This document summarizes five theories of international finance:
1) Interest Rate Parity relates spot and forward exchange rates to interest rate differentials between two countries. It states that interest rate differences should equal the forward premium or discount.
2) Purchasing Power Parity argues that exchange rates should adjust so that equivalent goods cost the same across countries after accounting for exchange rates and price levels. Relative PPP focuses on how inflation rate differences impact exchange rate changes.
3) The Fisher Effect describes the relationship between nominal interest rates, real interest rates, and inflation. It posits that nominal rates will adjust one-for-one with expected inflation so that real rates remain unchanged.
4) The International Fisher Effect extends
Foreign Exchange market & international Parity Relationspalakurthiharika
The document discusses several key concepts related to foreign exchange markets and exchange rate determination. It describes the foreign exchange market as where individuals, firms, banks, and brokers buy and sell foreign currencies. Exchange rates are determined by the demand and supply of currencies based on factors like interest rates, inflation rates, purchasing power parity, and investor psychology. Theories like interest rate parity and purchasing power parity aim to explain exchange rate movements, though other short-term factors also influence rates.
This document summarizes several international parity conditions:
1) Purchasing power parity states that identical goods should sell for the same price worldwide when accounting for transportation costs, taxes, and other factors. It is a manifestation of the law of one price applied internationally.
2) Absolute and relative purchasing power parity refer to comparing the price of a standard basket of goods across currencies and changes in inflation affecting exchange rates.
3) Interest rate parity or the Fisher effect relates nominal interest rates, real interest rates, and expected inflation rates both within and between countries. It posits that nominal rates equal real rates plus inflation.
The document discusses several concepts related to international finance including:
1) Purchasing power parity, interest rate parity, and the Fisher effect which relate exchange rates, interest rates, and inflation rates between countries.
2) Arbitrage opportunities that can arise from differences in exchange rates quoted by different traders.
3) Conditions like the law of one price that must hold for arbitrage to exist.
4) Absolute and relative forms of purchasing power parity and limitations of the theory.
5) How interest rate parity explains differences between spot and forward exchange rates.
This document provides an overview of international finance concepts including:
1. Types of currency quotes (direct, indirect) and how to convert between them.
2. Types of exchange rates (bid, offer, spread).
3. How to determine the appropriate rate to use when exposed to foreign currency (bid for receivables, offer for payables).
4. How to calculate cross rates between currencies not directly quoted by using a common currency.
5. How forward contracts can be used to hedge and eliminate currency risk on foreign currency receivables and payables.
The document discusses the Purchasing Power Parity (PPP) theory, which states that exchange rates between currencies are determined by their relative purchasing power. It explains that under PPP, exchange rates adjust to changes in inflation so that the same goods cost the same in each country when prices are converted to a common currency. The document outlines the absolute and relative versions of PPP theory and notes some limitations, such as differences in goods baskets between countries. An example is provided to demonstrate how exchange rates adjust proportionally according to changes in domestic and foreign inflation rates under relative PPP.
This document discusses theories related to foreign exchange rates, including purchasing power parity (PPP), interest rate parity (IRP), and the international Fisher effect (IFE). PPP states that exchange rates should adjust over time to account for inflation differences between countries. IRP suggests that interest rate differentials should equal expected changes in exchange rates. IFE describes how real interest rates should move with inflation according to nominal interest rates. Deviations from these theories can occur due to factors like trade barriers, market imperfections, and expectations of future exchange rates.
The document discusses the time value of money, which refers to the concept that money has greater value when received now rather than in the future due to opportunity costs, inflation, and uncertainty. It provides formulas for calculating future value, present value, and interest rates. It also discusses compound interest and how money can double over time depending on the interest rate and compounding periods. Examples are provided to demonstrate calculations for simple vs compound interest and different compounding periods.
A Quantitative Case Study on the Impact of Transaction Cost in High-Frequency...Cognizant
High-frequency trading (HFT) aims to achieve a small positive alpha on every trade, so transaction costs determine whether the algorithm is profitable. We offer a case study demonstrating the relationship between alphas, transaction costs, and profitability.
Foreign Exchange market & international Parity Relationspalakurthiharika
The document discusses several key concepts related to foreign exchange markets and exchange rate determination. It describes the foreign exchange market as where individuals, firms, banks, and brokers buy and sell foreign currencies. Exchange rates are determined by the demand and supply of currencies based on factors like interest rates, inflation rates, purchasing power parity, and investor psychology. Theories like interest rate parity and purchasing power parity aim to explain exchange rate movements, though other short-term factors also influence rates.
This document summarizes several international parity conditions:
1) Purchasing power parity states that identical goods should sell for the same price worldwide when accounting for transportation costs, taxes, and other factors. It is a manifestation of the law of one price applied internationally.
2) Absolute and relative purchasing power parity refer to comparing the price of a standard basket of goods across currencies and changes in inflation affecting exchange rates.
3) Interest rate parity or the Fisher effect relates nominal interest rates, real interest rates, and expected inflation rates both within and between countries. It posits that nominal rates equal real rates plus inflation.
The document discusses several concepts related to international finance including:
1) Purchasing power parity, interest rate parity, and the Fisher effect which relate exchange rates, interest rates, and inflation rates between countries.
2) Arbitrage opportunities that can arise from differences in exchange rates quoted by different traders.
3) Conditions like the law of one price that must hold for arbitrage to exist.
4) Absolute and relative forms of purchasing power parity and limitations of the theory.
5) How interest rate parity explains differences between spot and forward exchange rates.
