corporate finance

1. EXCHANGE RATES AND
INTERNATIONAL PARITY
RELATIONSHIPS
Dr Z MAZHAMBE

2. Foreign exchange Risk
• The risk of an investments value changing due to changes in currency
exchange rates.
• The risk that an investor will have to close out a long or short position
in a foreign currency at a loss due to an adverse movement in
exchange rate
• Transaction Risk - When a firm or individual has a receivable or a
payable in a foreign currency the foreign exchange rate may change,
causing an increase in the liability of the home country’s currency or a
decrease in receipts in the home countrys

3. Foreign Currency Risks
• Foreign payables – sourcing materials in a different
country/currency
• Foreign receivables – selling in a different
country/currency
• Foreign assets or liabilities – balance sheet risk

4. Types of Foreign Currency Risks
Changes in currency markets can impact a company’s earnings and cash flows in different ways. It’s
important to understand what these risks are, how to measure them, and how to manage them
Generally speaking there are two kinds of currency risk that a company must be aware of:
transactional risk and translational, or balance sheet risk.
Transactional risk involves sales or purchases that are denominated in a foreign currency
Translational risk involves the foreign assets or liabilities that sit on a company’s balance sheet
Both of these risks have different impacts on cash flows and earnings, so it’s important to understand
the difference between the two and how to manage each

5. Transactional Risk
• The risk related to sales or purchases in a foreign currency
• Typically these are the easiest to measure and identify, and as a result are easier to manage
• Transactional risks are typically shorter term in nature (< 1year) but can be longer term if a company
has long term commitments
• Transactional risk is important to understand because it directly affects cash flows
• An appreciating foreign currency may mean the costs for an importer go up, directly affecting
gross profit margins
• A depreciating foreign currency may mean that the domestic revenue of an exporter will be
lower if they are receiving the foreign currency
• Any timing mismatch between when a company makes a commitment to buy or sell a foreign
currency and when they actually pay or receive that currency could give rise to foreign exchange risk.

6. Translational Risk
• The risk related to holding assets or liabilities in a foreign currency
• These risks can be difficult to measure, as the level of assets or liabilities
can differ from day to day and can be difficult to quantify quickly.
• Translational risks are typically longer term in nature, such as factories in
foreign countries, long term debt, etc
• Translational risk directly affects the accounting earnings of a company,
although it doesn’t directly affect cash flow
• The impact to earnings is driven by the changes in the foreign currency
rate from the first day in the reporting period to the last day, although
many companies will re-measure their balance sheet on a quarterly or
monthly basis.

7. Exchange Rates – Floating & Managed
• Floating rate regimes— allow changes in the exchange rates between
two currencies to occur for currencies to reach a new exchange-rate
equilibrium
• Currencies that float freely respond to supply and demand conditions
• No government intervention to influence the price of the currency
• Managed fixed-rate regime— government buys and sells its currency in
the open market as a means of influencing the currency’s price
• Central banks holds foreign-exchange reserves
• can sell these reserves to affect exchange rates for the currency
• Governments use fiscal or monetary policy to influence the demand for
their currencies

8. The Real Exchange Rate
• The relative price level ratio q is an important concept.
It is called the real exchange rate
• Remember the key difference to avoid confusion.
• Nominal exchange rate E is the ratio at which currencies trade.
• Real exchange rate q is ratio at which goods baskets trade.
• However, the real exchange rate has some terminology in common with the
nominal exchange rate…

9. Real Exchange Appreciation and Depreciation
• Changes in the real exchange rate:
• If the real exchange rate rises
• more home goods needed in exchange for foreign goods
• intuitively called a real depreciation.
• If the real exchange rate falls
• fewer home goods needed in exchange for foreign goods
• Intuitively called a real appreciation.

10. FOREIGN EXCHANGE MARKETS
Forward premium =
Spot rate – Forward rate * 360
Forward rate Days

11. FOREIGN EXCHANGE MARKETS
Forward Discount =
Forward rate – Spot rate * 360
Spot rate Days

12. INTEREST RATE DIFFERENTIALS
8.7

13. Fisher Effect : Nominal Versus Real Interest
Rate
• Nominal interest rates reflect the financial return an individual gets
when he deposits money
• Unlike the nominal interest rate, the real interest rate considers
purchasing power in the equation.
• In the Fisher Effect, the nominal interest rate is the provided actual
interest rate that reflects the monetary growth padded over time to a
particular amount of money or currency owed to a financial lender.
• Real interest rate is the amount that mirrors the purchasing power of
the borrowed money as it grows over time

14. Fisher Effect : Nominal Versus Real Interest
Rate
• It shows how the money supply affects the nominal interest rate and
inflation rate as a tandem

15. Real Interest Parity
• The real interest parity condition explains differences
in expected real interest rates between two countries
by expected movements in the real exchange rates.
• Expected real interest rates in different countries
need not be equal, even in the long run, if continuing
change in output markets is expected.

