microsoft powerpoint - ifm module 1 [compatibility mode]iim-b

8/9/2019 Microsoft PowerPoint - IfM MODULE 1 [Compatibility Mode]Iim-b

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International financial

management

Harisha.B.V. (Associate) finance andcontrol, IIMB 1

HARISHA.B.V

AIP(FINANCE AND CONTROL)

IIM BANGALORE


2/110

Module 1

International financial environment. Nature of international risk exposure


Determination of Exchange rates

Balance of payments

Interest parity

International fisher effect


3/110

International FinancialEnvironment

No country is literally having any controlonce they crosses their nations border.


one country to another in respect of

borrowing ,repayments, debt equity ,

taxation policy, production and mfgpolicies,sales markets etc.


4/110

Though there are no particular characteristic featureof business economics in any country,developed

countries reflects the market mechanism and

individual choice is having greater freedom andimportance.


e en ency o pos wor war as een omultilateral agreement and many international

organizations have been created to facilitate the

multilateral format.e.g. IMF,IBRD,GATT,BIS,OECD,OPEC , etc.


5/110

Therefore it is described as being comprised

of a number of sovereign nation states with

distinct internal organizational structurescompeting against one another according to a

f i lin rmin m l il r l


negotiations ,and which is monitored by the

moral authority of the international

organization created for this purpose


6/110

FINANCE FUNCTION

TREASURERE CONTOLLER

FINANCIAL


PLANNINGANALYSIS

FUND

ACQUISITION

INVESTMENT

FINANCING

MANAGEMENT

INVESTMENT

DECISIONS

RISK

MANAGEMENT

EXTERNAL

REPORTING

TAX PLAN

AND

MANGT

MIS

& MGTACCOUNTING

BUDGET

PLANNING

CONTROL

ACCOUNTS

RECEIVABLE

source.APTE P.G.


7/110

IMPORTANCE /SCOPE OF IFM

MNCs AND CFO: International eventswhich affect the firm and steps can be takento gain through development or insulate


aga nst arm u ones. Exchange rate behavior

Interest rate behavior

Economy

Assets value


8/110

The emerging challenges

To keep update with significantenvironmental changes and analyze their

im lications for the firm.


To understand and analyze the complex

interrelationships between relevant

environmental variables and corporateresponses-own and competitive-to the

changes in them.


9/110

To be able to adapt the finance function to

significant changes in the firms own strategic

posture.A firms major change in the product market

mix,funding strategies,dividend policies,cash mgt

etc.

To take in stride ast failures and mistakes to


minimize their adverse impact.- a wrong takeover,large foreign loans etc

To design and implement effective solutions to takeadvantage of the opportunities offered by the market

and advances in financial theory.-derivatives etc.


10/110

Rewards of IFM

International trade & theory of Absoluteadvantage,comparative advantage,limitation.


ams sm t s t eory o so uteadvantageDavid Ricardos comparative advantage

posners theory of limitationproduct life cycle theorytheory of intra-industry trade


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INTUTIVE THINKING

NO INTERNATIONAL TRADE, NOINTERNATIONAL FINANCE



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Investment enhancing and consumption

smoothing.

Investment enhancing

Gain from return differential.


Gain of moving from a lower marginalefficiency (production without transport

facility)

Diversification(increasing returns without

increasing risks or reducing risks without

reducing returns.)


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CONSUMPTION SMOOTHINGE.g.:- 75 UNITS OF CONUMPTION

REQUIRMENT IN A COUNTRY.

YEARLY PRODUCE VARIES FROM

50 UNITS TO 100 UNITS.


SO WHENEVER 50 UNITS ARE

PRODUCED BORROW 25 UNITS.

WHENEVER 100 UNITS ARE

PRODUCED LEND 25 UNITS.


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INTERNATIONAL RISKEXPOSURE

RISK CAN BE BROADLY CLASSIFIEDINTO TWO,NAMELY


ENVIRONMENTAL RISKS


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RISK

Core business risks are operational riskssuch as an unsuccessful new productlaunch,interruptions in raw material


supp ers, a or pro ems, Environmental risks arise out of

unpredictable fluctuations in financial

variables such as exchange rates,interestrates and stock prices,rise in prices of rawmaterials.government policies.


