IRP and PPP

1. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Exchange Rate Determination

2. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Measuring Exchange Rate
Movements
• An exchange rate measures the value of one
currency in units of another currency.
• When a currency declines in value, it is said to
depreciate. When it increases in value, it is
said to appreciate.
• On the days when some currencies appreciate
while others depreciate against a particular
currency, that currency is said to be “mixed in
trading.”

3. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Measuring Exchange Rate
Movements
• The percentage change (% D) in the value
of a foreign currency is computed as
St – 1
St – St – 1
where St denotes the spot rate at time t.
• A positive % D represents appreciation of the foreign
currency, while a negative % D represents
depreciation.

4. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Exchange Rate Equilibrium
• An exchange rate represents the price of a
currency, which is determined by the
demand for that currency relative to the
supply for that currency.
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

5. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Value of
£
Quantity of £
$1.55
$1.50
$1.60
Equilibrium
exchange rate
D: Demand for £
S: Supply of £
Exchange Rate Equilibrium (2)
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

6. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Exchange Rate Equilibrium
• The liquidity of a currency affects the
sensitivity of the exchange rate to specific
transactions.
• With many willing buyers and sellers, even
large transactions can be easily
accommodated.
• Conversely, illiquid currencies tend to
exhibit more volatile exchange rate
movements.
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

7. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Factors that Influence
Exchange Rates (1)
e = percentage change in the spot rate
DINF = change in the relative inflation rate
D INT = change in the relative interest rate
DINC = change in the relative income level
DGC = change in government controls
DEXP = change in expectations of future
exchange rates
 )
EXP
GC
INC
INT
INF
f
e D
D
D
D
D
 ,
,
,
,
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

8. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
$/
£
Quantity of £
S0
D0
r0
U.S. inflation 
  U.S. demand for
British goods, and
hence £.
D1
r1
S1
Factors that Influence
Exchange Rates
Relative Inflation Rates
  British desire for U.S.
goods, and hence the
supply of £.
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

9. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
$/£
Quantity of £
r0
S0
D0
S1
D1
r1
U.S. interest rates 
  U.S. demand for
British bank deposits,
and hence £.
Factors that Influence
Exchange Rates
Relative Interest Rates
  British desire for U.S.
bank deposits, and
hence the supply of £.
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

10. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Factors that Influence
Exchange Rates
Relative Interest Rates
• It is thus useful to consider the real interest
rate, which adjusts the nominal interest rate
for inflation.
• A relatively high interest rate may actually
reflect expectations of relatively high
inflation, which may discourage foreign
investment.
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

11. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Factors that Influence
Exchange Rates
Relative Interest Rates
• This relationship is sometimes called the
Fisher effect.
• real nominal
interest  interest – inflation rate
rate rate
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

12. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
$/£
Quantity of £
S
0
D0
r0
U.S. income level 
  U.S. demand for
British goods, and
hence £.
D1
r1
Factors that Influence
Exchange Rates
Relative Income Levels
 No expected change for
the supply of £.
,S1
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

13. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Factors that Influence
Exchange Rates
Government Controls
• Governments may influence the equilibrium
exchange rate by:
– imposing foreign exchange barriers,
– imposing foreign trade barriers,
– intervening in the foreign exchange market, and
– affecting macro variables such as inflation,
interest rates, and income levels.
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

14. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Factors that Influence
Exchange Rates
Expectations
• Foreign exchange markets react to any
news that may have a future effect.
– News of a potential surge in U.S. inflation may
cause currency traders to sell dollars.
• Many institutional investors take currency
positions based on anticipated interest rate
movements in various countries.
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

15. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Factors that Influence
Exchange Rates
Expectations
• Economic signals that affect exchange rates can
change quickly, such that speculators may
overreact initially and then find that they have to
make a correction.
• Speculation on the currencies of emerging markets
can have a substantial impact on their exchange
rates.
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

16. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Factors that Influence
Exchange Rates
Interaction of Factors
• The various factors sometimes interact and
simultaneously affect exchange rate
movements.
• For example, an increase in income levels
sometimes causes expectations of higher
interest rates, thus placing opposing pressures
on foreign currency values.
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

