Chapter 8. Inflation, Interest Rates, and Exchange Rates. Lecture Outline

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1 Chapter 8 Inlation, Interest Rates, and Exchange Rates Lecture Outline Purchasing Power Parity (PPP) Interpretations o PPP Rationale Behind PPP Theory Derivation o PPP Using PPP to Estimate Exchange Rate Eects Graphic Analysis o PPP Testing the PPP Theory Why PPP Does Not Occur International Fisher Eect (IFE) Implications o the IFE or Foreign Investors Derivation o the IFE Graphic Analysis o the IFE Tests o the IFE Limitations o the IFE Comparison o IRP, PPP, and IFE

2 2 Inlation, Interest Rates, and Exchange Rates Chapter Theme This chapter discusses the relationship between inlation and exchange rates according to the purchasing power parity (PPP) theory. Since this is one o the most popular subjects in international inance, it is covered thoroughly. While PPP is a relevant theory, it should be emphasized that PPP will not always hold in reality. However, it provides a oundation in understanding how inlation can aect exchange rates. The international Fisher eect (IFE) is also discussed in this chapter. This theory is also very important. Yet, it should again be emphasized that this theory does not always hold. I the PPP and IFE theories held consistently, decision making by MNCs would be much easier. Because these theories do not hold consistently, an MNC s decision making is very challenging. Topics to Stimulate Class Discussion 1. Provide reasoning or why highly inlated countries tend to have weak home currencies. 2. Identiy the inlation rate o your home country and some well-known oreign country. Then identiy the percentage change o your home currency with respect to that oreign country. Did the currency change in the direction and by the magnitude that you would have expected according to PPP? I not, oer possible reasons or this discrepancy. 3. Identiy the quoted one-year interest rates in your home country and in a well-known oreign country as o one year ago. Also determine how your home currency changed relative to this oreign currency over the last year. Did the currency change according to the IFE theory? I not, does this inormation disprove IFE? Elaborate. 4. Provide a simple explanation o the dierence between interest rate parity (rom the previous chapter), PPP (rom this chapter), and IFE (rom this chapter). POINT/COUNTER-POINT: Does PPP Eliminate Concerns about Long-Term Exchange Rate Risk? POINT: Yes. Studies have shown that exchange rate movements are related to inlation dierentials in the long run. Based on PPP, the currency o a high-inlation country will depreciate against the dollar. A subsidiary in that country should generate inlated revenue rom the inlation, which will help oset the adverse exchange eects when its earnings are remitted to the parent. I a irm is ocused on long-term perormance, the deviations rom PPP will oset over time. In some years, the exchange rate eects may exceed the inlation eects, and in other years the inlation eects will exceed the exchange rate eects. COUNTER-POINT: No. Even i the relationship between inlation and exchange rate eects is consistent, this does not guarantee that the eects on the irm will be osetting. A subsidiary in a highinlation country will not necessarily be able to adjust its price level to keep up with the increased costs o doing business there. The eects vary with each MNC s situation. Even i the subsidiary can raise its prices to match the rising costs, there are short-term deviations rom PPP. The investors who invest in an MNC s stock may be concerned about short-term deviations rom PPP, because they will not necessarily