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FINANCIAL RISK

FINANCIAL RISK THUS CAN BECLEARLY SAID AS SUBSET OF

ENVIRONMENTAL RISKS.


Core business risks are peculiar to particular

firm, but environmental risks are pervasive

and affect all firms in a given industry.


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Difference b/w risk and exposure

Exposure is a measure of the sensitivity ofthe firms performance-however-measured-

to fluctuations in the relevant risk factor .


Risk is a measure of the extent of variability

of the performance measure attributable to

the risk factor.


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EXAMPLE

FOREIGN CURRENCYFLUCTUATIONS.


DETERMINED BY MAGNITUDE OF

EXPOSURE.


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Numerical example Exposure firm with 90 days payable of

$500,000.

Spot rate 42.90

Forward rate 43.10


eprec a on = . Therefore the loss will be Rs 100,000

Exposure =change in value of

payable/unanticipated change in exchange rate =100000/.20=500,000


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Explanation for the example

The change in the value of the payable perunit change in the exchange rate.


much will the value of the payable change if

the rupee dollar rate changes by one rupee

per dollar?.


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Example for Risk

Suppose a financial consulting firm gives

the following forecast of the value of the

spot exchange rate three months from now.


But it may go up to 45.50 or come down to

44.50 also.

Therefore exposure is .50 on either side butthe risk is different


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TYPES OF RISKS

ECONOMICAL AND POLITICAL RISKS GOVERNMENT AND TAXATION

EX HAN E RATE RI K


INTEREST RATE RISK

MARKET IMPERFECTIONS

AGENCY PROBLEMS(conflict of interestbetween decision makers and the owners ofthe MNC)


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Goals of MNCs

To protect and increase the shareholders value Exploit the global resources

Understand the IF environment


Use taxation tool effectively

Balancing between the holding and subsidiary

companys interests.

Market expansion

diversification


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INTERNATIONAL MONETARYSYSTMEM

EXCHANGE RATE REGIMES. MULTILATERAL FINANCIAL

Harisha.B.V. (Associate) finance and

control, IIMB 24

CURRENCY BLOCKS SUCH AS THE

ECONOMIC AND MONETARY

UNION(EMU) IN EUROPE.


25/110

EXCHANGE RATE REGIMES

Gold standard system(1870-1913) Inter country war period (1914-1944)

Br n r m n 1945-1973


control, IIMB 25

Fluctuating currency system (1973

onwards)


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GOLD STANDARD SYSTEM

IN THE EARLY DAYS GOLD WAS USED ASA STORAGE OF WEALTH AND AS AMEDIUM OF EXCHAGE.


control, IIMB 26

VALUE FOR ITS CURRENCY IN TERMSOF GOLD AND THEN TRY TO MAINTAINTHIS VALUE.

GOLD WAS MEASURED AS PER OUNCE 1OUNCE =31.1035GMS


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THREE IMPORTANT

FEATURES OF GOLD

STANDARD GOVERNMENT OF EACH COUNTRY

DEFINES ITS NATIONAL MONETARY UNIT


control, IIMB 27

FREE IMPORT OR EXPORT OF GOLD

TWO WAY CONVERTIBILITY BETWEENGOLD AND NATIONAL CURRENCIES AT ASTABLE RATIO.


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EXAMPLE

UNITED STATES DECLARED-$20.67/OUNCE OF GOLD.


control, IIMB 28

4.2474/OUNCE OF GOLD.

THERE FORE EXCHANGE RATE WILL

BE 20.67USD/4.2474GBP=$4.86656/GBP


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DRAW BACKS WHEN INFLATION INCREAES IN

PARTICULAR COUNTRY THE CURRENCYLOSES THE COMPETITIVENESS IN THE

WORLD MARKET. IMPORTS BEING GREATER THAN EXPORTS

LET TO A DECLINE IN THE CONFIDENCE


control, IIMB 29

OF THE CURRENCY. MANY TIMES GOLD WAS WITHDRAWN

FROM RESERVES AND SHIPPED ABROAD

TO PAY FOR IMPORTS. WITH LESS GOLD AT HOME,THE COUNTRYWAS FORCED TO REDUCE ITS MONEYSUPPLY


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CONTINUED

THIS RESULTED IN A SLOW DOWN IN

ECONOMIC ACTIVITY ,HIGH INTEREST

RATES,RECESSION,REDUCED NATIONALINCOME AND INCREASED


control, IIMB 30

.

