control, IIMB 43 44. World bank World bank lends for international projects and itlends at margin of half percent over its borrowingcost. IDA(international development Bank ) is the softlending arm of world bank. IFC(international financial corporation) lends tothe private sector World bank also provides assistance and advice todeveloping countries. Harisha.B.V. (Associate) finance andcontrol, IIMB 44 45. Asian Development Bank Asian development Bank was set up as anAsian version of world bank to providedevelopment finance to countries in Asianregion with head quarter in Philippines.Harisha.B.V. (Associate) finance and control, IIMB 45 46. Economic monetary union In 1957 first step was taken towards the formation ofEMU by six countries.-GERMANY,BELGIUM,NETHERLANDS,ITALY,LUXEMBURG AND FRANCE. In 1968 the same was converted to customs Unionby adopting single tariff wall for imports fromoutside the union. It converted into common market in 1993-BRITAIN,DENMARK,SWEDEN,IRELAND,FINLAND,GREECE,SPAIN,PROTUGAL,AUSTRIA JOINED (15) Harisha.B.V. (Associate) finance andcontrol, IIMB 46 47. Single currency unionThis converted into European community in1999.single currency Monetary Union was formed.Britain ,Sweden &Denmark opted out of the same,Greece was not found eligible.Euro emerged as alternative currency to US$.Here currency integrates without political integration. Harisha.B.V. (Associate) finance andcontrol, IIMB 47 48. GATT During world war II the world economywas badly shattered ,the international tradewas to be restored again which led toformulation of GATT. GATT became the only internationalinstrument of trade rules accepted acceptedby the worlds major trade nations. Harisha.B.V. (Associate) finance andcontrol, IIMB 48 49. BALANCE OF PAYMENTS THE BALANCE OF PAYMENT ISAN ACCOUNTING SYSTEM THATRECORDSTHEECONOMICTRANSACTION BETWEEN THERESIDENTS AND GOVERNMENTOF A PARTICUALR COUNTRYAND THE RESIDENTS AND GOVTOF THE REST OF THE WORLDDURING A YEAR. Harisha.B.V. (Associate) finance andcontrol, IIMB 49 50. THREE MAIN CATEGORIESOF BOP THE CURRENT ACCOUNT THE CAPITAL ACCOUNT THE RESERVE ACCOUNT Harisha.B.V. (Associate) finance andcontrol, IIMB 50 51. THREE MAIN CATEGORIESOF BOP THE CURRENT ACCOUNT THE CAPITAL ACCOUNT THE RESERVE ACCOUNT Harisha.B.V. (Associate) finance andcontrol, IIMB 51 52. CURRENT ACCOUNTPARTICULARSDEBIT(OF) CREDIT(IF)GOODS /SERVICESBUY SELLINVESTMENT INCOMEPAY RECEIVEUNILATERAL GIVERECEIVETRANFERSHarisha.B.V. (Associate) finance and control, IIMB 52 53. CAPITAL ACCOUNTPARTICULARS DEBIT (OF) CREDIT(IF)FDI OUTBOUND INBOUNDPORTFOLIO OUTBOUND INBOUNDOTHER CF(BANK DEPOSITING WITHDRAWINGDEPOSITS ETC)Harisha.B.V. (Associate) finance and control, IIMB53 54. Examples1.Export of goods against Bills ofExchange.Rs15000.2.Realization of Bills of Exchange and deposit inforeign bank account.3.Export of software services Rs 20000 for cash.4. Sale of foreign exchange by bank to RBI.5.Import on credit RS 30000 Harisha.B.V. (Associate) finance andcontrol, IIMB 54 55. 6. Foreign investment RS 40000.7. India received gift of $40000 fromAmerica.8.India made a gift of RS 12000 to Africa.9.Indian bank draws foreign currency of$15000 from RBI.Harisha.B.V. (Associate) finance and control, IIMB 55 56. Solution for the ExampleQuestion 1.Due from Foreigner A/C DR 15000To Export of merchandise A/c 15000 2.Foreign AssetsA/C DR 15000To Due from Foreigner A/C 15000. 3.Foreign Assets A/C DR 20000To Trade in services A/C 20000 Harisha.B.V. (Associate) finance andcontrol, IIMB 56 57. 4 Foreign exchange reserve A/c Dr 20000To Foreign exchange assetsA/c200005 Merchandise Imports A/c Dr30000To Liability to Foreigner A/c 200006 Foreign Exchange Assets A/c Dr 40000To FDI A/c40000 Harisha.B.V. (Associate) finance andcontrol, IIMB57 58. 