3 Inlation, Interest Rates, and Exchange Rates 3 hold the stock or the long term. Thus, investors may preer that irms manage in a manner that reduces the volatility in their perormance in short-run and long-run periods. WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support? Oer your own opinion on this issue. ANSWER: It is possible that inlation and exchange rate eects will oset over the long run. However, many investors will not be satisied because they may invest in the irm or just a ew years or even a shorter term. Thus, they will preer that MNCs assess their exposure to exchange rate risk and attempt to limit the risk. Answers to End o Chapter Questions 1. PPP. Explain the theory o purchasing power parity (PPP). Based on this theory, what is a general orecast o the values o currencies in countries with high inlation? ANSWER: PPP suggests that the purchasing power o a consumer will be similar when purchasing goods in a oreign country or in the home country. I inlation in a oreign country diers rom inlation in the home country, the exchange rate will adjust to maintain equal purchasing power. Currencies in countries with high inlation will be weak according to PPP, causing the purchasing power o goods in the home country versus these countries to be similar. 2. Rationale o PPP. Explain the rationale o the PPP theory. ANSWER: When inlation is high in a particular country, oreign demand or goods in that country will decrease. In addition, that country s demand or oreign goods should increase. Thus, the home currency o that country will weaken; this tendency should continue until the currency has weakened to the extent that a oreign country s goods are no more attractive than the home country s goods. Inlation dierentials are oset by exchange rate changes. 3. Testing PPP. Explain how you could determine whether PPP exists. Describe a limitation in testing whether PPP holds. ANSWER: One method is to choose two countries and compare the inlation dierential to the exchange rate change or several dierent periods. Then, determine whether the exchange rate changes were similar to what would have been expected under PPP theory. A second method is to choose a variety o countries and compare the inlation dierential o each oreign country relative to the home country or a given period. Then, determine whether the exchange rate changes o each oreign currency were what would have been expected based on the inlation dierentials under PPP theory. A limitation in testing PPP is that the results will vary with the base period chosen. The base period should relect an equilibrium position, but it is diicult to determine when such a period exists.

4 4 Inlation, Interest Rates, and Exchange Rates 4. Testing PPP. Inlation dierentials between the U.S. and other industrialized countries have typically been a ew percentage points in any given year. Yet, in many years annual exchange rates between the corresponding currencies have changed by 10 percent or more. What does this inormation suggest about PPP? ANSWER: The inormation suggests that there are other actors besides inlation dierentials that inluence exchange rate movements. Thus, the exchange rate movements will not necessarily conorm to inlation dierentials, and thereore PPP will not necessarily hold. 5. Limitations o PPP. Explain why PPP does not hold. ANSWER: PPP does not consistently hold because there are other actors besides inlation that inluences exchange rates. Thus, exchange rates will not move in perect tandem with inlation dierentials. In addition, there may not be substitutes or traded goods. Thereore, even when a country s inlation increases, the oreign demand or its products will not necessarily decrease (in the manner suggested by PPP) i substitutes are not available. 6. Implications o IFE. Explain the international Fisher eect (IFE). What is the rationale or the existence o the IFE? What are the implications o the IFE or irms with excess cash that consistently invest in oreign Treasury bills? Explain why the IFE may not hold. ANSWER: The IFE suggests that a currency s value will adjust in accordance with the dierential in interest rates between two countries. The rationale is that i a particular currency exhibits a high nominal interest rate, this may relect a high anticipated inlation. Thus, the inlation will place downward pressure on the currency s value i it occurs. The implications are that a irm that consistently purchases oreign Treasury bills will on average earn a similar return as on domestic Treasury bills. The IFE may not hold because exchange rate movements react to other actors in addition to interest rate dierentials. Thereore, an exchange rate will not necessarily adjust in accordance with the nominal interest rate dierentials, so that IFE may not hold. 7. Implications o IFE. Assume U.S. interest rates are generally above oreign interest rates. What does this suggest about the uture strength or weakness o the dollar based on the IFE? Should U.S. investors invest in oreign securities i they believe in the IFE? Should oreign investors invest in U.S. securities i they believe in the IFE? ANSWER: The IFE would suggest that the U.S. dollar will depreciate over time i U.S. interest rates are currently higher than oreign interest rates. Consequently, oreign investors who purchased U.S. securities would on average receive a similar yield as what they receive in their own country, and U.S. investors that purchased oreign securities would on average receive a yield similar to U.S. rates.