This document provides an overview of international finance concepts including:
1. Types of currency quotes (direct, indirect) and how to convert between them.
2. Types of exchange rates (bid, offer, spread).
3. How to determine the appropriate rate to use when exposed to foreign currency (bid for receivables, offer for payables).
4. How to calculate cross rates between currencies not directly quoted by using a common currency.
5. How forward contracts can be used to hedge and eliminate currency risk on foreign currency receivables and payables.
The document discusses the Purchasing Power Parity (PPP) theory, which states that exchange rates between currencies are determined by their relative purchasing power. It explains that under PPP, exchange rates adjust to changes in inflation so that the same goods cost the same in each country when prices are converted to a common currency. The document outlines the absolute and relative versions of PPP theory and notes some limitations, such as differences in goods baskets between countries. An example is provided to demonstrate how exchange rates adjust proportionally according to changes in domestic and foreign inflation rates under relative PPP.
This document discusses theories related to foreign exchange rates, including purchasing power parity (PPP), interest rate parity (IRP), and the international Fisher effect (IFE). PPP states that exchange rates should adjust over time to account for inflation differences between countries. IRP suggests that interest rate differentials should equal expected changes in exchange rates. IFE describes how real interest rates should move with inflation according to nominal interest rates. Deviations from these theories can occur due to factors like trade barriers, market imperfections, and expectations of future exchange rates.
The document discusses the time value of money, which refers to the concept that money has greater value when received now rather than in the future due to opportunity costs, inflation, and uncertainty. It provides formulas for calculating future value, present value, and interest rates. It also discusses compound interest and how money can double over time depending on the interest rate and compounding periods. Examples are provided to demonstrate calculations for simple vs compound interest and different compounding periods.
A Quantitative Case Study on the Impact of Transaction Cost in High-Frequency...Cognizant
High-frequency trading (HFT) aims to achieve a small positive alpha on every trade, so transaction costs determine whether the algorithm is profitable. We offer a case study demonstrating the relationship between alphas, transaction costs, and profitability.
This document discusses the concepts and formulae for pricing forwards and futures contracts. It begins by explaining that forward prices are calculated by adjusting the spot price for time value using the cost of carry approach. This involves factors like storage costs, interest charges, and convenience yield. Several formulae are provided to calculate forward prices based on whether storage costs are fixed or proportional, and whether income is fixed or proportional. The concepts of contango and backwardation markets are explained in relation to cost of carry. The document also discusses valuation of existing forward contracts and basis risk.
The document provides an outline and examples for lecture material on time value of money concepts. It discusses 1) valuing costs and benefits, 2) the time value of money and interest rates, 3) net present value decision rules, 4) arbitrage and the law of one price, and 5) applying concepts to risky securities. Worked examples are provided to illustrate key points such as calculating present and future value, comparing investment alternatives using net present value, and determining no-arbitrage prices.
This document discusses international finance concepts including exchange rates, forward rates, purchasing power parity, interest rate parity, and exchange rate risk. It provides examples and explanations of these topics. For instance, it explains that if the yen spot price is 108.173 yen per dollar and the 1-year forward rate is 111.715 yen per dollar, then the dollar is selling at a 3.27% premium relative to the yen. It also works through examples of calculating forward rates and converting cash flows between currencies.
This document provides an overview of bond evaluation. It defines key bond terms like coupon rate, face value, maturity date, and yield to maturity. It explains how to calculate current yield, spot interest rate, and bond price. Bond risks discussed are default risk and interest rate risk. The document contains examples of how to value a bond and calculate its yield.
- The document discusses transaction exposure (TE), which is the risk from changes in exchange rates for contracts that have been agreed to but not yet settled.
- It describes various ways to manage TE, including through forward contracts, money market hedges, options, and swaps. It also discusses operational techniques like invoice currency choice and exposure netting.
- Examples are provided to illustrate comparing forward contracts to money market hedges for an exporter receiving foreign currency and an importer paying foreign currency. The more advantageous hedge depends on interest rate differences.
1. The document discusses various derivatives concepts including forwards, futures, options, and hedging strategies.
2. It provides examples of how to calculate forward prices based on the interest rate differential between the underlying asset and borrowing rates.
3. It also discusses option concepts such as call and put options, strike prices, and factors that influence option prices.
This document provides an overview of key concepts related to valuation of securities, including time value of money, simple vs compound interest, future and present value calculations for single amounts, annuities, and growing annuities. It also discusses bond valuation terminology, risks associated with bonds such as interest rate risk and default risk, and accrued interest calculations. The document uses examples throughout to illustrate various time value of money and bond valuation concepts.
The document discusses currency derivatives such as forward contracts, futures contracts, and options contracts. It explains that forward contracts allow parties to lock in an exchange rate for a currency transaction occurring at a future date. Currency futures contracts are standardized exchange-traded contracts where the underlying asset is a currency. Currency options provide the right but not obligation to buy or sell a currency at a predetermined price.
The document provides information about bonds, including:
- Bonds are fixed income instruments that make defined coupon payments and are redeemed at par value at maturity.
- Bond prices are inversely related to interest rates and are influenced by risks like default, interest rate, and marketability.
- The yield to maturity (YTM) is the discount rate that makes the present value of future cash flows equal the market price.
- Duration measures the sensitivity of bond prices to interest rate changes, with longer duration bonds having higher sensitivity.
- Bond management strategies include passive buy-and-hold, indexing, and active strategies that try to time interest rate movements.
