International financial
management
HARISHA.B.V
AIP(FINANCE AND CONTROL)
IIM BANGALORE
Harisha.B.V. (Associate) finance and
control, IIMB 1

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 and
control, IIMB 2

International Financial
Environment
• No country is literally having any control
once they crosses their nation’s border.
• The restrictions and freedom varies from
one country to another in respect of
borrowing ,repayments, debt equity ,
taxation policy, production and mfg
policies,sales markets etc.
Harisha.B.V. (Associate) finance and
control, IIMB 3

•Though there are no particular characteristic feature
of business economics in any country,developed
countries reflects the market mechanism and
individual choice is having greater freedom and
importance.
•The tendency of post world war II has been to
multilateral agreement and many international
organizations have been created to facilitate the
multilateral format.e.g. IMF,IBRD,
GATT,BIS,OECD,OPEC , etc.
Harisha.B.V. (Associate) finance and
control, IIMB 4

Therefore it is described as being comprised
of a number of sovereign nation states with
distinct internal organizational structures
competing against one another according to a
set of guidelines determined by multilateral
negotiations ,and which is monitored by the
moral authority of the international
organization created for this purpose
Harisha.B.V. (Associate) finance and
control, IIMB 5

FINANCE FUNCTION
TREASURERE CONTOLLER
FINACIAL CASH FINANCIAL
EXTERNAL
PLANNING MANAGEMENT & MGT
REPORTING
ANALYSIS ACCOUNTING
FUND INVESTMENT TAX PLAN
DECISIONS BUDGET
AND
ACQUISITION PLANNING
MANGT
CONTROL
INVESTMENT RISK
FINANCING ACCOUNTS
MANAGEMENT MIS
RECEIVABLE
Harisha.B.V. (Associate) finance and
control, IIMB 6
source.APTE P.G.

IMPORTANCE /SCOPE OF IFM
• MNCs AND CFO: International events
which affect the firm and steps can be taken
to gain through development or insulate
against harmful ones.
• Exchange rate behavior
• Interest rate behavior
• Economy
• Assets value
Harisha.B.V. (Associate) finance and
control, IIMB 7

The emerging challenges
• To keep update with significant
environmental changes and analyze their
implications for the firm.
• To understand and analyze the complex
interrelationships between relevant
environmental variables and corporate
responses-own and competitive-to the
changes in them.
Harisha.B.V. (Associate) finance and
control, IIMB 8

•To be able to adapt the finance function to
significant changes in the firm’s own strategic
posture.A firms major change in the product –market
mix,funding strategies,dividend policies,cash mgt
etc.
•To take in stride past failures and mistakes to
minimize their adverse impact.- a wrong takeover,
large foreign loans etc
•To design and implement effective solutions to take
advantage of the opportunities offered by the market
and advances in financial theory.-derivatives etc.
Harisha.B.V. (Associate) finance and
control, IIMB 9

Rewards of IFM
• International trade & theory of Absolute
advantage,comparative advantage,
limitation.
Adams smith’s theory of Absolute
advantage
David Ricardo’s comparative advantage
posner’s theory of limitation
product life cycle theory
theory of intra-industry trade
Harisha.B.V. (Associate) finance and
control, IIMB 10

INTUTIVE THINKING
• NO INTERNATIONAL TRADE, NO
INTERNATIONAL FINANCE
Harisha.B.V. (Associate) finance and
control, IIMB 11

• Investment enhancing and consumption
smoothing.
Investment enhancing
Gain from return differential.
Gain of moving from a lower marginal
efficiency (production without transport
facility)
Diversification(increasing returns without
increasing risks or reducing risks without
reducing returns.) control, IIMBfinance and
Harisha.B.V. (Associate)
12

•CONSUMPTION SMOOTHING
•E.g.:- 75 UNITS OF CONUMPTION
REQUIRMENT IN A COUNTRY.
•YEARLY PRODUCE VARIES FROM
50 UNITS TO 100 UNITS.
•SO WHENEVER 50 UNITS ARE
PRODUCED BORROW 25 UNITS.
•WHENEVER 100 UNITS ARE
PRODUCED LEND 25 UNITS.
Harisha.B.V. (Associate) finance and
control, IIMB 13

