Brian Butler: TBird int'l finance class 02

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Series of lectures from Brian Butler, given during fall 2008 session at Thunderbird Global MBA, Miami campus:

This lecture 02: learn to use International Fisher effect (IFE), and PPP, Law of one Price, Big Mac index to estimate long term currency (FX) trends

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Brian Butler: TBird int'l finance class 02

  1. 1. Contact Information: Brian David Butler Miami Campus Facilitator International Economics & Trade (Prof. Grosse) Email: [email_address] Cell: 786-457-0984 Blog: http://blog.globotrends.com/ Wiki: http://kookyplan.pbwiki.com/brianbutler Connect professionally: http://www.linkedin.com/in/briandbutler http://www.linkedin.com/e/gis/69362 Connect personally: http://www.facebook.com/people/Brian_Butler/293500110
  2. 2. Global MBA International Finance & International Trade GM6212 2 nd session. September 27, 2008 Last Class Now Next… Define: Theories Apply - FX markets -PPP -hedging - Arbitrage -IFE -real life
  3. 3. Review last session: <ul><li>Many markets ….banks set the market </li></ul><ul><li>There is no such thing as “THE” exchange rate…there are many </li></ul><ul><li>Arbitrage is the mechanism that equalizes exchange rates across markets….Its how FX rates are set </li></ul><ul><li>For exam…Should be able to solve…… </li></ul><ul><li>Exchange rate arbitrage, Interest arbitrage </li></ul>
  4. 4. <ul><li>Topics to cover today: </li></ul><ul><li>Analysis of exchange rates & determinants </li></ul><ul><ul><li>Law of one price </li></ul></ul><ul><ul><li>PPP – purchasing power parity </li></ul></ul><ul><ul><li>Big Mac index </li></ul></ul><ul><ul><li>IFE – international fisher effect </li></ul></ul><ul><ul><li>Interest parity </li></ul></ul><ul><li>Economic crisis on Wall Street </li></ul>
  5. 5. Exchange Rate Determination E[XR S ] – XR S XR S UFR UNBIASED FORWARD RATE IFE INT’L FISHER EFFECT INTEREST RATE PARITY IRP PARITY PURCHASING POWER (Forward Premium) (Interest Differential) FISHER EFFECT FE (%  Spot Rate*) (Inflation Differential*) THIS MODEL IGNORES GOVERNMENT CONTROLS AND TRANSACTIONS COSTS * = Forecasted Value XR = Domestic Currency Foreign Currency
  6. 6. Law of One Price <ul><li>Identical goods - must sell for the same price when their prices are expressed in terms of the same currency </li></ul><ul><li>Assumptions: </li></ul><ul><ul><li>Free from transportation costs </li></ul></ul><ul><ul><li>Free from import barriers, no tariffs </li></ul></ul>
  7. 7. Law of One Price <ul><li>Example: </li></ul><ul><li>Levis Jeans in NYC cost $50 </li></ul><ul><li>Levis Jeans in London = 30 pounds </li></ul><ul><li>What is the implied exchange rate? </li></ul>
  8. 8. Law of One Price <ul><li>Example: </li></ul><ul><li>Levis Jeans in NYC cost $50 </li></ul><ul><li>Levis Jeans in London = 30 pounds </li></ul><ul><li>What is the implied exchange rate? </li></ul><ul><li>Answer: $1.66 / pound </li></ul>
  9. 9. Law of One Price <ul><li>But, what happens if inflation in the US brings the dollar price up to $55 (a 10% US inflation)? What should happen to the FX rate? Does the US dollar appreciate? </li></ul><ul><li>Levis Jeans in NYC cost $50 $55 </li></ul><ul><li>Levis Jeans in London = 30 pounds </li></ul><ul><li>FX rate: $1.66 / pound </li></ul><ul><li>New rate ???? Will dollar appreciate? </li></ul>