THIS LED TO CHAOS IN MANY

COUNTRIES INCLUDING US AND UK BECAUSE OF HIGHER INFLATION.


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THE INTER WAR YEARS

WORLD WAR I DISTURBED THESTABILITY OF EXCHANGE RATES

FOR CURRENCIES OF MAJOR


control, IIMB 31

COUNTRIES. THE ROLE OF GREAT BRITAIN AS

THE WORLDS MAJOR CREDITOR

NATION ALSO CAME TO AN END

AFTER WORLD WAR I


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THE UNITED STATES BEGAN TO ASSUME

THE ROLE OF THE LEADING CREDITORNATION.


control, IIMB 32

AFTER RECOVERING FROM WAR SOMECOUNTRIES TRIED TO RETURN TO THE

GOLD STANDARD SYSTEM,AND FEW

COUNTRIES LIKE US ,UK, SWISS,FRANCE,SCANDINAVIAN COUNTRIES EVEN

RESTORED GOLD SYSTEM.


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THE GREATEST MISTAKE DONE BY GREAT

BRITAIN HERE IS THEY RETURNED BACK

TO $4.87/POUND.

DURING THIS PERIOD US WAS FACING


control, IIMB 33

INFLATION AT A LESSER RATE THAN UK.

THIS RESULTED IN INCRASEDUNEMPLOYMENT AND ECONOMIC

STAGNATION IN BRITAIN.


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IN 1934

IN 193 US DOLLAR WAS DEVALUED TO 35$

/OUNCE OF GOLD.THIS SYSTME IS CALLEDAS MODIFIED GOLD STANDARD OR GOLD


control, IIMB 34

.

AFTER WORLD WARII ONLY NATIONCONTINUED TO REMAIN CONVERTIBLE

WAS THE DOLLAR.


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THE BRETTON WOODSYSTEM

THE DEPRESSION FOLLOWED BY WAR

IN 1930 DIMINI HED MMER IAL


control, IIMB 35

TRADE.

REVIVAL OF SYSTEM BY

RECONSTRUCTION BEGAN WITHBRETTON WOODS AGREEMENT IN

NEW HAMPSHIRE. US.


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MAIN POINTS

THE GOLD STANDARD SYSTEM WASSCRAPPED.


control, IIMB 36

THE BRITISH WANTED A REDUCEDROLE FOR GOLD.

THE AGREEMENT ESTABLISHED ADOLLAR BASED INTERNATIONAL

MONETARY SYSTEM


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TWO NEW INSTITUTIONS WERE CREATED ,

IMF AND IBRD(WORLD BANK).

DOLLAR REMAINED AT 35 PER OUNCE.

EACH COUNTRY WAS OBLIGATED TO

DEFINE ITS MONETARY UNITS IN TERMS OF


control, IIMB 37

.

EACH CURRENCY WAS PERMITTED TO

FLUCTUATE WITHING PLUS OR MINUS 1%

TEN PERCENT DEVALUATION WAS

ALLOWED WITH APPROVAL OF IMF


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THE BREAKDOWN OF BWA

SOME OF THE DEVELOPED COUNTRIESCURRENCIES STARTED BECOMING


control, IIMB 38

.

THERE WAS MUCH IMBALANCE

BETWEEN SURPLUS AND DEFICIT

NATIONS.

US DOLLAR FELL IN VALUE AGAINST A

NUMBER OF MAJOR CURRENCIES.


39/110

SMITHSONIAN AGREEMENT

THE WORLDS LEADING COUNTRIES

CALLED THE G10 PRODUCED THE

SMITHSONIAN AGREEMENT ONDEC,18,1971.


control, IIMB 39

NEW ET F R TE WERE FIXEDWITHOUT PERMISSION OF IMF.