The document discusses the time value of money concept. It states that time value of money refers to money being worth more the earlier it is received. It also discusses key concepts like present value, future value, compounding, discounting, and how to calculate future and present values using formulas that factor in variables like interest rates and time periods. The document also mentions how risk and inflation impact interest rates in determining the cost of capital.
This document discusses financial derivatives such as futures and forwards. It defines a derivative as a financial instrument whose value is based on an underlying asset. Futures are standardized forward contracts that are traded on an organized exchange. Forwards are customized contracts where two parties agree to buy or sell an asset at a set price on a future date. The document provides examples of gold futures and wheat forwards to illustrate how these derivatives derive their value from changes in the price of the underlying asset.
The document discusses various topics related to interest rate futures, including:
1) Day count conventions used in different money market instruments and bonds in the US.
2) How treasury bond prices are quoted and how futures contracts work for treasury bonds.
3) Eurodollar futures contracts which are based on 3-month LIBOR rates and how they are settled.
4) How forward rates can be determined from Eurodollar futures and extending the LIBOR zero curve.
5) Duration matching and calculating hedge ratios to hedge interest rate risk.
International Financial Management, International trading, Arbitrage, Put or ...Md. Ismail Hossen
An assignment on case study and presentation on International Financial Management where mainly four things were studied
1) Arbitrage Oppurtunity
2) Exercising the put and call option
3) Sell or Keep
4) Risk of Expose
This PPT is made to give basic idea of time value of money, this will explain the simple interest and compound interest also the cash flows through compounding and discounting methods. In the second part of PPT we will take some practical problems and solutions.
Derivatives derive their value from underlying assets such as stocks, commodities, currencies, and bonds. The main types of derivatives are forwards, futures, and options. Forwards involve an obligation for both parties to fulfill the contract terms at a future date. Futures are standardized contracts traded on an exchange with high liquidity. Options confer the right but not obligation to buy or sell the underlying asset at a strike price by an expiry date. Key participants in derivatives markets include speculators, hedgers, and arbitrageurs. Common derivatives strategies involve futures arbitrage, hedging, directional spreads, and volatility spreads.
The document contains 13 problems related to valuation of securities such as stocks and bonds. Key details include calculating stock prices given dividend growth rates, required rates of return, bond yields and prices given coupon rates and maturities. The problems require using concepts like present value, dividend discount model, yield to maturity and understanding how interest rate changes affect bond prices.
This document discusses the valuation of bonds and shares. It covers the fundamental characteristics of different types of shares and bonds, and how to value them using present value concepts. Key valuation methods discussed include yield to maturity, current yield, yield to call, and duration. The document also examines how bond values are affected by changes in interest rates and the term structure of interest rates. Different theories for the typical upward sloping yield curve are presented, including the expectation theory and liquidity premium theory.
The document introduces the binomial option pricing model, which uses a binomial tree to represent the possible paths an underlying asset's price may take over the life of an option. It assumes a risk-neutral world where expected returns are equal to the risk-free rate. The model prices options by constructing hedge portfolios that eliminate risk, with the option price being the value that makes the portfolio worth the same whether the asset price rises or falls. For a single time period, if the asset price can rise by u or fall by d, with hedge ratio h, the option price C is derived as p(1-p)P, where p is (r-d)/(u-d) and P is the payoff function.
This document discusses several international parity conditions:
- The law of one price states that identical goods should have the same price when expressed in a common currency.
- Purchasing power parity suggests that exchange rates will adjust to compensate for differences in prices of the same goods between countries.
- Covered interest parity implies that interest rate differentials should be offset by changes in forward exchange rates to prevent arbitrage opportunities.
- Reasons for deviations from these conditions include trade barriers, non-traded goods, measurement issues, and political/tax differences.
This document discusses interest rate parity theory. It begins by defining spot and forward rates. Spot rates are prices for immediate settlement, while forward rates refer to rates for future currency delivery adjusted for cost of carry. Interest rate parity theory states that interest rate differentials between currencies will be reflected in forward premiums or discounts. The theory prevents arbitrage opportunities by making returns equal whether investing domestically or abroad when measured in the home currency. The document provides an example of covered and uncovered interest rate parity. Covered parity involves hedging exchange rate risk while uncovered parity does not. Empirical evidence shows uncovered parity often fails while covered parity generally holds for major currencies over short time horizons.
This document discusses the concepts and formulae for pricing forwards and futures contracts. It begins by explaining that forward prices are calculated by adjusting the spot price for time value using the cost of carry approach. This involves factors like storage costs, interest charges, and convenience yield. Several formulae are provided to calculate forward prices based on whether storage costs are fixed or proportional, and whether income is fixed or proportional. The concepts of contango and backwardation markets are explained in relation to cost of carry. The document also discusses valuation of existing forward contracts and basis risk.
The document provides an outline and examples for lecture material on time value of money concepts. It discusses 1) valuing costs and benefits, 2) the time value of money and interest rates, 3) net present value decision rules, 4) arbitrage and the law of one price, and 5) applying concepts to risky securities. Worked examples are provided to illustrate key points such as calculating present and future value, comparing investment alternatives using net present value, and determining no-arbitrage prices.
This document discusses international finance concepts including exchange rates, forward rates, purchasing power parity, interest rate parity, and exchange rate risk. It provides examples and explanations of these topics. For instance, it explains that if the yen spot price is 108.173 yen per dollar and the 1-year forward rate is 111.715 yen per dollar, then the dollar is selling at a 3.27% premium relative to the yen. It also works through examples of calculating forward rates and converting cash flows between currencies.