INTERNATIONAL RISK
EXPOSURE
• RISK CAN BE BROADLY CLASSIFIED
INTO TWO,NAMELY
• CORE BUSINESS RISKS
• ENVIRONMENTAL RISKS
Harisha.B.V. (Associate) finance and
control, IIMB 14

RISK
• Core business risks are operational risks
such as an unsuccessful new product
launch,interruptions in raw material
suppliers,labor problems,
• Environmental risks arise out of
unpredictable fluctuations in financial
variables such as exchange rates,interest
rates and stock prices,rise in prices of raw
materials.government policies.
Harisha.B.V. (Associate) finance and
control, IIMB 15

FINANCIAL RISK
• FINANCIAL RISK THUS CAN BE
CLEARLY SAID AS SUBSET OF
ENVIRONMENTAL RISKS.
• Core business risks are peculiar to particular
firm, but environmental risks are pervasive
and affect all firms in a given industry.
Harisha.B.V. (Associate) finance and
control, IIMB 16

Difference b/w risk and exposure
• Exposure is a measure of the sensitivity of
the firms performance-however-measured-
to fluctuations in the relevant risk factor .
• Risk is a measure of the extent of variability
of the performance measure attributable to
the risk factor.
Harisha.B.V. (Associate) finance and
control, IIMB 17

EXAMPLE
• FOREIGN CURRENCY
FLUCTUATIONS.
THE MAGNITUTE OF RISK IS
DETERMINED BY MAGNITUDE OF
EXPOSURE.
Harisha.B.V. (Associate) finance and
control, IIMB 18

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 of
payable/unanticipated change in exchange rate
• =100000/.20=500,000
Harisha.B.V. (Associate) finance and
control, IIMB 19

Explanation for the example
• The change in the value of the payable per
unit change in the exchange rate.
• Exposure answers the question: “by how
much will the value of the payable change if
the rupee dollar rate changes by one rupee
per dollar?”.
Harisha.B.V. (Associate) finance and
control, IIMB 20

Example for Risk
• Suppose a financial consulting firm gives
the following forecast of the value of the
spot exchange rate three months from now.
• 3 months forward rate is Rs 45/$
• But it may go up to 45.50 or come down to
44.50 also.
• Therefore exposure is .50 on either side but
the risk is different
Harisha.B.V. (Associate) finance and
control, IIMB 21

TYPES OF RISKS
• ECONOMICAL AND POLITICAL RISKS
• GOVERNMENT AND TAXATION
• EXCHANGE RATE RISK
• INTEREST RATE RISK
• MARKET IMPERFECTIONS
• AGENCY PROBLEMS(conflict of interest
between decision makers and the owners of
the MNC)
Harisha.B.V. (Associate) finance and
control, IIMB 22

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 subsidiary
company’s interests.
• Market expansion
• diversification
Harisha.B.V. (Associate) finance and
control, IIMB 23

INTERNATIONAL MONETARY
SYSTMEM
• EXCHANGE RATE REGIMES.
• MULTILATERAL FINANCIAL
INSTITUTIONS
• CURRENCY BLOCKS SUCH AS THE
ECONOMIC AND MONETARY
UNION(EMU) IN EUROPE.
Harisha.B.V. (Associate) finance and
control, IIMB 24

EXCHANGE RATE REGIMES
• Gold standard system(1870-1913)
• Inter country war period (1914-1944)
• Bretton wood agreement (1945-1973)
• Fluctuating currency system (1973
onwards)
Harisha.B.V. (Associate) finance and
control, IIMB 25

GOLD STANDARD SYSTEM
• IN THE EARLY DAYS GOLD WAS USED AS
A STORAGE OF WEALTH AND AS A
MEDIUM OF EXCHAGE.
• EACH COUNTRY SHOULD SET A PAR
VALUE FOR ITS CURRENCY IN TERMS
OF GOLD AND THEN TRY TO MAINTAIN
THIS VALUE.
• GOLD WAS MEASURED AS PER OUNCE
• 1OUNCE =31.1035GMS
Harisha.B.V. (Associate) finance and
control, IIMB 26