7 Foreign Exchange asset A/c Dr 40000To Unrequited Transfer A/c 400008 Unrequited Transfer A/c Dr 12000To Foreign Exchange asset A/c 120009 Foreign exchange AssetA/c Dr 15000 To foreign Exchange Reserve A/c15000Harisha.B.V. (Associate) finance and control, IIMB 58 59. The official reserve account Official reserves are government owned assets. The official reserve account represents onlypurchases and sales by the central bank of thecountry. If a country has BOP deficit then ,the central bankhas to run down its official assets such as gold,foreign exchange ,SDR or borrow fresh fromforeign central banks. Harisha.B.V. (Associate) finance andcontrol, IIMB 59 60. What moves exchange rates? Since the advent of floating exchange ratesin 1973 economists, currency traders andother professionals are expending enormousintellectual effort to find out the forceswhich drive exchange rates and buildreliable exchange rate forecasting models.Harisha.B.V. (Associate) finance and control, IIMB 60 61. Exchange rate is the relative price of one currencyin terms of another.It is the main component which influences trade,relative profitability of various industries, realwages of workers and finally allocation of recourses.We like much of the profession are doubtful of thevalue of the further time series modeling ofexchange rates.(frankel and rose 1995) Harisha.B.V. (Associate) finance andcontrol, IIMB 61 62. Theories of exchange ratedetermination1. ARBITRAGE AND THE LAW OF ONE PRICE2. PURCHASING POWER PARITY3. THE FISHER EFFECT4. THE INTERNATIONAL FISHER EFFECT5. INTEREST RATE PARITY THEORY6. THE RELATIONSHIP BETWEEN THE FORWARD AND FUTURE SPOT RATE7. CURRENCY FORECASTINGHarisha.B.V. (Associate) finance and control, IIMB 62 63. PART I. ARBITRAGE AND THE LAW OF ONE PRICEI.THE LAW OF ONE PRICE A. Law states:Identical goods sell for thesame price worldwide.Harisha.B.V. (Associate) finance and control, IIMB 63 64. ARBITRAGE AND THE LAW OFONE PRICEB.Theoretical basis:If the price after exchange-rateadjustment were not equal,arbitrage in the goods worldwideensures eventually it will.Harisha.B.V. (Associate) finance and control, IIMB 64 65. ARBITRAGE AND THE LAW OF ONE PRICEC. Five Parity Conditions ResultFrom These Arbitrage Activities1. Purchasing Power Parity (PPP)2. The Fisher Effect (FE)3. The International Fisher Effect (IFE)4. Interest Rate Parity (IRP)5. Unbiased Forward Rate (UFR)Harisha.B.V. (Associate) finance and control, IIMB 65 66. ARBITRAGE AND THE LAW OF ONE PRICED. Five Parity Conditions Linked by 1. The adjustment of variousrates and prices to inflation. Harisha.B.V. (Associate) finance andcontrol, IIMB 66 67. ARBITRAGE AND THE LAW OF ONE PRICE2. The notion that money should have no effect on real variables (since they have been adjusted for price changes). Harisha.B.V. (Associate) finance andcontrol, IIMB 67 68. ARBITRAGE AND THE LAW OF ONE PRICEE. Inflation and home currency depreciation: 1. jointly determined by the growth of domestic money supply; 2. Relative to the growth of domestic money demand.Harisha.B.V. (Associate) finance and control, IIMB 68 69. ARBITRAGE AND THE LAW OF ONE PRICE F. THE LAW OF ONE PRICE- enforced by internationalarbitrage. Harisha.B.V. (Associate) finance andcontrol, IIMB 69 70. Purchasing power parity theory This theory was enunciated by GustavCassel. Purchasing power of a currency isdetermined by the amount of goods andservices that can be purchased with one unitof currency. This reflects the relative purchasing powersof the currency Harisha.B.V. (Associate) finance andcontrol, IIMB 70 71. Example One parker pen in India = RS 150 The same pen in US= $ 3 Therefore 1$= 50 RsHarisha.B.V. (Associate) finance and control, IIMB 71 72. Two types of PPPT Two versions Absolute purchasing power parity. Relative purchasing power parity.PPPT.xlsHarisha.B.V. (Associate) finance and control, IIMB 72 73. Absolute PPPT The level of exchange rate at any time equals theratio of purchasing powers of the two currencies. Sa/b= Pa/Pb Sa/b= exchange rate between the currency of nationA and currency of nation B Pa= price level in nation A Pb= price level in nation B. Harisha.B.V. (Associate) finance andcontrol, IIMB 73 74. Draw backsThe rates can vary considerably due to the factors like1. Transportation cost.2. Tariffs3. Quotas4. Government intervention ,directly in the exchange markets.5. Some goods cannot enter international trade- construction,transportation.6. Service industry cost varies drastically. Harisha.B.V. (Associate) finance and control, IIMB 74 75. Relative The proportionate change in exchange ratebetween two currencies between two pointsof time approximately equals to differencein the inflation rates in the two countriesover the same time interval.Harisha.B.V. (Associate) finance and control, IIMB 75 76. PURCHASING POWER PARITY 1. In mathematical terms: t et =(1 + i h ) e0 (1+if ) t where et = future spot ratee0= spot rateih= home inflationif= foreign inflationt = the time periodHarisha.B.V. (Associate) finance