This document provides an overview of bond evaluation. It defines key bond terms like coupon rate, face value, maturity date, and yield to maturity. It explains how to calculate current yield, spot interest rate, and bond price. Bond risks discussed are default risk and interest rate risk. The document contains examples of how to value a bond and calculate its yield.
- The document discusses transaction exposure (TE), which is the risk from changes in exchange rates for contracts that have been agreed to but not yet settled.
- It describes various ways to manage TE, including through forward contracts, money market hedges, options, and swaps. It also discusses operational techniques like invoice currency choice and exposure netting.
- Examples are provided to illustrate comparing forward contracts to money market hedges for an exporter receiving foreign currency and an importer paying foreign currency. The more advantageous hedge depends on interest rate differences.
1. The document discusses various derivatives concepts including forwards, futures, options, and hedging strategies.
2. It provides examples of how to calculate forward prices based on the interest rate differential between the underlying asset and borrowing rates.
3. It also discusses option concepts such as call and put options, strike prices, and factors that influence option prices.
This document provides an overview of key concepts related to valuation of securities, including time value of money, simple vs compound interest, future and present value calculations for single amounts, annuities, and growing annuities. It also discusses bond valuation terminology, risks associated with bonds such as interest rate risk and default risk, and accrued interest calculations. The document uses examples throughout to illustrate various time value of money and bond valuation concepts.
The document discusses currency derivatives such as forward contracts, futures contracts, and options contracts. It explains that forward contracts allow parties to lock in an exchange rate for a currency transaction occurring at a future date. Currency futures contracts are standardized exchange-traded contracts where the underlying asset is a currency. Currency options provide the right but not obligation to buy or sell a currency at a predetermined price.
The document provides information about bonds, including:
- Bonds are fixed income instruments that make defined coupon payments and are redeemed at par value at maturity.
- Bond prices are inversely related to interest rates and are influenced by risks like default, interest rate, and marketability.
- The yield to maturity (YTM) is the discount rate that makes the present value of future cash flows equal the market price.
- Duration measures the sensitivity of bond prices to interest rate changes, with longer duration bonds having higher sensitivity.
- Bond management strategies include passive buy-and-hold, indexing, and active strategies that try to time interest rate movements.
The document discusses the time value of money concept. It states that time value of money refers to money being worth more the earlier it is received. It also discusses key concepts like present value, future value, compounding, discounting, and how to calculate future and present values using formulas that factor in variables like interest rates and time periods. The document also mentions how risk and inflation impact interest rates in determining the cost of capital.
This document discusses financial derivatives such as futures and forwards. It defines a derivative as a financial instrument whose value is based on an underlying asset. Futures are standardized forward contracts that are traded on an organized exchange. Forwards are customized contracts where two parties agree to buy or sell an asset at a set price on a future date. The document provides examples of gold futures and wheat forwards to illustrate how these derivatives derive their value from changes in the price of the underlying asset.
The document discusses various topics related to interest rate futures, including:
1) Day count conventions used in different money market instruments and bonds in the US.
2) How treasury bond prices are quoted and how futures contracts work for treasury bonds.
3) Eurodollar futures contracts which are based on 3-month LIBOR rates and how they are settled.
4) How forward rates can be determined from Eurodollar futures and extending the LIBOR zero curve.
5) Duration matching and calculating hedge ratios to hedge interest rate risk.
International Financial Management, International trading, Arbitrage, Put or ...Md. Ismail Hossen
An assignment on case study and presentation on International Financial Management where mainly four things were studied
1) Arbitrage Oppurtunity
2) Exercising the put and call option
3) Sell or Keep
4) Risk of Expose
This PPT is made to give basic idea of time value of money, this will explain the simple interest and compound interest also the cash flows through compounding and discounting methods. In the second part of PPT we will take some practical problems and solutions.
Derivatives derive their value from underlying assets such as stocks, commodities, currencies, and bonds. The main types of derivatives are forwards, futures, and options. Forwards involve an obligation for both parties to fulfill the contract terms at a future date. Futures are standardized contracts traded on an exchange with high liquidity. Options confer the right but not obligation to buy or sell the underlying asset at a strike price by an expiry date. Key participants in derivatives markets include speculators, hedgers, and arbitrageurs. Common derivatives strategies involve futures arbitrage, hedging, directional spreads, and volatility spreads.
The document contains 13 problems related to valuation of securities such as stocks and bonds. Key details include calculating stock prices given dividend growth rates, required rates of return, bond yields and prices given coupon rates and maturities. The problems require using concepts like present value, dividend discount model, yield to maturity and understanding how interest rate changes affect bond prices.
This document discusses the valuation of bonds and shares. It covers the fundamental characteristics of different types of shares and bonds, and how to value them using present value concepts. Key valuation methods discussed include yield to maturity, current yield, yield to call, and duration. The document also examines how bond values are affected by changes in interest rates and the term structure of interest rates. Different theories for the typical upward sloping yield curve are presented, including the expectation theory and liquidity premium theory.
The document introduces the binomial option pricing model, which uses a binomial tree to represent the possible paths an underlying asset's price may take over the life of an option. It assumes a risk-neutral world where expected returns are equal to the risk-free rate. The model prices options by constructing hedge portfolios that eliminate risk, with the option price being the value that makes the portfolio worth the same whether the asset price rises or falls. For a single time period, if the asset price can rise by u or fall by d, with hedge ratio h, the option price C is derived as p(1-p)P, where p is (r-d)/(u-d) and P is the payoff function.