THREE IMPORTANT
FEATURES OF GOLD
STANDARD
• GOVERNMENT OF EACH COUNTRY
DEFINES ITS NATIONAL MONETARY UNIT
IN TERMS OF GOLD
• FREE IMPORT OR EXPORT OF GOLD
• TWO WAY CONVERTIBILITY BETWEEN
GOLD AND NATIONAL CURRENCIES AT A
STABLE RATIO.
Harisha.B.V. (Associate) finance and
control, IIMB 27

EXAMPLE
• UNITED STATES DECLARED-
$20.67/OUNCE OF GOLD.
• BRITISH POUND WAS AT
4.2474/OUNCE OF GOLD.
• THERE FORE EXCHANGE RATE WILL
BE 20.67USD/4.2474GBP=$4.86656/GBP
Harisha.B.V. (Associate) finance and
control, IIMB 28

DRAW BACKS
• WHEN INFLATION INCREAES IN
PARTICULAR COUNTRY THE CURRENCY
LOSES THE COMPETITIVENESS IN THE
WORLD MARKET.
• IMPORTS BEING GREATER THAN EXPORTS
LET TO A DECLINE IN THE CONFIDENCE
OF THE CURRENCY.
• MANY TIMES GOLD WAS WITHDRAWN
FROM RESERVES AND SHIPPED ABROAD
TO PAY FOR IMPORTS.
• WITH LESS GOLD AT HOME,THE COUNTRY
WAS FORCED TO REDUCE ITS MONEY
SUPPLY Harisha.B.V. (Associate) finance and
control, IIMB 29

CONTINUED
•THIS RESULTED IN A SLOW DOWN IN
ECONOMIC ACTIVITY ,HIGH INTEREST
RATES,RECESSION,REDUCED NATIONAL
INCOME AND INCREASED
UNEMPLOYMENT.
•THIS LED TO CHAOS IN MANY
COUNTRIES INCLUDING US AND UK
BECAUSE OF HIGHER INFLATION.
Harisha.B.V. (Associate) finance and
control, IIMB 30

THE INTER WAR YEARS
• WORLD WAR I DISTURBED THE
STABILITY OF EXCHANGE RATES
FOR CURRENCIES OF MAJOR
COUNTRIES.
• THE ROLE OF GREAT BRITAIN AS
THE WORLD’S MAJOR CREDITOR
NATION ALSO CAME TO AN END
AFTER WORLD WAR I
Harisha.B.V. (Associate) finance and
control, IIMB 31

THE UNITED STATES BEGAN TO ASSUME
THE ROLE OF THE LEADING CREDITOR
NATION.
AFTER RECOVERING FROM WAR SOME
COUNTRIES TRIED TO RETURN TO THE
GOLD STANDARD SYSTEM,AND FEW
COUNTRIES LIKE US ,UK, SWISS,
FRANCE,SCANDINAVIAN COUNTRIES EVEN
RESTORED GOLD SYSTEM. and
Harisha.B.V. (Associate) finance
control, IIMB 32

THE GREATEST MISTAKE DONE BY GREAT
BRITAIN HERE IS THEY RETURNED BACK
TO $4.87/POUND.
DURING THIS PERIOD US WAS FACING
INFLATION AT A LESSER RATE THAN UK.
THIS RESULTED IN INCRASED
UNEMPLOYMENT AND ECONOMIC
STAGNATION IN BRITAIN.
Harisha.B.V. (Associate) finance and
control, IIMB 33

IN 1934
IN 193 US DOLLAR WAS DEVALUED TO 35$
/OUNCE OF GOLD.THIS SYSTME IS CALLED
AS MODIFIED GOLD STANDARD OR GOLD
EXCHANGE STANDARD.
AFTER WORLD WARII ONLY NATION
CONTINUED TO REMAIN CONVERTIBLE
WAS THE DOLLAR.
Harisha.B.V. (Associate) finance and
control, IIMB 34