16. The Fisher Effect
• The Fisher effect examines the link between the inflation rate,
nominal interest rates and real interest rates.
• It starts with the awareness real interest rate = nominal interest rate –
expected inflation.
• One implication of the Fisher effect is that nominal interest rates tend
to mirror inflation, making monetary policy neutral.

17. The Fisher Effects
• An increase (decrease) in the expected rate of inflation will cause
a proportionate increase (decrease) in the interest rate in the
country.
For US, the Fisher effect is written as:
1 + i$ = (1+ $)(1 + E[$])
approximation:
$ is the equilibrium expected “real” US interest rate
E[$] is the expected rate of US inflation
i$ is the equilibrium expected nominal US interest rate

18. Interest Rate Parity
• F – forward rate, FC/DC
• S – spot rate, FC/DC
• rFC – interest rate of foreign currency __________
• rDC – interest rate of domestic currency __________
DC
DC
FC
r
r
r
S
S
F




1 DC
FC
r
r
S
F



1
1

19. International Fisher Effect
• The International Fisher Effect (IFE) is an exchange-rate model that extends the
standard Fisher Effect and is used in forex trading and analysis.
• It is based on present and future risk-free nominal interest rates rather than pure
inflation, and it is used to predict and understand the present and future spot
currency price movements
• This uses the Fisher effect to predict a link between interest rates and exchange
rate movements.
• International Fisher Effect shows you the changes in the exchange rates of two
currencies correlate with the difference in nominal interest rates between the
two countries
• The argument is that if a country has higher nominal interest rates, this will tend
to cause depreciation because higher nominal rates imply that inflation is higher

20. International Fisher Effect
• The IFE is based on the analysis of interest rates associated with present
and future risk-free investments, such as Treasuries, and is used to help
predict currency movements.
• This is in contrast to other methods that solely use inflation rates in the
prediction of exchange rate shifts, instead functioning as a combined view
relating inflation and interest rates to a currency's appreciation or
depreciation.
• Inflation expectations and nominal interest rates around the world are
generally low, and the size of interest rate changes is correspondingly
relatively small.
• Direct indications of inflation rates, such as consumer price indexes (CPI),
are more often used to estimate expected changes in currency exchange
rates

21. Assumptions of the International Fisher Effect
• Capital freely flows between countries
• Real interest rates are the equal between countries in the world
• Difference in nominal interest rates between countries equals
expected inflation (expected inflation)
• Capital markets are internationally integrated
• No currency controls

22. Criticisms of International Fisher Effect
• First, nominal interest rates are not the only determinant of nominal
exchange rates. International trade, which determines exchange rates,
operates not only through price, but also through quality. That might offset
the effects of differences in inflation (nominal interest rates) between the
two countries
• Second, capital flows do not flow freely. In Fisher’s assumption, capital
flows freely between countries, leading to equal real interest rates
worldwide. Because real interest rates are equal, nominal interest rates will
roughly equal the difference in expected inflation in each country.
• Third, exchange rates work not only through international trade but also
through capital flows. If the domestic interest rate is higher, foreign
investors favor to enter, increasing demand for the domestic currency and
causing appreciation. Thus, capital movements offset the effects of
differences in inflation on exchange rates.

23. Fisher Effect and International Fisher Effect
• The Fisher Effect claims that the combination of the anticipated rate
of inflation and the real rate of return are represented in the nominal
interest rates.
• The IFE expands on the Fisher Effect, suggesting that because nominal
interest rates reflect anticipated inflation rates and currency exchange
rate changes are driven by inflation rates, then currency changes are
proportionate to the difference between the two nations' nominal
interest rates.

24. Purchasing Power Parity
• Absolute PPP states that the purchasing power of any
currency is the same in any country and implies
relative PPP.
• Relative PPP predicts that percentage changes in
exchange rates equal differences in national inflation
rates.
• The law of one price is a building block of the PPP
theory.
• It states that under free competition and in the absence of
trade impediments, a good must sell for a single price
regardless of where in the world it is sold.

25. Purchasing Power Parity
• S0 – spot rate at the start of the period, FC/DC
• S1 – expected spot rate at the start of the period, FC/DC
• FC – expected inflation rate of foreign country (FC)
• DC – expected inflation rate of domestic country (DC)
DC
DC
FC
S
S
S







1
0
0
1
DC
FC
S
S





1
1
0
1