This document discusses several international parity conditions:
- The law of one price states that identical goods should have the same price when expressed in a common currency.
- Purchasing power parity suggests that exchange rates will adjust to compensate for differences in prices of the same goods between countries.
- Covered interest parity implies that interest rate differentials should be offset by changes in forward exchange rates to prevent arbitrage opportunities.
- Reasons for deviations from these conditions include trade barriers, non-traded goods, measurement issues, and political/tax differences.
This document discusses interest rate parity theory. It begins by defining spot and forward rates. Spot rates are prices for immediate settlement, while forward rates refer to rates for future currency delivery adjusted for cost of carry. Interest rate parity theory states that interest rate differentials between currencies will be reflected in forward premiums or discounts. The theory prevents arbitrage opportunities by making returns equal whether investing domestically or abroad when measured in the home currency. The document provides an example of covered and uncovered interest rate parity. Covered parity involves hedging exchange rate risk while uncovered parity does not. Empirical evidence shows uncovered parity often fails while covered parity generally holds for major currencies over short time horizons.
Carry trade involves borrowing money in a market with low interest rates and investing in a market with high interest rates to profit from the interest rate differential. However, it also carries currency risk as it involves two different currencies. For carry trade to be profitable, the exchange rate between the two currencies must remain stable. If the currency of investment weakens against the currency of borrowing, the investor can face losses instead of gains.
The document discusses foreign exchange markets. It provides information on:
1) The foreign exchange market is a global network that allows currencies to be exchanged. Exchange rates are the prices of currencies relative to each other, such as $1 = Rs. 48.50.
2) Arbitrage is the process of exploiting price differences between markets. If exchange rates differ, arbitragers can buy currency where it's cheaper and immediately sell it where it's more expensive.
3) Foreign exchange transactions involve converting one currency to another and carry exchange rate risk if rates change before settlement. Transactions are settled through payment systems like nostro/vostro accounts and SWIFT.
Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. A theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Covered interest arbitrage allows an investor to exploit interest rate differentials between currencies by investing in the higher yielding currency while hedging exchange rate risk through a forward contract. The international fisher effect suggests that interest rate differentials between countries may be the result of differences in expected inflation, and that exchange rates will adjust to changes in expected inflation differentials.
Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. A theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Covered interest arbitrage allows an investor to exploit interest rate differentials between currencies by investing in the higher yielding currency and hedging exchange risk through a forward contract. Once market forces eliminate arbitrage opportunities, interest rate parity is achieved where exchange rates align so that covered interest arbitrage is no longer feasible.
The document discusses several foreign exchange parity conditions and arbitrage activities:
1) Purchasing power parity states that exchange rates will adjust to reflect differences in inflation rates between countries. Absolute PPP says price levels should be equal globally, while relative PPP says exchange rates adjust for domestic and foreign price levels.
2) Interest rate parity establishes that forward rates differ from spot rates by an amount offsetting interest rate differentials, eliminating arbitrage profits.
3) Arbitrage activities seek to profit from temporary deviations from these parity conditions by exploiting differences in currency prices across locations or markets. This helps drive prices back into alignment.
The document discusses interest rate parity theory, which states that any difference in interest rates between two countries should be equal to the forward premium or discount on the exchange rate between their currencies. It provides examples of how investors could earn the same return by investing domestically or internationally when interest rate parity holds. The theory aims to prevent arbitrage opportunities by having the exchange rate adjust to offset interest rate differentials. The document also discusses covered and uncovered interest rate parity, with covered interest rate parity seen as more empirically valid for short-term investments in developed economies.
Foreign exchange refers to foreign currencies and bank deposits denominated in foreign currency. The foreign exchange market allows people to trade one currency for another. The exchange rate between two countries is the price at which their residents trade currencies. Nominal exchange rates are relative prices of currencies, while real exchange rates also account for differences in inflation between countries and the relative prices of goods. Purchasing power parity theory suggests identical goods should have the same price in different locations after accounting for exchange rates. The Big Mac Index published by The Economist uses McDonald's Big Mac burgers, which are produced to similar standards globally, to estimate real exchange rates between currencies.
Foreign exchange refers to foreign currencies and bank deposits denominated in foreign currency. The foreign exchange market allows people to trade one currency for another. The exchange rate between two countries is the price at which their residents trade currencies. Nominal exchange rates are relative prices of currencies, while real exchange rates also account for differences in inflation between countries and the relative prices of goods. Purchasing power parity theory holds that identical goods should have the same price across locations after accounting for exchange rates. The Big Mac Index published by The Economist uses McDonald's Big Mac burgers to estimate real exchange rates between currencies based on purchasing power parity.
International parity-conditions-9-feb-2010Nitesh Mandal
This document discusses several international parity conditions that can be used to predict foreign exchange rates:
1. Purchasing power parity (PPP) states that exchange rates should equalize price levels between countries based on a basket of goods.
2. The international Fisher effect (IFE) states that exchange rates adjust to equalize interest rate differentials between countries.
3. Interest rate parity (IRP) focuses on spot and forward exchange rates between countries' money and bond markets and establishes a break-even condition for returns.
4. Forward rates are expected to be an unbiased predictor of future spot rates according to the expectations theory of exchange rates.
These parity conditions are interrelated
The document discusses various aspects of foreign exchange rates including:
1. Exchange rates are the ratio between two currencies and are quoted regularly in publications. Major world currencies include the USD, Euro, Yen, GBP, etc.
2. Exchange rates can be quoted directly or indirectly. Direct quotes place the domestic currency first while indirect quotes place it second.