THE US $ WAS FURTHER DEVALUED

FROM 35 TO 38 PER OUNCE OF GOLD.

THE FLUCTUATION OF 2.25% WAS

ALLOWED.


40/110

FLEXIBLE EXCHANGE RATEREGIME,1973-PRESENT

AMERICA ABANDONED THE DOLLAR GOLD LINK IN 1971.


control, IIMB 40

ARE PURELY DETERMINED BY FORCESOF DEMAND AND SUPPLY.

DIRTY FLOAT =AUTHORITIES HAVEINTERVENED MORE OR LESS INTENSELY

IN FOREIGN EXCHANGE MARKETS.


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AS OF NOW THERE IS NO CONSENSUSEITHER ACADEMIC ECONOMISTS OR

AMONG POLICY MAKERS OR AMONG

BUSINESSMEN AND BANKERS AS TO THEIDEAL EXCHANGE RATE REGIME.


control, IIMB 41

MACRO ECONOMIC POLICY WITHIN ANECONOMY HAS BECOME AN EXTREMELY

COMPLEX.


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MULTILATERAL FINANCIALINSTITUTIONS

IMF International monetary fund. 29 countries signed in Bretton hood .

rr n m m r hi i 182 n ri


control, IIMB 42

Each member contributes the reservesnamed quota

Quotas depends from country to country.

25% will be paid in gold and balance incurrency.


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When the country faces a BOP deficit ,IMF will

advance the reserves.

IMF was constituted to maintain the exchangerates.


control, IIMB 43

Devaluation of currency requres prior approval ofIMF

Countries with chronic BOP deficits were allowedto depreciate their currencies.


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World bank

World bank lends for international projects and itlends at margin of half percent over its borrowingcost.


control, IIMB 44

lending arm of world bank. IFC(international financial corporation) lends to

the private sector

World bank also provides assistance and advice todeveloping countries.


45/110

Economic monetar nion


46/110

Economic monetary union

In 1957 first step was taken towards the formation ofEMU by six countries.-GERMANY,BELGIUM,NETHERLANDS,ITALY,

LUXEMBURG AND FRANCE. In 1968 the same was converted to customs Union


control, IIMB 46

outside the union.

It converted into common market in 1993-BRITAIN,DENMARK,SWEDEN,IRELAND,FINLAND,GREECE,SPAIN,PROTUGAL,AUSTRIA JOINED (15)


47/110

Single currency unionThis converted into European community in

1999.single currency Monetary Union was formed.

Britain ,Sweden &Denmark opted out of the same,


control, IIMB 47

Greece was not found eligible.Euro emerged as alternative currency to US$.

Here currency integrates without political integration.


48/110


49/110

BALANCE OF PAYMENTS THE BALANCE OF PAYMENT IS

AN ACCOUNTING SYSTEM THATRECORDS THE ECONOMIC


control, IIMB 49

RESIDENTS AND GOVERNMENTOF A PARTICUALR COUNTRY

AND THE RESIDENTS AND GOVTOF THE REST OF THE WORLDDURING A YEAR.


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THREE MAIN CATEGORIESOF BOP

THE CURRENT ACCOUNT THE CAPITAL ACCOUNT


control, IIMB 50


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THREE MAIN CATEGORIESOF BOP

THE CURRENT ACCOUNT THE CAPITAL ACCOUNT


control, IIMB 51

CURRENT ACCOUNT


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PARTICULARS DEBIT(OF) CREDIT(IF)

GOODS /SERVICES

BUY SELL

CURRENT ACCOUNT


control, IIMB 52

UNILATERALTRANFERS GIVE RECEIVE


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CAPITAL ACCOUNT

PARTICULARS DEBIT (OF) CREDIT(IF)

FDI OUTBOUND INBOUND


control, IIMB 53

PORTFOLIO OUTBOUND INBOUND

OTHER CF(BANKDEPOSITS ETC) DEPOSITING WITHDRAWING

Examples


54/110

p

1.Export of goods against Bills ofExchange.Rs15000.