17. Trade-Related
Factors
1. Inflation
Differential
2. Income
Differential
3. Gov’t Trade
Restrictions
Financial
Factors
1. Interest Rate
Differential
2. Capital Flow
Restrictions
How Factors Can Affect Exchange Rates
U.K. demand for foreign
goods, i.e. demand for
foreign currency
Foreign demand for U.K.
goods, i.e. supply of
foreign currency
U.K. demand for foreign
securities, i.e. demand for
foreign currency
Foreign demand for U.K.
securities, i.e. supply of
foreign currency
Exchange
rate
between
foreign
currency
and the
dollar
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

18. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Factors that Influence
Exchange Rates
Interaction of Factors
Large volume of international trade 
relative inflation rates may be more influential
Large volume of capital flows  interest rate
fluctuations may be more influential
• The sensitivity of an exchange rate to the
factors is dependent on the volume of
international transactions between the two
countries.
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

19. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Factors that Influence
Exchange Rates
Interaction of Factors
• An understanding of exchange rate
equilibrium does not guarantee accurate
forecasts of future exchange rates because
that will depend in part on how the factors
that affect exchange rates will change in
the future.
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA

20. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Interest Rate Parity
• Interest Rate Parity Defined
• Covered Interest Arbitrage
• Interest Rate Parity & Exchange Rate
Determination
• Reasons for Deviations from Interest Rate
Parity

21. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Interest Rate Parity Defined
• IRP is an arbitrage condition.
• If IRP did not hold, then it would be
possible for an astute trader to make
unlimited amounts of money exploiting the
arbitrage opportunity.
• Since we don’t typically observe persistent
arbitrage conditions, we can safely
assume that IRP holds.

22. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Interest Rate Parity Defined
Formally,
(F/S)(1 + i¥) = (1 + ius)
or if you prefer,
S
F
i
i



¥
$
1
1
IRP is sometimes approximated as
S
(F- S)
)
-i
(i ¥ 
$

23. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Purchasing Power Parity (PPP)
1. Statement of Purchasing Power Parity
a. Absolute Form of PPP: without international barriers,
consumers shift their demand to wherever prices are
lower. Prices of the same basket of products in two
different countries should be equal when measured in
common currency.
b. Relative Form of PPP: Due to market imperfections,
prices of the same basket of products in different
countries will not necessarily be the same when
measured in a common currency. However, the rate of
change in prices should be somewhat similar when
measured in common currency as long as
transportation costs and trade barriers are unchanged.

24. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
24
Purchasing Power Parity
1. Relationship between relative inflation rates (I)
and the change in the exchange rate (e).
Check the derivation.
2. Simplified PPP relationship
1
1
1




f
h
f
I
I
e
f
h
f I
I
e 


25. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
25
International Fisher Effect (IFE)
1. IFE suggests that the nominal interest rate
contain two components:
a. Expected inflation rate
b. Real interest rate
2. Implications of the IFE: currencies with high
interest rates will have high expected inflation
and will be expected depreciate.
3. Implications of the IFE for foreign investors:
foreign investors will be adversely affected by
the effects of relatively high U.S. inflation rate if
they try to capitalize on high U.S. interest rates.

26. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
26
Derivation of the International Fisher Effect
1. Relationship between the interest rate (i)
differential between two countries and expected
change in the exchange rate (e)
2. Simplified relationship
1
1
1




f
h
f
i
i
e
f
h
f i
i
e 


27. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
27
Comparison of the IRP, PPP, and IFE Theories
27

28. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Forecasting Exchange Rates
• Efficient Markets Approach
• Fundamental Approach
• Technical Approach

29. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Efficient Markets Approach
• Financial Markets are efficient if prices reflect all
available and relevant information.
• If this is so, exchange rates will only change
when new information arrives, thus:
St = E[St+1]
and
Ft = E[St+1| It]
• Predicting exchange rates using the efficient
markets approach is affordable and is hard to
beat.

30. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Fundamental Approach
• Involves econometrics to develop models
that use a variety of explanatory variables.
This involves three steps:
– step 1: Estimate the structural model.
– step 2: Estimate future parameter values.
– step 3: Use the model to develop forecasts.
• The downside is that fundamental models
do not work any better than the forward rate
model or the random walk model.

31. Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Technical Approach
• Technical analysis looks for patterns in the
past behavior of exchange rates.
• Clearly it is based upon the premise that
history repeats itself.
• Thus it is at odds with the EMH