  10. 10. <ul><li>Levis Jeans in NYC cost $50 $55 </li></ul><ul><li>Levis Jeans in London = 30 pounds </li></ul><ul><li>FX rate: $1.66 / pound </li></ul><ul><li>Answer: new rate should be $1.83 / pound </li></ul><ul><li>US dollar should DEPRECIATE with inflation. </li></ul>10% change
  11. 11. <ul><li>If the actual FX rate: $1.66 / pound </li></ul><ul><li>And expected FX rate : $1.83 / pound </li></ul><ul><li>But, the currency doesn’t change… </li></ul><ul><li>Is the US dollar overvalued? Or undervalued? </li></ul><ul><li>By how much exactly? </li></ul>
  12. 12. Law of One Price <ul><li>Over valued by 10% </li></ul><ul><li>Because it only takes $1.66 to buy a pound….when it should take $1.83 </li></ul>
  13. 13. Purchasing Power Parity E[XR S ] – XR S XR S UFR UNBIASED FORWARD RATE IFE INT’L FISHER EFFECT INTEREST RATE PARITY IRP PARITY PURCHASING POWER (Forward Premium) (Interest Differential) FISHER EFFECT FE (%  Spot Rate*) (Inflation Differential*) THIS MODEL IGNORES GOVERNMENT CONTROLS AND TRANSACTIONS COSTS * = Forecasted Value XR = Domestic Currency Foreign Currency
  14. 14. PPP – purchasing power parity E[XR S ] – XR S XR S PARITY PURCHASING POWER (%  Spot Rate*) (Inflation Differential*) It looks confusing, but is simple. PPP states that … % change in spot rate = inflation differential That’s all.
  15. 15. Purchasing Power Parity <ul><li>Same as “Law of One price”…except… </li></ul><ul><ul><li>Law of one price = for one good only </li></ul></ul><ul><ul><li>PPP = basket of goods (ex; CPI measure inflation) </li></ul></ul>
  16. 16. Purchasing Power Parity <ul><li>Relates inflation to FX: </li></ul><ul><li>If “price level” goes up (inflation)…then purchasing power down, and the currency should depreciate. </li></ul>
  17. 17. PPP- example <ul><li>Question: How to use PPP to predict future FX rates? </li></ul><ul><li>Goal: Predict 1-year FX rate (USD / Brazilian Real) </li></ul><ul><li>Assume current Spot rate = R$2.80 BRL / USD </li></ul><ul><li>Expected inflation rates for next year = 2% in USA and 6% in Brazil </li></ul><ul><li>What is expected FX rate in 1 year? </li></ul><ul><li>Should the BRL currency appreciate? </li></ul>
  18. 18. PPP <ul><li>Key Formula ( Simplified ) </li></ul><ul><li>E[XR] = XR spot [ 1 + inflation </li></ul><ul><li> 1 + inflation] </li></ul><ul><li>But, what units go on top / bottom…is it dollars per Euro? Or Euros per dollar? </li></ul>
  19. 19. <ul><li>E[XR] = XR spot [ 1 + inflation </li></ul><ul><li> 1 + inflation] </li></ul><ul><li>= R$ 2.8 BRL *[ 1 + .06 BRL </li></ul><ul><li>$1.0 USD 1 + .02] USD </li></ul><ul><li>= R$ 2.9098 / USD </li></ul><ul><li>From Brazils perspective, is this appreciation? Or Depreciation of the BRL? </li></ul>
  20. 20. Problems with PPP <ul><li>What problems do you see? </li></ul><ul><li>Is PPP any good in reality? </li></ul><ul><li>What are the drawbacks? </li></ul><ul><li>Why doesn’t it work? </li></ul>
  21. 21. Problems with PPP <ul><li>Very difficult to find identical products </li></ul><ul><li>Basket of goods in one country different than in other </li></ul><ul><li>Many goods are not traded (even though they are in the CPI) – labor rates, real estate, electricity </li></ul><ul><li>Assumption of 0 transaction cost is unrealistic </li></ul>
  22. 22. Big Mac Index <ul><li>Overcomes some of PPP’s limitations </li></ul><ul><ul><li>Identical product </li></ul></ul><ul><ul><li>Many countries </li></ul></ul><ul><ul><li>Standardized ingredients: bread, wheat, beef, lettuce, condiments, etc. </li></ul></ul>