2.Realization of Bills of Exchange and deposit inforeign bank account.


control, IIMB 54

3.Export of software services Rs 20000 for cash.

4. Sale of foreign exchange by bank to RBI.

5.Import on credit RS 30000


55/110

6. Foreign investment RS 40000.

7. India received gift of $40000 from

America.

8.India made a gift of RS 12000 to Africa.


control, IIMB 55

9.Indian bank draws foreign currency of$15000 from RBI.

Solution for the Example


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Question 1.Due from Foreigner A/C DR 15000

To Export of merchandise A/c 15000


control, IIMB 56

.

To Due from Foreigner A/C 15000.

3.Foreign Assets A/C DR 20000To Trade in services A/C 20000

4 F i h A/ D 20000


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4 Foreign exchange reserve A/c Dr 20000

To Foreign exchange assets A/c 20000

5 Merchandise Imports A/c Dr 30000


control, IIMB 57

To Liability to Foreigner A/c 20000

6 Foreign Exchange Assets A/c Dr 40000To FDI A/c 40000


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59/110

The official reserve account

Official reserves are government owned assets.

The official reserve account represents only

purchases and sales by the central bank of the


control, IIMB 59

country.

If a country has BOP deficit then ,the central bank

has to run down its official assets such as gold

,foreign exchange ,SDR or borrow fresh from

foreign central banks.


60/110

What moves exchange rates?

Since the advent of floating exchange ratesin 1973 economists, currency traders and

other rofessionals are ex endin enormous


control, IIMB 60

intellectual effort to find out the forceswhich drive exchange rates and build

reliable exchange rate forecasting models.


61/110

Exchange rate is the relative price of one currencyin terms of another.

It is the main component which influences trade,relative profitability of various industries, real


control, IIMB 61

.

We like much of the profession are doubtful of the

value of the further time series modeling of

exchange rates.(frankel and rose 1995)


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Theories of exchange ratedetermination1. ARBITRAGE AND THE LAW OF ONE PRICE

2. PURCHASING POWER PARITY

3. THE FISHER EFFECT


control, IIMB 62

4. THE INTERNATIONAL FISHER EFFECT

5. INTEREST RATE PARITY THEORY

6. THE RELATIONSHIP BETWEEN THE

FORWARD AND FUTURE SPOT RATE7. CURRENCY FORECASTING


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PART I. ARBITRAGE AND THE LAWOF ONE PRICE

I. THE LAW OF ONE PRICEA. Law states:


control, IIMB 63

Identical goods sell for thesame price worldwide.


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ARBITRAGE AND THE LAW OFONE PRICE

B. Theoretical basis:

If the rice after exchan e-rate


control, IIMB 64

adjustment were not equal,

arbitrage in the goods worldwide

ensures eventually it will.


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66/110


D. Five Parity Conditions Linkedby


control, IIMB 66

1. The adjustment of variousrates and prices to inflation.


67/110


2. The notion that moneyshould have no effect on


control, IIMB 67

real variables (since theyhave been adjusted for

price changes).


68/110


E. Inflation and home currencydepreciation:


control, IIMB 68

.

growth of domestic moneysupply;

2. Relative to the growth of

domestic money demand.


69/110

ARBITRAGE AND THE LAW OF

ONE PRICE

F. THE LAW OF ONE PRICE


control, IIMB 69

- enforced by internationalarbitrage.


70/110

Purchasing power parity theory

This theory was enunciated by GustavCassel.

Purchasing power of a currency is


control, IIMB 70

determined by the amount of goods andservices that can be purchased with one unitof currency.

This reflects the relative purchasing powersof the currency


71/110

Example

One parker pen in India = RS 150

The same pen in US= $ 3


control, IIMB 71


72/110

Two types of PPPT

Two versions


control, IIMB 72

.

Relative purchasing power parity.

PPPT.xls

Absolute PPPT


73/110

The level of exchange rate at any time equals theratio of purchasing powers of the two currencies.

Sa/b= Pa/Pb


control, IIMB 73

Sa/b= exchange rate between the currency of nationA and currency of nation B

Pa= price level in nation A Pb= price level in nation B.

