International Financial Management: INBU 4200 Fall Semester 2004

1. International Financial Management: INBU 4200Fall Semester 2004 Lecture 4: Part 4 International Parity Relationships: The International Fisher Effect (Chapter 5)

2. Recall: Two Long Run Parity Models • Purchasing Power Parity • Exchange rate between two countries should be equal to the ratio of the two countries price level. • The change in the exchange rate will be equal to, but opposite in sign to, the difference in inflation. • International Fisher Effect • The change in the exchange rate will be equal to, but opposite in sign to, the difference in the nominal interest rate between two countries. • Both of these models are regarded as longer term forecasting models. • Not concerned with where spot rates will be in a couple of minutes, hours, days or weeks.

3. International Fisher Effect • The last major foreign exchange parity model is the International Fisher Effect. • This model begins with the Fisher interest rate model: • Attributed to the economist Irving Fisher (see next slide) • Explanation of the market (nominal) interest rate. • Market interest rate is made up of two critical components: • Real rate requirement; relates to the real growth rate in the economy. • Inflationary expectations premium; the markets expectations regarding future rates of inflation

4. 1867-1947. One of the earliest American neo-classical economists Noted for: The Quantity Theory of Money (MV = PT) Theory of Interest Just days before the October 1929 Wall Street crash, he was quoted as saying that stock prices were not over inflated but, rather, had achieved a “new, permanent plateau.” Irving Fisher

5. Fisher Interest Rate Model • The Fisher model assumes: • Real rate requirement relatively stable over time. • Inflationary expectations subject to wide swings over time. • Thus, the inflationary expectations premium is subject to large changes over time. • Thus, changes in market interest rates occur primarily because of changes in expected inflation!

6. The Fisher Effect • The Fisher Effect is best stated as: • A change in the expected rate of inflation will result in a direct and proportionate change in the market rate of interest. • Assume the following: • real rate requirement is 3.0% • Expected rate of inflation is 1.0% • Under these conditions, the market interest rate would be 4% • If the expected rate of inflation increases to 2.0%, the market interest rate would rise to 5%.

7. Fisher Effect Data CPI Forecast 2 Year Gov’t Country20042005Bond Rate Australia +2.2% +2.5% 5.27% U.S. +1.9% +1.8% 2.45% Switzerland +0.7% +0.4% 1.13% Japan -0.1% nil 0.14% Forecast: The Economist Poll, May 29, 2004 Conclusion: Higher expected rate of inflation counties are associated with higher market interest rates.

8. Fisher Effect Cross Border Assumptions • Model assumes that the real rate requirement is the same across major industrial countries. • Thus observed market interest rate differences between counties is accounted for on the basis of differences in inflation expectations. • Example: • If the United States 1 year interest rate is 5% in the United Kingdom 1 year interest rate is 7%, then: • The expected rate of inflation is 2% higher in the U.K. over the next 12 months.

9. International Fisher Effect • International Fisher effect parity model suggests that: • Changes in exchange rates will be driven by differences in market interest rates between countries. • Relationship to Exchange Rates • The currencies of high interest rate countries will weaken (depreciate). • The currencies of low interest rate countries will strengthen (appreciate) • Why? • Because differences in interest rates capture (incorporate) differences in expected inflation.

10. Summary: Exchange Rate – Interest Rate Relationship • Relatively high interest rate countries have high inflationary “expectations” conditions. • Relatively high inflation causes a currency to weaken (depreciate): see PPP model. • Relatively low interest rate countries have low inflationary “expectations” conditions. • Relatively low inflation causes a currency to strengthen (appreciate): see PPP model

11. Forecasting With the International Fisher Effect • Assumptions: • The exchange rate will change by a percentage amount equal to the observed market interest rate difference. • Exchange rate will move opposite to the observed interest rate difference. • Data to be used: • Use (National) Government securities • Use yields to maturities (not coupon yields) • Match maturity of securities with forecasted time period • Very Important

12. Japanese Yen Example • Using interest rate data from Bloomberg’s web site (rates and bonds): • http://www.bloomberg.com/markets/index.html • 2 year U.S. Government rate: 2.65% • 2 year Japanese Government rate: 0.14% • Higher U.S. interest rate is accounted for on the basis of higher expected U.S. inflation: = 2.65% – 0.14% = 2.51% • Forecast: Yen over the next two years.

13. Yen Exchange Rate Change • Given the expected inflation differences, the yen will appreciate 2.51% per year. • Current spot rate JPY110.44/USD. • Spot rate 1 year from now: 107.67 = 110.44 - (110.44 x .0251) = 110.44 – 2.77 = 107.67\ • Spot rate 2 years from now: 104.97 = 107.67 – (107.67 x .0251) = 107.67 – 2.70 = 104.97 Note: Yen is quoted in European terms, hence the minus sign in the above calculation. The minus sign represents an appreciation of the yen.

14. Australian Dollar Example • Using interest rate data from Bloomberg’s web site (rates and bonds): • http://www.bloomberg.com/markets/index.html • 2 year U.S. Government rate: 2.65% • 2 year Australian Government rate: 5.13% • Higher Australian interest rate is accounted for on the basis of higher expected inflation in Australia: = 2.65% – 5.13% = -2.48% • Forecast: Australian dollar over the next two years.

15. Exchange Rate Change • Given the expected inflation differences, the Australian dollar will depreciate 2.48% per year. • Current spot rate USD.7262/AUD. • Spot rate 1 year from now: .7569 = .7762 - (.7762 x .0248) = .7762 - .0193 = .7569 • Spot rate 2 years from now: 3.09 = .7569 - (.7569 x .0248) = .7569 - .0188 = .7381 • Note: The Australian dollar is quoted in American terms; hence the minus sign in the above calculation • The minus sign represents a depreciation of the Australian dollar.