THE BRETTON WOOD
SYSTEM
THE DEPRESSION FOLLOWED BY WAR
IN 1930 DIMINISHED COMMERCIAL
TRADE.
REVIVAL OF SYSTEM BY
RECONSTRUCTION BEGAN WITH
BRETTON WOODS AGREEMENT IN
NEW HAMPSHIRE. US.
Harisha.B.V. (Associate) finance and
control, IIMB 35

MAIN POINTS
THE GOLD STANDARD SYSTEM WAS
SCRAPPED.
THE BRITISH WANTED A REDUCED
ROLE FOR GOLD.
THE AGREEMENT ESTABLISHED A
DOLLAR BASED INTERNATIONAL
MONETARY SYSTEM
Harisha.B.V. (Associate) finance and
control, IIMB 36

•TWO NEW INSTITUTIONS WERE CREATED ,
IMF AND IBRD(WORLD BANK).
•DOLLAR REMAINED AT 35 PER OUNCE.
•EACH COUNTRY WAS OBLIGATED TO
DEFINE ITS MONETARY UNITS IN TERMS OF
GOLD OR DOLLAR.
•EACH CURRENCY WAS PERMITTED TO
FLUCTUATE WITHING PLUS OR MINUS 1%
•TEN PERCENT DEVALUATION WAS
ALLOWED WITH APPROVAL OF IMF
Harisha.B.V. (Associate) finance and
control, IIMB 37

THE BREAKDOWN OF BWA
SOME OF THE DEVELOPED COUNTRIES
CURRENCIES STARTED BECOMING
CONVERTIBLE BY 1971.
THERE WAS MUCH IMBALANCE
BETWEEN SURPLUS AND DEFICIT
NATIONS.
US DOLLAR FELL IN VALUE AGAINST A
NUMBER OF MAJOR IIMBfinance and
CURRENCIES.
Harisha.B.V. (Associate)
control, 38

SMITHSONIAN AGREEMENT
•THE WORLD’S LEADING COUNTRIES
CALLED THE G10 PRODUCED THE
SMITHSONIAN AGREEMENT ON
DEC,18,1971.
•NEW SET OF RATES WERE FIXED
WITHOUT PERMISSION OF IMF.
•THE US $ WAS FURTHER DEVALUED
FROM 35 TO 38 PER OUNCE OF GOLD.
•THE FLUCTUATION OF 2.25% WAS
Harisha.B.V. (Associate) finance and
ALLOWED. control, IIMB 39

FLEXIBLE EXCHANGE RATE
REGIME,1973-PRESENT
• AMERICA ABANDONED THE DOLLAR –
GOLD LINK IN 1971.
• PURE FLOAT – THE EXCHANGE RATES
ARE PURELY DETERMINED BY FORCES
OF DEMAND AND SUPPLY.
• DIRTY FLOAT =AUTHORITIES HAVE
INTERVENED MORE OR LESS INTENSELY
IN FOREIGN EXCHANGE MARKETS.
Harisha.B.V. (Associate) finance and
control, IIMB 40

AS OF NOW THERE IS NO CONSENSUS
EITHER ACADEMIC ECONOMISTS OR
AMONG POLICY MAKERS OR AMONG
BUSINESSMEN AND BANKERS AS TO THE
IDEAL EXCHANGE RATE REGIME.
MACRO ECONOMIC POLICY WITHIN AN
ECONOMY HAS BECOME AN EXTREMELY
COMPLEX.
Harisha.B.V. (Associate) finance and
control, IIMB 41

MULTILATERAL FINANCIAL
INSTITUTIONS
• IMF – International monetary fund.
• 29 countries signed in Bretton hood .
• Current membership is 182 countries.
• Each member contributes the reserves
named quota
• Quotas depends from country to country.
• 25% will be paid in gold and balance in
currency.
Harisha.B.V. (Associate) finance and
control, IIMB 42

When the country faces a BOP deficit ,IMF will
advance the reserves.
IMF was constituted to maintain the exchange
rates.
Devaluation of currency requres prior approval of
IMF
Countries with chronic BOP deficits were allowed
to depreciate their currencies.
Harisha.B.V. (Associate) finance and
control, IIMB 43