Draw backs


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The rates can vary considerably due to thefactors like

1. Transportation cost.

2. Tariffs


control, IIMB 74

.

4. Government intervention ,directly in the

exchange markets.

5. Some goods cannot enter international trade-construction,transportation.

6. Service industry cost varies drastically.


75/110

Relative

The proportionate change in exchange rate

between two currencies between two points

of time a roximatel e uals to difference


control, IIMB 75

in the inflation rates in the two countriesover the same time interval.


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PURCHASING POWER PARITY

1. In mathematical terms:

( )tht ie +=

1


control, IIMB 76

where et = future spot rate

e0 = spot rate

ih = home inflationif = foreign inflation

t = the time period

fie +10


77/110


2. If purchasing power parity is

expected to hold, then the best


control, IIMB 77

-

spot rate should be

( )

( )tf

t

h

t i

i

ee +

+=

1

1

0


78/110


3. A more simplified but less precise

relationship is


control, IIMB 78

that is, the percentage change should be

approximately equal to the inflation ratedifferential.

fh

t

iie=

0


79/110


4. PPP saysthe currency with the higher


control, IIMB 79

n at on rate s expecte to

depreciate relative to the

currency with the lower rate of

inflation.


80/110


B. Real Exchange Rates:the quoted or nominal rate


control, IIMB 80

a us e or a coun ry s

inflation rate is

t

h

t

f

tt i

i

ee )1(

)1('

+

+

=


81/110

Draw back

Previously said all draw back holdgood.


control, IIMB 81

peop e are some mes more appe e

towards particular currency.

Asset market approach.


82/110

Forecasting

By making use of PPPT theory futurespot rate can be forecasted as follows.


control, IIMB 82

S1=S0*(1+ rA / 1+ rB)

Fishers Effect.


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The fisher effect holds that the level ofnominal interest rates in a given country is

related to both real return and expected rateof inflation .


control, IIMB 83

The currency with higher rates of inflationshould bear higher nominal interest rates andvice versa.

If the real return is x % and inflation is y%then the nominal rate should be x% + y%


84/110

Formula

1 + NR = (1 + RR) * ( 1+ IR)


control, IIMB 84

What do you mean by Nominal interest rate

and real interest rate?


85/110

Nominal interest Rate Nominal rate express the ratio of exchange

between current money and future money . 100 RS invested today @10 % will be 110


control, IIMB 85

RS at the end of the year.

It does not explain how many more goods

or services we can purchase with this 10

RS because value of money will changeover.


86/110

Real interest Rate

Real interest rate represents the rate atwhich current goods and services are


control, IIMB 86

and services. Therefore it is the real interest rate and

not the nominal interest rate thatinterests the investors.

l


87/110

Example Suppose investor requires real return to

be 3%,and the rate of inflation over theyear is expected to be 5%.


control, IIMB 87

GBP = 1/1.05 = 0.9524 or 95.24 %

Therefore nominal interest rate

expected will be GBP 0.9524*(1+r ) =1.03

r = 8.15 %

Relevant equation


88/110

If no government intervention is practiced and

law of one price holds then interest rate

differentials should reflect inflation

differentials .


control, IIMB 88

rh - rf = ih - if According to the Fisher Effect, countries with

higher inflation rates have higher interest rates.

Due to capital market integration globally,

interest rate differentials are eroding.

International Fisher Effect


89/110

The international holds that differences in

the rate of appreciation or depreciation

between two currencies is related tonominal interest rates between two


control, IIMB 89

countries .

Currency with a low interest rates is

expected to appreciate relative to a

currency of a country with high interestrates and vice versa.

IFE = PPP + FE

THE INTERNATIONAL FISHER


90/110


EFFECT

IFE = PPP + FE


control, IIMB 90

t

f

tht

r

r

e

e

)1(

)1(

0 +

+=

Example

If 1 i i 7 % U S


91/110

If 1 year interest is 7 % on U.S.treasury bills and 4 % on Swiss Franc

Treasury Bills and current exchangerate is $ 0.63 = 1 CHF.


control, IIMB 91

Expected future spot rate in one yearare

S1/0.63 = ( 1+0.07) / ( 1+ 0.04) S1 = .06482



92/110


EFFECT

B. Fisher postulated


control, IIMB 92

1. The nominal interest ratedifferential should reflect

the inflation rate differential.