3. Spot exchange rates are determined by the interplay of demand and supply forces in the foreign exchange market. Factors like the balance of payments, inflation, interest rates, and others influence spot rates.
The document discusses interest rate parity and covered interest arbitrage. It provides definitions and explanations of these concepts. Specifically:
1) Interest rate parity is a condition where the interest rate differential between two countries equals the difference between the forward exchange rate and the spot exchange rate.
2) Covered interest arbitrage involves borrowing in the lower yielding currency, converting to the higher yielding currency, and hedging the exchange risk through a forward contract.
3) Market forces will eliminate opportunities for covered interest arbitrage by adjusting interest rates and exchange rates until parity is reached.
Management of funds is a critical aspect of financial management. Management of funds acts as the foremost concern whether it is in a business undertaking or in an educational institution. Financial management, which is simply meant dealing with management of money matters.
Financial Management is efficient use of economic resources namely capital funds. Financial management is concerned with the managerial decisions that result in the acquisition and financing of short term and long term credits for the firm. Here it deals with the situations that require selection of specific assets, or a combination of assets and the selection of specific problem of size and growth of an enterprise. Herein the analysis deals with the expected inflows and outflows of funds and their effect on managerial objectives. In short, Financial Management deals with Procurement of funds and their effective utilization in the business.Management of funds is a critical aspect of financial management. Management of funds acts as the foremost concern whether it is in a business undertaking or in an educational institution. Financial management, which is simply meant dealing with management of money matters.
Financial Management is efficient use of economic resources namely capital funds. Financial management is concerned with the managerial decisions that result in the acquisition and financing of short term and long term credits for the firm. Here it deals with the situations that require selection of specific assets, or a combination of assets and the selection of specific problem of size and growth of an enterprise. Herein the analysis deals with the expected inflows and outflows of funds and their effect on managerial objectives. In short, Financial Management deals with Procurement of funds and their effective utilization in the business.
Management of funds is a critical aspect of financial management. Management of funds acts as the foremost concern whether it is in a business undertaking or in an educational institution. Financial management, which is simply meant dealing with management of money matters.
Financial Management is efficient use of economic resources namely capital funds. Financial management is concerned with the managerial decisions that result in the acquisition and financing of short term and long term credits for the firm. Here it deals with the situations that require selection of specific assets, or a combination of assets and the selection of specific problem of size and growth of an enterprise. Herein the analysis deals with the expected inflows and outflows of funds and their effect on managerial objectives. In short, Financial Management deals with Procurement of funds and their effective utilization in the business.
Management of funds is a critical aspect of financial management. Management of funds acts as the foremost concern whether it is in a business undertaking or in an educational institution. Financial management, Management of fund
The document discusses the time value of money concept. It defines time value of money as the preference for money now rather than in the future, due to its potential to grow in value over time through interest-earning investments. The document outlines different time value of money calculations including future value, present value, and calculations for lump sums, cash flows, and annuities. It provides examples of calculating future value for lump sums and cash flow streams using the future value formula.
1. Foreign exchange refers to foreign currencies and bank deposits denominated in foreign currencies that are traded on foreign exchange markets globally.
2. Exchange rates represent the price at which one country's currency can be traded for another's. Nominal exchange rates are the relative prices of currencies, while real exchange rates also account for differences in inflation between countries.
3. The Big Mac Index published by The Economist uses the global price of McDonald's Big Macs to estimate purchasing power parity exchange rates between currencies based on the theory that the same good should cost the same in different countries when prices are adjusted for exchange rates.
The document discusses the concept of time value of money. It defines time value of money as the principle that money available today is worth more than the same amount in the future due to its potential to grow in value over time through investment and interest. The document outlines different time value of money calculations including future value, present value, and discusses how to determine the value of a lump sum investment today versus in the future using formulas and examples.
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Niraj On International Finance Theory
1. Summary on
International Finance Theory
by
Niraj Thapa
CA-Final (ICAI)
Broadly this theory may be discussed under 5 sub theories, they are:
1) Interest Rate Parity
2) Purchasing Power Parity
3) Fisher Effect
4) International Fisher Effect
5) Expectation Theory
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2. 1)Interest Rate Parity:
This theory states that the interest rate differential between two countries (say $ interest and Rs. interest
should be same for exchange risk.) should be equal to the percentage difference between forward
exchange rate and spot exchange rate. This theory holds till there is no restriction on moving money from
one economy/country/currency to another. Practically, dealers set the forward prices by comparing the
differences between $ interest and Rs. interest.
To be precise, when money market and currency are in equilibrium then any interest rates differential
should be equal to the % difference in forward exchange rates and spot exchange rate, i.e., there won’t
be any question of earning riskless profit otherwise arbitrageurs will earn riskless profit.
IRP Theory relates to a condition of equality of returns on comparable money market instruments.
IRP relates Spot Rate and Forward Rate using two countries’ risk free rates.
For clarity we may take an example:
Suppose an investor has $100000 at the beginning of the year to be invested for a period of 1 year.
Let us say $ interest rates on deposits equals 2% p.a. on the other hand Indian deposits offer attractive
interest rate of 10% and exchange rate is Rs.50 per $. Now it is to be decided where the amount should be
invested.
Solution:
Case I: If the investor invests in US: Amount at the end of the period will be as 100000*102%= $102000
(100000 as principal plus 2000 as interest)
Case II: If he wishes to invest in India:
-First he has to convert the $ amount into Rupee amount, i.e. he has to buy corresponding rupees,
hence he can buy 100000*50=Rs.50,00,000.