  23. 23. Big Mac Index
  24. 24. Big Mac Index <ul><li>Example: </li></ul><ul><li>If a Big Mac costs: </li></ul><ul><li>$3.57 in US… </li></ul><ul><li>R$ 7.5 in Brazil </li></ul><ul><li>What is the implied exchange rate? (R$/$) </li></ul>
  25. 25. Big Mac Index <ul><li>If a Big Mac costs: </li></ul><ul><li>$3.57 in US… </li></ul><ul><li>R$ 7.5 in Brazil </li></ul><ul><li>Implied exchange rate? = R$2.1 / USD </li></ul><ul><li>But, actual FX rate = R$1.58 / USD </li></ul><ul><li>So, is the Brazilian Real overvalued? / under valued? By how much? </li></ul>
  26. 26. Big Mac Index <ul><li>Implied exchange rate? = R$2.1 / USD </li></ul><ul><li>But, actual FX rate = R$1.58 / USD </li></ul><ul><li>Brazilian Real is “over” valued… </li></ul><ul><ul><li>Because with one USD you should be able to purchase $2.1 worth of Big Macs in Brazil, but you can only purchase $1.58…. </li></ul></ul><ul><ul><li>By how much? (2.1 – 1.58) / 1.58 = 33% over valued </li></ul></ul>
  27. 27. Big Mac Index <ul><li>How can you use this index to make business decisions? </li></ul><ul><li>What are the Limitations: ????? Discuss </li></ul>
  28. 28. Exchange Rate Determination E[XR S ] – XR S XR S UFR UNBIASED FORWARD RATE IFE INT’L FISHER EFFECT INTEREST RATE PARITY IRP PARITY PURCHASING POWER (Forward Premium) (Interest Differential) FISHER EFFECT FE (%  Spot Rate*) (Inflation Differential*) THIS MODEL IGNORES GOVERNMENT CONTROLS AND TRANSACTIONS COSTS * = Forecasted Value XR = Domestic Currency Foreign Currency
  29. 29. IFE E[XR S ] – XR S XR S IFE INT’L FISHER EFFECT (Interest Differential) (%  Spot Rate*) Looks confusing, but is simple. IFE states that … % change in spot rate = interest differential That’s all.
  30. 30. IFE <ul><li>Key Formula ( simplified ) </li></ul><ul><li>E[XR] = XR spot [ 1 + interest </li></ul><ul><li> 1 + interest] </li></ul><ul><li>But, what units go on top / bottom…is it dollars per Euro? Or Euros per dollar? </li></ul><ul><li>Lets do an example….. </li></ul>
  31. 31. IFE - example <ul><li>Goal: Predict 6-month FX rate (USD / Swiss Franc) </li></ul><ul><li>Assume current Spot rate = 1.10 SF / $USD </li></ul><ul><li>Annualized interest rates on 6-month deposit </li></ul><ul><li>US = 3.1 % </li></ul><ul><li>Swiss = 2.8% </li></ul><ul><li>What is expected FX rate in 6 months? </li></ul><ul><li>Should the US currency appreciate? </li></ul>
  32. 32. <ul><li>E[XR] = XR spot [ 1 + interest </li></ul><ul><li> 1 + interest] </li></ul><ul><li>= 1.10 SF *[ 1 + .028/2 SF </li></ul><ul><li>$1.0 USD 1 + .031/2] USD </li></ul><ul><li>= 1.098375 SF / USD </li></ul><ul><li>Is this appreciation? Or Depreciation of the USD? </li></ul>
  33. 33. <ul><li>Interest Rate Parity (p323-5) </li></ul><ul><li>FX market in equilibrium ONLY when interest rate parity exists </li></ul><ul><li>When deposits of all currencies offer the same EXPECTED rate of return </li></ul><ul><li>Rate + expected (appreciation / depreciation) = rate </li></ul><ul><li>Example: US / Euro. If US interest = 5%, EU = 10%, but US dollar is expected to appreciate +5% = balance </li></ul>