93/110

THE INTERNATIONAL FISHEREFFECT

B. Fisher postulated


control, IIMB 93

2. Expected rates of return areequal in the absence of

government intervention.



94/110


C. Simplified IFE equation:


control, IIMB 94

rf s re at ve y sma

1 0

0

h f

e er r

e

=



95/110


D. Implications of IFE


control, IIMB 95

1.Currency with the lower interestrate expected to appreciate relative toone with a higher rate.



96/110


D. Implications of IFE


control, IIMB 96

2. Financial market arbitrage:

insures interest rate differential

is an unbiased predictor of change in

future spot rate.

Theory of interest Rate Parity

First developed by J M Keynes 1930


97/110

First developed by J.M.Keynes 1930 .

Like PPPT ,IRPT is also law of one price.

The premium or discount of one currency against another


control, IIMB 97

should reflect the interest differential between the two

currencies.

In a perfect market situation ,where there is no restriction

on the flow of money ,one should be able to gain the same

real value on ones monetary assets irrespective of the

country where they are held.

Forecasting

(F S)/S = (rh rf)


98/110

(F - S)/S = (rh - rf)

where rh = the home rate rf = the foreign rate

The appreciation or depreciation of one


control, IIMB 98

approximately equal to the interest ratedifferential.

PPPT is law of one price in the market ofgoods and services and IRPT is in securitiesmarket

INTEREST RATE PARITY


99/110

INTEREST RATE PARITYTHEORY

In equilibrium, returns on currencieswill be the same


control, IIMB 99

. .

interest parity exists which can bewritten

(1 + rh) = F

(1 + rf) S


THEORY


100/110

THEORY

Covered Interest Arbitrage

1. Conditions required:


control, IIMB 100

nterest rate erent a oes not equa

the forward premium or discount.

2. Funds will move to a country with a

more attractive rate.


THEORY


101/110

THEORYMarket pressures develop:

As one currency is more demanded spot and sold

forward.


control, IIMB 101

Inflow of fund depresses interest rates.

Parity eventually reached.


THEORY


102/110

THEORYSummary:Interest Rate Parity states:

1.Higher interest rates on a currency offset by


control, IIMB 102

.

2.Lower interest rates are offset by forwardpremiums.

Criticisms Availability of funds that can be used for arbitrage is

not infinite.


103/110

not infinite.

Markets are not always perfect, governmentintervention will be there which leads to dirty float.


control, IIMB 103

Capital flows depends not only on interest rates butdepends on also liquidity and the ease of placement.

Speculation becomes important when market losesconfidence in the future of a currency.

Forecasting exchange rate in short

term


104/110

term

Method of advanced indicators


control, IIMB 104

future spot rate

Graphical methods



105/110


Here country's reserves to its imports are

considered as a main indicators. N = R / I * 12.


control, IIMB 105

N = number of months

R= reserves

I = imports

If N is less than 3 months the currency isvulnerable and may face devaluation

Forward rate as Predictor of future

spot rate


106/110

spot rate.

Some authors believe that forward rates


control, IIMB 106

are e y o e an un ase pre c or o

the future spot rate.

Graphical methods


107/110

Graphical methods

Bar chart

Curve of support


control, IIMB 107

Rate Time curve

Forecasting in medium and long

term


108/110

term


control, IIMB 108

Economic approach

Sociological and political approach.

Economic approach


109/110

Economic approach

Structure of the balance of Payments

Examination of interest rates


control, IIMB 109

rates Comparative examination of inflation

rates

Study of activity and employment level.

Sociological and political approach


110/110

g p pp

Proximity of elections

Behavior of opposition parties

Recommendation of IMF etc


control, IIMB 110

Rigorous control of foreign exchange

Interest rate hike Deflationary policy

microsoft powerpoint - ifm module 1 [compatibility mode]iim-b

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