World bank
• World bank lends for international projects and it
lends at margin of half percent over its borrowing
cost.
• IDA(international development Bank ) is the soft
lending arm of world bank.
• IFC(international financial corporation) lends to
the private sector
• World bank also provides assistance and advice to
developing countries.
Harisha.B.V. (Associate) finance and
control, IIMB 44

Asian Development Bank
• Asian development Bank was set up as an
Asian version of world bank to provide
development finance to countries in Asian
region with head quarter in Philippines.
Harisha.B.V. (Associate) finance and
control, IIMB 45

Economic monetary union
• In 1957 first step was taken towards the formation of
EMU by six countries.-
GERMANY,BELGIUM,NETHERLANDS,ITALY,
LUXEMBURG AND FRANCE.
• In 1968 the same was converted to customs Union
by adopting single tariff wall for imports from
outside the union.
• It converted into common market in 1993-
BRITAIN,DENMARK,SWEDEN
,IRELAND,FINLAND,GREECE,SPAIN,PROTUG
AL,AUSTRIA JOINED (15)
Harisha.B.V. (Associate) finance and
control, IIMB 46

Single currency union
This converted into European community in
1999.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 and
control, IIMB 47

GATT
• During world war II the world economy
was badly shattered ,the international trade
was to be restored again which led to
formulation of GATT.
• GATT became the only international
instrument of trade rules accepted accepted
by the world’s major trade nations.
Harisha.B.V. (Associate) finance and
control, IIMB 48

BALANCE OF PAYMENTS
• THE BALANCE OF PAYMENT IS
AN ACCOUNTING SYSTEM THAT
RECORDS THE ECONOMIC
TRANSACTION BETWEEN THE
RESIDENTS AND GOVERNMENT
OF A PARTICUALR COUNTRY
AND THE RESIDENTS AND GOVT
OF THE REST OF THE WORLD
DURING A YEAR.
Harisha.B.V. (Associate) finance and
control, IIMB 49

THREE MAIN CATEGORIES
OF BOP
• THE CURRENT ACCOUNT
• THE CAPITAL ACCOUNT
• THE RESERVE ACCOUNT
Harisha.B.V. (Associate) finance and
control, IIMB 50

THREE MAIN CATEGORIES
OF BOP
• THE CURRENT ACCOUNT
• THE CAPITAL ACCOUNT
• THE RESERVE ACCOUNT
Harisha.B.V. (Associate) finance and
control, IIMB 51

CURRENT ACCOUNT
PARTICULARS DEBIT(OF) CREDIT(IF)
GOODS /SERVICES BUY SELL
INVESTMENT INCOME PAY RECEIVE
UNILATERAL GIVE RECEIVE
TRANFERS
Harisha.B.V. (Associate) finance and
control, IIMB 52

CAPITAL ACCOUNT
PARTICULARS DEBIT (OF) CREDIT(IF)
FDI OUTBOUND INBOUND
PORTFOLIO OUTBOUND INBOUND
OTHER CF(BANK DEPOSITING WITHDRAWING
DEPOSITS ETC)
Harisha.B.V. (Associate) finance and
control, IIMB 53

Examples
1.Export of goods against Bills of
Exchange.Rs15000.
2.Realization of Bills of Exchange and deposit in
foreign 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 and
control, IIMB 54

6. Foreign investment RS 40000.
7. India received gift of $40000 from
America.
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

Solution for the Example
Question
• 1.Due from Foreigner A/C DR 15000
To Export of merchandise A/c 15000
• 2.Foreign Assets A/C DR 15000
To Due from Foreigner A/C 15000.
• 3.Foreign Assets A/C DR 20000
To Trade in services A/C 20000
Harisha.B.V. (Associate) finance and
control, IIMB 56

4 Foreign exchange reserve A/c Dr 20000
To Foreign exchange assets A/c 20000
5 Merchandise Imports A/c Dr 30000
To Liability to Foreigner A/c 20000
6 Foreign Exchange Assets A/c Dr 40000
To FDI A/c 40000
Harisha.B.V. (Associate) finance and
control, IIMB 57

7 Foreign Exchange asset A/c Dr 40000
To Unrequited Transfer A/c 40000
8 Unrequited Transfer A/c Dr 12000
To Foreign Exchange asset A/c 12000
9 Foreign exchange Asset A/c Dr 15000
To foreign Exchange Reserve A/c 15000
Harisha.B.V. (Associate) finance and
control, IIMB 58