-Now he will invest the amount @ 10%, finally at the year end he will have Rs.
50,00,000*110%=55,00,000 (50,00,000-principal + 5,00,000-interest) in his hand.
Hence at last the investor has to convert the Rs. amount generated into $, and we do not know what will
be the exchange rate at the year end.
Now see how this theory helps us. As per this theory we can fix today the price at which the Rs. amount to
be sold. Such rate(price) fixed today is the forward rate. The one year forward rate is 53.9216*. Therefore
by selling Rupees generated at the year end, the investor will be sure to earn 5500000/53.9216=$101999.
Talking about the conclusion we can say that these two investments are offering almost exactly same rate of
return.
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3. Now see how 53.9216 is computed as forward rate between $ and Rs.
For every $ invested you will get (1 + R$) and investing in India you will get SR*(1+ RRS)/FR and these have
to be equal so as to prevent arbitrage.
Some Formulae:
(i) (FR-SR)/SR= (Rq- Rb) [here, q means quote currency means and b stands for base currency]
[Satisfying the first line of the theory]
(ii) FR=SR*[1+ (Rq- Rb)] [solve first formula]
(iii) (1+Rb) = SR* (1+ Rq)/FR [This formula will give exact result while the above formula gives
approximate result]
(iv) FR/SR = (1+ Rq)/ (1+Rb) [solve iii]
(v) (FR-SR)/SR =(Rq- Rb)/(1+Rb) [converting formula at point (i) from approximate to exactness]
(vi) FR= SR*[1+ (Rq- Rb)]t
[In case we have t periods and IRP approximation]
Note:There are not 5 formulae, only two –giving approximate and accurate results.
Meanings
forward exchangerate:
the agreed upon exchange
rate to be used in
aforward trade
forward trade:
an agreement to
exchange currency at
some time in future
spot exchnge rate:
the exchange rate on a
spot trade
spot trade:
an agreement to trade
currencies based on
today's exchange rate for
settlement within two
business days
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4. 2)Purchasing Power Parity:
Basically, we have seen that IRP theory is used in obtaining Forward Rate. But we have not discussed how spot
rate is determined. Thus, this theory helps in this issue.
There are two forms of PPP-(i) Absolute Form of PPP & (ii) Relative Form of PPP
Absolute Form of PPP:
The basic idea behind this theory is that a commodity costs the same regardless of what currency is used to
purchase it or where it is selling. This is a straight forward concept. Loosely, speaking as per this theory 1$ will
buy same number of say, burger anywhere in the world.
Assumptions required to hold absolute PPP true
o The transaction cost of trading – shipping, insurance, spoilage & so on must be zero.
o There must be no barrier on trading-no tariffs, taxes or other political barriers.
o The goods traded (burgers) in one place (economy) must be identical to the burger traded in another
economy.
Let’s be clear with some cases:
If the burger in India costs Rs. 100 in India and exchange rate is Rs.50 per $, then the same burger should cost
Rs.100/50=$2 in America.
Formally discussing:
Let S0 be the spot exchange rate between Rs. & $ [exchange rate is quoted as Rs./$]
P$be the current price in US
P`be the current price in India
Then absolute PPP says that PRs=S0 * P$
If in case the actual exchange rate is Rs.40/$ then with$2 a trader in America would buy a burger in America
and ship it to India and sell the same in India @ Rs.100 per burger and convert the Rs.100 into $, as a result of
which he will get 100/40 =$2.5, hence he is gaining $0.5 in this transaction.
Since, the trader is making riskless profit and the burgers start moving from US Market to India as a result of
which there will be reduced supply of burgers in US and the prices will start rising in US economy at the same
time India will lower the price of burger due to increased supply, this will continue till equilibrium is
maintained in these two economies. At last the exchange rate quoted will be expected to rise form Rs.40
Practically, Absolute PPP will not hold true (ignoring some exceptions) because the assumptions of this theory
are rarely met.
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5. Relative Form of PPP
This theory does nottell us about what determines the absolute level of exchange rate, moreover, it tells
what determines the change in the exchange rate over the given period.
Strictly speaking, this theory implies that the differential inflation rate is always identical to the change in
spot rate.
Hence change in exchange rates is determined by the difference in the inflation rates of two countries, i.e.
any difference in the rates of inflation will be offset by a change in exchange rate.
If so then let, S0 be the current spot exchange rate at t0 [Rs./$]
E(St ) be the expected exchange rate in t periods
iqbe the inflation in quote currency [iRs]
ibbe the inflation rate in base currency[i$ ]
Now by definition,
[E(St )- S0 ]/ S0 =[iq-ib]
Solving this we get,
E(St )= S0 *[1+{ iq-ib}]
E(St )= S0 *(1+iq )/(1+ib )
Note:For validity of Relative PPP, validity of Absolute PPP is not mandatory. It is already discussed that
Absolute PPP will hold true for rare goods, we shall be focusing more on relative PPP.
For example, if prices are rising by 1.0% in the United States and by 6.0% in Mexico, the number of pesos
that you can buy for $1 must rise by 1.06/1.01 - 1, or about 5.0%. Therefore purchasing power parity says
that to estimate changes in the spot rate of exchange, you need to estimate differences in inflation rates.
Note: If inflation and interest differential are equal then PPP and IRP would give same result.
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6. 3)Fisher Effect:
“A change in the expected inflation rate causes the same proportionate change in the nominal interest
rate; it has no effect on the required real interest rate.”