  34. 34. Credit Crisis timeline <ul><li>http://en.wikipedia.org/wiki/Subprime_crisis_impact_timeline </li></ul><ul><li>September 7, 2008 : Federal takeover of Fannie Mae and Freddie Mac [25] [26] </li></ul><ul><li>September 14, 2008 : Merrill Lynch sold to Bank of America amidst fears of a liquidity crisis and Lehman Brothers collapse [27] </li></ul><ul><li>September 15, 2008 : Lehman Brothers files for bankruptcy protection [28] </li></ul><ul><li>September 16, 2008 : Moody's and Standard and Poor's downgrade ratings on AIG 's credit on concerns over continuing losses to mortgage-backed securities, sending the company into fears of insolvency . [29] [30] </li></ul><ul><li>September 17, 2008 : The US Federal Reserve loans $85 billion to American International Group (AIG) to avoid bankruptcy. </li></ul><ul><li>September 19, 2008 : Paulson financial rescue plan unveiled after a volatile week in stock and debt markets. </li></ul><ul><li>September 25, 2008 : Washington Mutual was seized by the Federal Deposit Insurance Corporation , and it's banking assets were sold to JP MorganChase for $1.9bn. </li></ul>
  35. 35. Credit Crisis – key points <ul><li>Banking business model </li></ul><ul><ul><li>Borrow short, lend long </li></ul></ul><ul><li>Federal guarantee in exchange for regulation </li></ul><ul><li>What is the problem today? </li></ul><ul><ul><li>Banks don’t trust each other, stop lending </li></ul></ul><ul><ul><li>Libor rates spike </li></ul></ul><ul><ul><li>Flight to safety – everyone buying Treasuries </li></ul></ul><ul><li>What should the government do? </li></ul><ul><ul><li>Lender of last resort – pump money back into system </li></ul></ul>
  36. 36. Credit Crisis – how it relates to our class? <ul><li>We learned last class: </li></ul><ul><ul><li>Companies can borrow from Eurocurrency market </li></ul></ul><ul><ul><li>Lower rates, due to less regulation </li></ul></ul><ul><ul><li>Market = trillion + per day (hundreds of trillions per year) </li></ul></ul>
  37. 37. Credit Crisis – how it relates to our class? <ul><li>2. Effect on currency markets </li></ul><ul><ul><li>Fundamentals out the window </li></ul></ul><ul><ul><li>Driver of FX = macro themes </li></ul></ul><ul><ul><ul><li>Repatriation of US dollars to US </li></ul></ul></ul><ul><ul><ul><li>Flight to quality </li></ul></ul></ul><ul><ul><ul><li>Unwinding of carry trade </li></ul></ul></ul><ul><ul><ul><li>TED spread </li></ul></ul></ul>
  38. 38. Credit Crisis – how it relates to our class? <ul><ul><li>LIBOR = root of problem </li></ul></ul><ul><ul><li>Libor rates shoot up. Banks stop lending. </li></ul></ul><ul><ul><li>Causing troubles for banks, companies looking for short term finance. </li></ul></ul><ul><ul><li>Remember bank business model (borrow short, lend long) </li></ul></ul>
  39. 39. Near collapse – Last Thursday 9/18/08 <ul><li>According to one analyst on CNBC, we were a “few hundred trades away from a complete collapse” of the money market. </li></ul><ul><li>Interbank lending grinds to near-standstill - Sep-17 </li></ul><ul><li>Money markets fund sector shocked - Sep-17 </li></ul><ul><li>Interbank loans at standstill - Sep-20 </li></ul>
  40. 40. Fed to the rescue <ul><li>Fed steps in: </li></ul><ul><li>Ban on short selling </li></ul><ul><li>Extend federal guarantee to money market mutual funds ( US money market funds aided Sep 19 2008) </li></ul><ul><li>“ Paulson Plan” - $700 bn plan to buy up “toxic” debt </li></ul>
  41. 41. But the problems continue… <ul><li>“ The violent shifts in Libor levels have prompted some commentators to say that Libor is broken,” said JP Morgan. “The more relevant – and frankly scarier – question to contemplate is: ‘what if Libor is not broken? What is Libor telling us about the state of the global money markets?”: FT.com , September 26 2008 </li></ul>

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