The official reserve account
• Official reserves are government owned assets.
• The official reserve account represents only
purchases and sales by the central bank of the
country.
• If a country has BOP deficit then ,the central bank
has to run down its official assets such as gold
,foreign exchange ,SDR or borrow fresh from
foreign central banks.
Harisha.B.V. (Associate) finance and
control, IIMB 59

What moves exchange rates?
• Since the advent of floating exchange rates
in 1973 economists, currency traders and
other professionals are expending enormous
intellectual effort to find out the forces
which drive exchange rates and build
reliable exchange rate forecasting models.
Harisha.B.V. (Associate) finance and
control, IIMB 60

•Exchange rate is the relative price of one currency
in terms of another.
•It is the main component which influences trade
,relative profitability of various industries, real
wages of workers and finally allocation of recourses.
•“We like much of the profession are doubtful of the
value of the further time series modeling of
exchange rates.”(frankel and rose 1995)
Harisha.B.V. (Associate) finance and
control, IIMB 61

Theories of exchange rate
determination
1. ARBITRAGE AND THE LAW OF ONE PRICE
2. PURCHASING POWER PARITY
3. THE FISHER EFFECT
4. THE INTERNATIONAL FISHER EFFECT
5. INTEREST RATE PARITY THEORY
6. THE RELATIONSHIP BETWEEN THE
FORWARD AND FUTURE SPOT RATE
7. CURRENCY FORECASTING
Harisha.B.V. (Associate) finance and
control, IIMB 62

PART I. ARBITRAGE AND THE LAW
OF ONE PRICE
I. THE LAW OF ONE PRICE
A. Law states:
Identical goods sell for the
same price worldwide.
Harisha.B.V. (Associate) finance and
control, IIMB 63

ARBITRAGE AND THE LAW OF
ONE PRICE
B. Theoretical basis:
If the price after exchange-rate
adjustment were not equal,
arbitrage in the goods worldwide
ensures eventually it will.
Harisha.B.V. (Associate) finance and
control, IIMB 64

ARBITRAGE AND THE LAW OF ONE
PRICE
C. Five Parity Conditions Result
From These Arbitrage Activities
1. 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

ARBITRAGE AND THE LAW OF
ONE PRICE
D. Five Parity Conditions Linked
by
1. The adjustment of various
rates and prices to inflation.
Harisha.B.V. (Associate) finance and
control, IIMB 66

ARBITRAGE AND THE LAW OF
ONE PRICE
2. The notion that money
should have no effect on
real variables (since they
have been adjusted for
price changes).
Harisha.B.V. (Associate) finance and
control, IIMB 67

ARBITRAGE AND THE LAW OF
ONE PRICE
E. 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

ARBITRAGE AND THE LAW OF
ONE PRICE
F. THE LAW OF ONE PRICE
- enforced by international
arbitrage.
Harisha.B.V. (Associate) finance and
control, IIMB 69

Purchasing power parity theory
• This theory was enunciated by Gustav
Cassel.
• Purchasing power of a currency is
determined by the amount of goods and
services that can be purchased with one unit
of currency.
• This reflects the relative purchasing powers
of the currency
Harisha.B.V. (Associate) finance and
control, IIMB 70

Example
• One parker pen in India = RS 150
• The same pen in US= $ 3
• Therefore 1$= 50 Rs
Harisha.B.V. (Associate) finance and
control, IIMB 71

Two types of PPPT
• Two versions
• Absolute purchasing power parity.
• Relative purchasing power parity.
•PPPT.xls
Harisha.B.V. (Associate) finance and
control, IIMB 72

Absolute PPPT
• The level of exchange rate at any time equals the
ratio of purchasing powers of the two currencies.
• Sa/b= Pa/Pb
• Sa/b= exchange rate between the currency of nation
A and currency of nation B
• Pa= price level in nation A
• Pb= price level in nation B.
Harisha.B.V. (Associate) finance and
control, IIMB 73

