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International Financial Markets: Exchange Rates, Interest Rates and Inflation Rates

International Financial Markets: Exchange Rates, Interest Rates and Inflation Rates. Exchange Rates. Price of a unit of one currency in terms of another; e.g. £/$, €/$ People care about what a currency can bring in terms of goods & services or a rate of return

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International Financial Markets: Exchange Rates, Interest Rates and Inflation Rates

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  1. International Financial Markets:Exchange Rates, Interest Rates and Inflation Rates

  2. Exchange Rates • Price of a unit of one currency in terms of another; e.g. £/$, €/$ • People care about what a currency can bring in terms of goods & services or a rate of return • How one currency trades against another depends on how each trades against goods and services or financial instruments

  3. Parity Relationships • In equilibrium, the same product or financial instrument should cost the same (in terms of a given currency) in any country • Otherwise, there is an incentive to trade • How strong are the barriers to trade?

  4. Purchasing Power Parity (PPP) • S0, the spot exchange rate, is measured as €/$ • If the same good sells for P$ in the U.S. and Peuro in Europe, then in equilibrium:

  5. Checking PPP for the Big Mac • Suppose the spot exchange rate is .7569 €/$ • In Paris, you can buy a Big Mac for €2.84, the equivalent of $3.75 • However, a Big Mac in NYC costs $3.00 • Let’s take a trip • The secret to arbitrage: do it big

  6. Paris To-Do List • Borrow €1 billion (@2.08375% annualized rate per day) • Convert to €1bil/.7569 = $1,321,178,491 • Board plane to NYC

  7. NYC To-Do List • Rent fleet of 18-wheelers • Buy $1,321,178,491/3.00 = 440,392,830 Big Macs • Return to airport and board cargo planes to Paris

  8. Paris Return To-Do List • Sell 440,392,830 Big Macs @ €2.84: €1,250,715,637 • Pay bank €1,000,114,181 (principal plus int.) • End day, tired but happy with €250,601,456 (=$331,089.253.50)

  9. Relative PPP If transaction costs prevent $ prices for every single good from being equated across countries, maybe the average $ price of a general market basket of goods will be equated

  10. Relative PPP and Expected Exchange Rates Expected depreciation of ¥ relative to $ is related to amount by which Japanese inflation rate exceed that in U.S.

  11. General Relative PPP Over Time

  12. Interest Rate Parity (IRP) • F1 is the one-period forward exchange rate (say, £/$) • If IRP doesn’t hold there is a relatively easy and low-cost arbitrage opportunity

  13. Arbitrage Opportunity • Ability to buy and sell perfect substitutes at different prices in 2 markets • Earn profit with no risk and without putting up any of your own money • Arbitrage opportunities will be driven out in an efficient capital market

  14. General IRP Over Time • Suppose Ft = E(St); e.g., assume forward rates are unbiased predictors of future spot rates • Combine IRP with PPP

  15. IRP + Relative PPP • Relation between nominal interest rates in different countries and their relative inflation rates • Cross-multiply (1+RUS)t and (1+hUK)t

  16. International Fisher Effect • In equilibrium, real interest rates tend to be equated across countries

  17. International Capital Budgeting:Home Currency Approach • Translate all foreign cash flows into $ using spot and expected future exchange rates; discount at $ discount rate • S0 and E(St) measured as for. curr./$

  18. International Capital Budgeting:Foreign Currency Approach • Discount foreign currency (FC) cash flows at FC discount rate to find FC in FC terms • Translate the result into $ using the spot exchange rate

  19. The Role of Interest Rate Parity • If IRP holds, the relationship between RFC and R$ is given by:

  20. Equivalence of the Two Approaches

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