and control, IIMB 76 77. PURCHASING POWER PARITY2. If purchasing power parity is expected to hold, then the best prediction for the one-period spot rate should bet e = e (1+ i h ) t 0( + i1 f )t Harisha.B.V. (Associate) finance andcontrol, IIMB 77 78. PURCHASING POWER PARITY 3. A more simplified but less preciserelationship is et= ih i f e0 that is, the percentage change should be approximately equal to the inflation rate differential.Harisha.B.V. (Associate) finance and control, IIMB 78 79. PURCHASING POWER PARITY4. PPP says the currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation. Harisha.B.V. (Associate) finance andcontrol, IIMB 79 80. PURCHASING POWER PARITYB. Real Exchange Rates: the quoted or nominal rate adjusted for a countrys inflation rate is t(1 + i f ) e t= et t (1 + i h )Harisha.B.V. (Associate) finance and control, IIMB 80 81. Draw back Previously said all draw back holdgood. If people are sometimes more appetitetowards particular currency. Asset market approach. Harisha.B.V. (Associate) finance andcontrol, IIMB 81 82. Forecasting By making use of PPPT theory futurespot rate can be forecasted as follows. S1=S0*(1+ rA / 1+ rB) Harisha.B.V. (Associate) finance andcontrol, IIMB 82 83. Fishers Effect. The fisher effect holds that the level ofnominal interest rates in a given country isrelated to both real return and expected rateof inflation . The currency with higher rates of inflationshould bear higher nominal interest rates andvice versa. If the real return is x % and inflation is y%then the nominal rate should be x% + y% Harisha.B.V. (Associate) finance andcontrol, IIMB 83 84. Formula 1 + NR = (1 + RR) * ( 1+ IR) NR = RR +IR + (RR*IR) What do you mean by Nominal interest rateand real interest rate?Harisha.B.V. (Associate) finance and control, IIMB 84 85. Nominal interest Rate Nominal rate express the ratio of exchangebetween current money and future money . 100 RS invested today @10 % will be 110RS at the end of the year. It does not explain how many more goodsor services we can purchase with this 10RS because value of money will changeover. Harisha.B.V. (Associate) finance andcontrol, IIMB 85 86. Real interest Rate Real interest rate represents the rate atwhich current goods and services arebeing transformed into future goodsand services. Therefore it is the real interest rate andnot the nominal interest rate thatinterests the investors.Harisha.B.V. (Associate) finance and control, IIMB 86 87. Example Suppose investor requires real return tobe 3%,and the rate of inflation over theyear is expected to be 5%. The purchasing power of pound will be GBP = 1/1.05 = 0.9524 or 95.24 % Therefore nominal interest rateexpected will be GBP 0.9524*(1+r ) =1.03 r = 8.15 % Harisha.B.V. (Associate) finance andcontrol, IIMB 87 88. Relevant equation If no government intervention is practiced andlaw of one price holds then interest ratedifferentials should reflect inflationdifferentials .rh - rf = ih - if According to the Fisher Effect, countries withhigher inflation rates have higher interest rates. Due to capital market integration globally,interest rate differentials are eroding.Harisha.B.V. (Associate) finance and control, IIMB 88 89. International Fisher Effect The international holds that differences inthe rate of appreciation or depreciationbetween two currencies is related tonominal interest rates between twocountries . Currency with a low interest rates isexpected to appreciate relative to acurrency of a country with high interestrates and vice versa. Harisha.B.V. (Associate) finance and IFE = PPP + FEcontrol, IIMB 89 90. THE INTERNATIONAL FISHER EFFECTIFE = PPP + FE tet (1 + r h ) =e0 (1 + r f ) tHarisha.B.V. (Associate) finance and control, IIMB 90 91. Example If 1 year interest is 7 % on U.S.treasury bills and 4 % on Swiss FrancTreasury Bills and current exchangerate is $ 0.63 = 1 CHF. Expected future spot rate in one yearare S1/0.63 = ( 1+0.07) / ( 1+ 0.04) S1 = .06482 Harisha.B.V. (Associate) finance andcontrol, IIMB 91 92. THE INTERNATIONAL FISHEREFFECTB. Fisher postulated 1. The nominal interest ratedifferential should reflectthe inflation rate differential.Harisha.B.V. (Associate) finance and control, IIMB 92 93. THE INTERNATIONAL FISHER EFFECTB. Fisher postulated 2. Expected rates of return are equal in the absence of government intervention. Harisha.B.V. (Associate) finance andcontrol, IIMB 