Draw backs
• The rates can vary considerably due to the
factors like
1. Transportation cost.
2. Tariffs
3. Quotas
4. 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

Relative
• The proportionate change in exchange rate
between two currencies between two points
of time approximately equals to difference
in the inflation rates in the two countries
over the same time interval.
Harisha.B.V. (Associate) finance and
control, IIMB 75

PURCHASING POWER PARITY
1. In mathematical terms:
t
e t
=
(1 + i h )
e 0 (
1 + i f )
t
where et = future spot rate
e0 = spot rate
ih = home inflation
if = foreign inflation
t = the time period
Harisha.B.V. (Associate) finance and
control, IIMB 76

PURCHASING POWER PARITY
2. If purchasing power parity is
expected to hold, then the best
prediction for the one-period
spot rate should be
t
e = e
(1
+ i h )
t 0
( + i
1 f )
t
Harisha.B.V. (Associate) finance and
control, IIMB 77

PURCHASING POWER PARITY
3. A more simplified but less precise
relationship 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

PURCHASING POWER PARITY
4. 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 and
control, IIMB 79

PURCHASING POWER PARITY
B. Real Exchange Rates:
the quoted or nominal rate
adjusted for a country’s
inflation rate is
t
'
(1 + i f )
e t = e t t
(1 + i h )
Harisha.B.V. (Associate) finance and
control, IIMB 80

Draw back
• Previously said all draw back hold
good.
• If people are sometimes more appetite
towards particular currency.
• Asset market approach.
Harisha.B.V. (Associate) finance and
control, IIMB 81

Forecasting
• By making use of PPPT theory future
spot rate can be forecasted as follows.
• S1=S0*(1+ rA / 1+ rB)
Harisha.B.V. (Associate) finance and
control, IIMB 82

Fisher’s Effect.
• The fisher effect holds that the level of
nominal interest rates in a given country is
related to both real return and expected rate
of inflation .
• The currency with higher rates of inflation
should bear higher nominal interest rates and
vice versa.
• If the real return is x % and inflation is y%
then the nominal rate should be x% + y%
Harisha.B.V. (Associate) finance and
control, IIMB 83

Formula
• 1 + NR = (1 + RR) * ( 1+ IR)
• NR = RR +IR + (RR*IR)
• What do you mean by Nominal interest rate
and real interest rate?
Harisha.B.V. (Associate) finance and
control, IIMB 84

Nominal interest Rate
• Nominal rate express the ratio of exchange
between current money and future money .
• 100 RS invested today @10 % will be 110
RS at the end of the year.
• It does not explain how many more goods
or services we can purchase with this 10
RS because value of money will change
over.
Harisha.B.V. (Associate) finance and
control, IIMB 85

Real interest Rate
• Real interest rate represents the rate at
which current goods and services are
being transformed into future goods
and services.
• Therefore it is the real interest rate and
not the nominal interest rate that
interests the investors.
Harisha.B.V. (Associate) finance and
control, IIMB 86

Example
• Suppose investor requires real return to
be 3%,and the rate of inflation over the
year is expected to be 5%.
• The purchasing power of pound will be
GBP = 1/1.05 = 0.9524 or 95.24 %
• Therefore nominal interest rate
expected will be GBP 0.9524*(1+r ) =
1.03
• r = 8.15 % Harisha.B.V. (Associate) finance and
control, IIMB 87

Relevant equation
• If no government intervention is practiced and
law of one price holds then interest rate
differentials should reflect inflation
differentials .
rh - rf = ih - if
• According to the Fisher Effect, countries with
higher 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

International Fisher Effect
• The international holds that differences in
the rate of appreciation or depreciation
between two currencies is related to
nominal interest rates between two
countries .
• Currency with a low interest rates is
expected to appreciate relative to a
currency of a country with high interest
rates and vice versa.
Harisha.B.V. (Associate) finance and
• IFE = PPP + FE control, IIMB 89

THE INTERNATIONAL FISHER
EFFECT
IFE = PPP + FE
t
et (1 + r h )
=
e0 (1 + r f ) t
Harisha.B.V. (Associate) finance and
control, IIMB 90

