1. 1
Multinational Financial
Management
Alan Shapiro
7th
Edition
J.Wiley & Sons
Power Points by
Joseph F. Greco, Ph.D.
California State University, Fullerton

2. 2
CHAPTER 4
PARITY CONDITIONS
AND
CURRENCY
FORECASTING

3. 3
CHAPTER OVERVIEW
I. ARBITRAGE AND THE LAW OF
ONE PRICE
II. PURCHASING POWER PARITY
III. THE FISHER EFFECT
IV. THE INTERNATIONAL FISHER EFFECT
V. INTEREST RATE PARITY THEORY
VI. THE RELATIONSHIP BETWEEN
THE FORWARD AND FUTURE
SPOT RATE
VII. CURRENCY FORECASTING

4. 4
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.

5. 5
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.

6. 6
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)

7. 7
ARBITRAGE AND THE LAW OF ONE
PRICE
D. Five Parity Conditions Linked
by
1. The adjustment of various
rates and prices to inflation.

8. 8
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).

9. 9
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.

10. 10
ARBITRAGE AND THE LAW OF ONE
PRICE
F. THE LAW OF ONE PRICE
- enforced by international
arbitrage.

11. 11
PART II. PURCHASING POWER
PARITY
I. THE THEORY OF PURCHASING
POWER PARITY:
states that spot exchange rates
between currencies will change to
the differential in inflation rates
between countries.

12. 12
PURCHASING POWER PARITY
II. ABSOLUTE PURCHASING
POWER PARITY
A. Price levels adjusted for
exchange rates should be
equal between countries

13. 13
PURCHASING POWER PARITY
II. ABSOLUTE PURCHASING
POWER PARITY
B. One unit of currency has
same purchasing power
globally.

14. 14
PURCHASING POWER PARITY
III. RELATIVE PURCHASING
POWER PARITY
A. states that the exchange
rate of one currency against
another will adjust to reflect
changes in the price levels of the
two countries.

15. 15
PURCHASING POWER PARITY
1. In mathematical terms:
where et = future spot rate
e0 = spot rate
ih = home inflation
if = foreign inflation
t = the time period
( )
( )t
f
t
ht
i
i
e
e
+
+
=
1
1
0

16. 16
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
f
t
h
t
i
i
ee
+
+
=
1
1
0

17. 17
PURCHASING POWER PARITY
3. A more simplified but less precise
relationship is
that is, the percentage change should be
approximately equal to the inflation rate
differential.
fh
t
ii
e
e
−=
0

18. 18
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.

19. 19
PURCHASING POWER PARITY
B. Real Exchange Rates:
the quoted or nominal rate
adjusted for a country’s
inflation rate is
t
h
t
f
tt
i
i
ee
)1(
)1('
+
+
=

20. 20
PURCHASING POWER PARITY
C. Real exchange rates
1. If exchange rates adjust to
inflation differential, PPP
states that real exchange rates
stay the same.

21. 21
PURCHASING POWER PARITY
C. Real exchange rates
2. Competitive positions:
domestic and foreign firms
are unaffected.

22. 22
PART III.
THE FISHER EFFECT (FE)
I. THE FISHER EFFECT
states that nominal interest rates (r)
are a function of the real interest
rate (a) and a premium (i) for
inflation expectations.
R = a + i

23. 23
THE FISHER EFFECT
B. Real Rates of Interest
1. Should tend toward equality
everywhere through arbitrage.
2. With no government
interference nominal rates vary
by inflation differential or
rh - rf = ih - if

24. 24
THE FISHER EFFECT
C. According to the Fisher Effect,
countries with higher inflation
rates have higher interest rates.

25. 25
THE FISHER EFFECT
D. Due to capital market
integration globally, interest
rate differentials are eroding.

26. 26
PART IV. THE INTERNATIONAL
FISHER EFFECT (IFE)
I. IFE STATES:
A. the spot rate adjusts to the
interest rate differential
between two countries.

27. 27
THE INTERNATIONAL FISHER
EFFECT
IFE = PPP + FE
t
f
t
ht
r
r
e
e
)1(
)1(
0 +
+
=

28. 28
THE INTERNATIONAL FISHER
EFFECT
B. Fisher postulated
1. The nominal interest rate
differential should reflect
the inflation rate differential.

29. 29
THE INTERNATIONAL FISHER
EFFECT
B. Fisher postulated
2. Expected rates of return are
equal in the absence of
government intervention.

30. 30
THE INTERNATIONAL FISHER
EFFECT
C. Simplified IFE equation:
(if rf is relatively small)
1 0
0
h f
e e
r r
e
−
− =

31. 31
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.

32. 32
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.

33. 33
PART VI. INTEREST RATE PARITY
THEORY
I. INTRODUCTION
A. The Theory states:
the forward rate (F) differs
from the spot rate (S) at
equilibrium by an amount
equal to the interest
differential (rh - rf) between two
countries.

34. 34
INTEREST RATE PARITY
THEORY
2. The forward premium or
discount equals the interest
rate differential.
(F - S)/S = (rh - rf)
where rh = the home rate
rf = the foreign rate

35. 35
INTEREST RATE PARITY
THEORY
3. 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

36. 36
INTEREST RATE PARITY
THEORY
B. 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.

37. 37
INTEREST RATE PARITY
THEORY
3. Market pressures develop:
a. As one currency is more demanded spot
and sold forward.
b. Inflow of fund depresses interest rates.
c. Parity eventually reached.

38. 38
INTEREST RATE PARITY
THEORY
C. 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.

39. 39
PART VI. THE RELATIONSHIP BETWEEN THE
FORWARD AND THE FUTURE SPOT RATE
I. THE UNBIASED FORWARD RATE
A. States that if the forward rate
is unbiased, then it should
reflect the expected future
spot rate.
B. Stated as
ft = et

40. 40
PART VI. CURRENCYFORECASTING
I. FORECASTING MODELS
A. Created to forecast exchange rates in
addition to parity conditions.
B. Two types of forecast:
1. Market-based
2. Model-based

41. 41
CURRENCY FORECASTING
MARKET-BASED FORECASTS:
derived from market indicators.
A. The current forward rate contains implicit
information about exchange rate changes
for one year.
B. Interest rate differentials may be
used to predict exchange rates beyond
one year.

42. 42
CURRENCY FORECASTING
MODEL-BASED FORECASTS:
include fundamental and technical
analysis.
A. Fundamental relies on key
macroeconomic variables and policies
which most like affect exchange
rates.
B. Technical relies on use of
1. Historical volume and price data
2. Charting and trend analysis