93 94. THE INTERNATIONAL FISHER EFFECT C. Simplified IFE equation:(if rf is relatively small)e1 e 0rh r f= e0 Harisha.B.V. (Associate) finance andcontrol, IIMB 94 95. THE INTERNATIONAL FISHER EFFECTD. Implications of IFE 1.Currency with the lower interest rate expected to appreciate relative to one with a higher rate.Harisha.B.V. (Associate) finance and control, IIMB 95 96. THE INTERNATIONAL FISHER EFFECTD. Implications of IFE2. Financial market arbitrage: insures interest rate differential is an unbiased predictor of change in future spot rate. Harisha.B.V. (Associate) finance andcontrol, IIMB 96 97. Theory of interest Rate Parity First developed by J.M.Keynes 1930 . Like PPPT ,IRPT is also law of one price. The premium or discount of one currency against anothershould reflect the interest differential between the twocurrencies. In a perfect market situation ,where there is no restrictionon the flow of money ,one should be able to gain the samereal value on ones monetary assets irrespective of thecountry where they are control, IIMBfinance and held.Harisha.B.V. (Associate) 97 98. Forecasting (F - S)/S = (rh - rf)where rh = the home rate rf = the foreign rate The appreciation or depreciation of onecurrency against another should beapproximately equal to the interest ratedifferential. PPPT is law of one price in the market ofgoods and services and IRPT is in securitiesmarketHarisha.B.V. (Associate) finance and control, IIMB 98 99. INTEREST RATE PARITY THEORYIn equilibrium, returns on currencies will be the same i. e. No profit will be realized and interest parity exists which can be written(1 + rh) = F(1 + rf)SHarisha.B.V. (Associate) finance and control, IIMB 99 100. INTEREST RATE PARITY THEORYCovered Interest Arbitrage1. Conditions required: interest rate differential does not equal the forward premium or discount.2. Funds will move to a country with a more attractive rate. Harisha.B.V. (Associate) finance andcontrol, IIMB 100 101. INTEREST RATE PARITYTHEORYMarket pressures develop: As one currency is more demanded spot and sold forward. Inflow of fund depresses interest rates. Parity eventually reached. Harisha.B.V. (Associate) finance andcontrol, IIMB 101 102. INTEREST RATE PARITYTHEORYSummary: Interest Rate Parity states:1.Higher interest rates on a currency offset by forward discounts.2.Lower interest rates are offset by forward premiums.Harisha.B.V. (Associate) finance and control, IIMB 102 103. Criticisms Availability of funds that can be used for arbitrage isnot infinite. Markets are not always perfect, governmentintervention will be there which leads to dirty float. Capital flows depends not only on interest rates butdepends on also liquidity and the ease of placement. Speculation becomes important when market losesconfidence in the future of a currency.Harisha.B.V. (Associate) finance and control, IIMB 103 104. Forecasting exchange rate in short term Method of advanced indicators Use of forward rate as particular of thefuture spot rate Graphical methodsHarisha.B.V. (Associate) finance and control, IIMB 104 105. Method of advanced indicators Here countrys reserves to its imports areconsidered as a main indicators. N = R / I * 12. N = number of months R= reserves I = imports If N is less than 3 months the currency isvulnerable and may face devaluationHarisha.B.V. (Associate) finance and control, IIMB 105 106. Forward rate as Predictor of futurespot rate. Some authors believe that forward ratesare likely to be an unbiased predictor ofthe future spot rate. Harisha.B.V. (Associate) finance andcontrol, IIMB 106 107. Graphical methods Bar chart Curve of support Curve of Resistance Rate Time curve Harisha.B.V. (Associate) finance andcontrol, IIMB 107 108. Forecasting in medium and longterm Economic approach Sociological and political approach.Harisha.B.V. (Associate) finance and control, IIMB 108 109. Economic approach Structure of the balance of Payments Examination of interest rates Comparative examination of interestrates Comparative examination of inflationrates Study of activity and employment level.Harisha.B.V. (Associate) finance and control, IIMB 109 110. Sociological and political approach Proximity of elections Behavior of opposition parties Recommendation of IMF etc Rigorous control of foreign exchange Interest rate hike Deflationary policyHarisha.B.V. (Associate) finance and control, IIMB 110