This theory tells us the relationship between nominal rates, real rates and inflation. Thus with the help of
this theory we can review more carefully the relation between inflation and interests. It is obvious that
the investors are ultimately concerned with what they can buy with their money, they need
compensation for inflation.
Nominal Return (Money Return): It indicates the rate which money is growing. Nominal rates are called
nominal because they have not been adjusted for inflation. It includes inflation. Transactions can be done
in the market taking the basis of this return.
Real Return:This return is without inflation. It indicates the rate at which the purchasing power is
growing. These are the rates which have been adjusted for inflation.
Example: You have Rs. 1000 today and if you invest the same amount you will be with Rs. 1155 at the year
end. And with the same Rs. 1000 you can buy 20 hamburgers at the beginning of the year. Assume the
inflation rate to be 5%. (i.e. the price is expected to go up by 5% during the year.)
Now the question arises here about the impact of inflation.
See the calculation here:
Investment at t0 =1000
At year end you will get 1155
Then we can say that nominal interest rate (money return) is (1155-1000)/1000=15.5%
At the beginning you can buy 20 hamburgers [cost per hamburgers is 1000/20=50]
Due to rise in price you have to pay 50*1.05=52.50 for 1 hamburgers at year end.
If you want to buy the hamburgers at the end with your invested amount then you can buy
1155/52.50=22 hamburgers only.
What I would like to concentrate is that despite of 15.50% increase in my investment my purchasing
power have gone up by 10% only because of inflation. Frankly speaking I am really 10% rich only.
It can also be stated that with 5% inflation, each of the Rs. 1155 nominal dollars we get is worth 5% less in
real terms.
Hence the real Rs. Value of our investment is 1155/1.05=1100 only.
The nominal rate on an investment is the % change in number of rupees you have.
The real rate of the investment is the % change in how much you can buy with your rupees-ie, the %
change in your buying power.
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7. Now I would like to make relationship using these 3 terms (real rate, nominal rate & inflation) and the
credit for this goes to the great economist Irving Fisher.
Fisher effect tells,
(1+R)=(1+r)*(1+i) [This is the domestic Fisher effect]
Where,
R=Nominal Risk Free Rate
r= Real Risk Free Rate [Fisher assumed this rate to be constant across the countries]
i=Inflation Rate
Finally solving above equation we will get,
r=(R-i)/(1+i)
{(1+i) is the discounting factor, r is constant, if we ignore (1+i) in the denominator because the
denominator will be slightly more than one, if done as said, then result of (R-1)/(1+i) will be approximately
equal to
(R-1), the we will get R~r+i, means ‘R’ is directly proportional to ‘i’ since ‘r’ is constant}
Fisher on arriving to the conclusion says that investors are not foolish. They do care about the impact of
inflation &know that inflation reduces purchasing power and, therefore, they will demand an increase in
the nominal rate before lending money.
A rise in the rate of inflation causes the nominal rate to rise just enough so that the real rate of interest is
unaffected. In other words, the real rate is invariant to the rate of inflation.
Fisher is of the view that ‘r’ will remain constant irrespective of inflationbut not all economists would
agree with Fisher that the real rate of interest is unaffected by the inflation rate. Practically ‘r’ differs as
per economic conditions of the country.
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8. 4)International Fisher Effect [also called common real interest rates]
This theory is based on the idea that a country with a higher interest rate will have a higher rate of inflation
ultimately it causes its currency to depreciate. In theoretical terms, this relationship is expressed as an equality
between the expected % change in exchange rate and the difference between the two countries’ interest
rates, divided by one plus the second country’s interest rate.
This tells us that the difference in returns between the home country and a foreign country is just equal to the
difference in inflation rates.
Mathematically,
(1+Rfc )/(1+ Rhc)=(1+ ifc)/(1+ ihc)
Because the divisor approximates 1, the expected percent exchange rate change roughly equals the interest
rate differential.
ifc− ihc= Rfc− Rhc
International
Fisher Effect = Relative
PPP + Fisher
Effect
Nominal Interest
Rates decides
future spot rate
Inflation diff. decides
future spot rates
If 'r' is constant then
inflation diff. equals
nominal intt. diff
Interest differential
should be offset
difference in
exchange rates
Inflation Differential should
be offset by difference in
exchange rates (i.e diff.
betn. Spot rate and
expected spot rate)
If'r' is constant
then higher
interest rate is
due to higher
inflation
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9. 5)Expectation Theory
This theory tells that ‘today’s forward rate’ is going to be the ‘future spot rate’.
If this theory, holds then FR=E(S)
Economists and scholars based on their experience and research over the period have seen that forward
rates moreover exaggerate the likely change in the spot rate. When FR predicts that the SR will rise in
future, then the FR is over estimating the Future SR and vice versa then SR will change as per the
prediction, however many researchers have found that , when the forward rate predicts a rise, the spot
rate is more likely to fall, and vice versa. You may refer “K. A. Froot and R. H. Thaler, “Anomalies:
Foreign Exchange,” Journal of Economic Perspectives 4 (1990), pp. 179–192”
So, this finding is notconsistent with the expectations theory.
Because of this we say “forward rate is an unbiased predictor of future spot rate”.
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10. AT A GLANCE:
Disclaimer:
The above article is contributed by a CA Final student of the Institute and is meant for learning purpose.
Due care have been taken into consideration that the content presented above do not violate the opinion of
any writers and copyright issues.
For any suggestions, queries and corrections write at: Tniraj20@hotmail.com
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