Example
• If 1 year interest is 7 % on U.S.
treasury bills and 4 % on Swiss Franc
Treasury Bills and current exchange
rate is $ 0.63 = 1 CHF.
• Expected future spot rate in one year
are
• S1/0.63 = ( 1+0.07) / ( 1+ 0.04)
• S1 = .06482
Harisha.B.V. (Associate) finance and
control, IIMB 91

THE INTERNATIONAL FISHER
EFFECT
B. Fisher postulated
1. The nominal interest rate
differential should reflect
the inflation rate differential.
Harisha.B.V. (Associate) finance and
control, IIMB 92

THE INTERNATIONAL FISHER
EFFECT
B. Fisher postulated
2. Expected rates of return are
equal in the absence of
government intervention.
Harisha.B.V. (Associate) finance and
control, IIMB 93

THE INTERNATIONAL FISHER
EFFECT
C. Simplified IFE equation:
(if rf is relatively small)
e1 − e 0
rh − r f =
e0
Harisha.B.V. (Associate) finance and
control, IIMB 94

THE INTERNATIONAL FISHER
EFFECT
D. 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

THE INTERNATIONAL FISHER
EFFECT
D. Implications of IFE
2. Financial market arbitrage:
insures interest rate differential
is an unbiased predictor of change in
future spot rate.
Harisha.B.V. (Associate) finance and
control, IIMB 96

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 another
should reflect the interest differential between the two
currencies.
• In a perfect market situation ,where there is no restriction
on the flow of money ,one should be able to gain the same
real value on one’s monetary assets irrespective of the
country where they are control, IIMBfinance and
held.
Harisha.B.V. (Associate)
97

Forecasting
• (F - S)/S = (rh - rf)
where rh = the home rate rf = the foreign rate
• The appreciation or depreciation of one
currency against another should be
approximately equal to the interest rate
differential.
• PPPT is law of one price in the market of
goods and services and IRPT is in securities
market Harisha.B.V. (Associate) finance and
control, IIMB 98

INTEREST RATE PARITY
THEORY
In 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) S
Harisha.B.V. (Associate) finance and
control, IIMB 99

INTEREST RATE PARITY
THEORY
Covered Interest Arbitrage
1. 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 and
control, IIMB 100

INTEREST RATE PARITY
THEORY
Market 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 and
control, IIMB 101

INTEREST RATE PARITY
THEORY
Summary:
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

Criticisms
• Availability of funds that can be used for arbitrage is
not infinite.
• Markets are not always perfect, government
intervention will be there which leads to dirty float.
• Capital flows depends not only on interest rates but
depends on also liquidity and the ease of placement.
• Speculation becomes important when market loses
confidence in the future of a currency.
Harisha.B.V. (Associate) finance and
control, IIMB 103

Forecasting exchange rate in short
term
• Method of advanced indicators
• Use of forward rate as particular of the
future spot rate
• Graphical methods
Harisha.B.V. (Associate) finance and
control, IIMB 104

Method of advanced indicators
• Here country's reserves to its imports are
considered 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 is
vulnerable and may face devaluation
Harisha.B.V. (Associate) finance and
control, IIMB 105

Forward rate as Predictor of future
spot rate.
• Some authors believe that forward rates
are likely to be an unbiased predictor of
the future spot rate.
Harisha.B.V. (Associate) finance and
control, IIMB 106

Graphical methods
• Bar chart
• Curve of support
• Curve of Resistance
• Rate Time curve
Harisha.B.V. (Associate) finance and
control, IIMB 107

Forecasting in medium and long
term
• Economic approach
• Sociological and political approach.
Harisha.B.V. (Associate) finance and
control, IIMB 108

Economic approach
• Structure of the balance of Payments
• Examination of interest rates
• Comparative examination of interest
rates
• Comparative examination of inflation
rates
• Study of activity and employment level.
Harisha.B.V. (Associate) finance and
control, IIMB 109

Sociological and political approach
• Proximity of elections
• Behavior of opposition parties
• Recommendation of IMF etc
• Rigorous control of foreign exchange
• Interest rate hike
• Deflationary policy
Harisha.B.V. (Associate) finance and
control, IIMB 110