5 Inlation, Interest Rates, and Exchange Rates 5 8. Comparing Parity Theories. Compare and contrast interest rate parity (discussed in the previous chapter), purchasing power parity (PPP), and the international Fisher eect (IFE). ANSWER: Interest rate parity can be evaluated using data at any one point in time to determine the relationship between the interest rate dierential o two countries and the orward premium (or discount). PPP suggests a relationship between the inlation dierential o two countries and the percentage change in the spot exchange rate over time. IFE suggests a relationship between the interest rate dierential o two countries and the percentage change in the spot exchange rate over time. IFE is based on nominal interest rate dierentials, which are inluenced by expected inlation. Thus, the IFE is closely related to PPP. 9. Real Interest Rate. One assumption made in developing the IFE is that all investors in all countries have the same real interest rate. What does this mean? ANSWER: The real return is the nominal return minus the inlation rate. I all investors require the same real return, then the dierentials in nominal interest rates should be solely due to dierentials in anticipated inlation among countries. 10. Interpreting Inlationary Expectations. I investors in the United States and Canada require the same real interest rate, and the nominal rate o interest is 2 percent higher in Canada, what does this imply about expectations o U.S. inlation and Canadian inlation? What do these inlationary expectations suggest about uture exchange rates? ANSWER: Expected inlation in Canada is 2 percent above expected inlation in the U.S. I these inlationary expectations come true, PPP would suggest that the value o the Canadian dollar should depreciate by 2 percent against the U.S. dollar. 11. PPP Applied to the Euro. Assume that several European countries that use the euro as their currency experience higher inlation than the United States, while two other European countries that use the euro as their currency experience lower inlation than the United States. According to PPP, how will the euro s value against the dollar be aected? ANSWER: The high European inlation overall would reduce the U.S. demand or European products, increase the European demand or U.S. products, and cause the euro to depreciate against the dollar. According to the PPP theory, the euro's value would adjust in response to the weighted inlation rates o the European countries that are represented by the euro relative to the inlation in the U.S. I the European inlation rises, while the U.S. inlation remains low, there would be downward pressure on the euro. 12. Source o Weak Currencies. Currencies o some Latin American countries, such as Brazil and Venezuela, requently weaken against most other currencies. What concept in this chapter explains this occurrence? Why don t all U.S.-based MNCs use orward contracts to hedge their uture remittances o unds rom Latin American countries to the U.S. even i they expect depreciation o the currencies against the dollar?

6 6 Inlation, Interest Rates, and Exchange Rates ANSWER: Latin American countries typically have very high inlation, as much as 200 percent or more. PPP theory would suggest that currencies o these countries will depreciate against the U.S. dollar (and other major currencies) in order to retain purchasing power across countries. The high inlation discourages demand or Latin American imports and places downward pressure in their Latin American currencies. Depreciation o the currencies osets the increased prices on Latin American goods rom the perspective o importers in other countries. Interest rate parity orces the orward rates to contain a large discount due to the high interest rates in Latin America, which relects a disadvantage o hedging these currencies. The decision to hedge makes more sense i the expected degree o depreciation exceeds the degree o the orward discount. Also, keep in mind that some remittances cannot be perectly hedged anyway because the amount o uture remittances is uncertain. 13. PPP. Japan has typically had lower inlation than the United States. How would one expect this to aect the Japanese yen s value? Why does this expected relationship not always occur? ANSWER: Japan s low inlation should place upward pressure on the yen s value. Yet, other actors can sometimes oset this pressure. For example, Japan heavily invests in U.S. securities, which places downward pressure on the yen s value. 14. IFE. Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in the United States is 8 percent or one-year securities that are ree rom deault risk. What does the IFE suggest about the dierential in expected inlation in these two countries? Using this inormation and the PPP theory, describe the expected nominal return to U.S. investors who invest in Mexico. ANSWER: I investors rom the U.S. and Mexico required the same real (inlation-adjusted) return, then any dierence in nominal interest rates is due to dierences in expected inlation. Thus, the inlation rate in Mexico is expected to be about 40 percent above the U.S. inlation rate. According to PPP, the Mexican peso should depreciate by the amount o the dierential between U.S. and Mexican inlation rates. Using a 40 percent dierential, the Mexican peso should depreciate by about 40 percent. Given a 48 percent nominal interest rate in Mexico and expected depreciation o the peso o 40 percent, U.S. investors will earn about 8 percent. (This answer used the inexact ormula, since the concept is stressed here more than precision.) 15. IFE. Shouldn t the IFE discourage investors rom attempting to capitalize on higher oreign interest rates? Why do some investors continue to invest overseas, even when they have no other transactions overseas? ANSWER: According to the IFE, higher oreign interest rates should not attract investors because these rates imply high expected inlation rates, which in turn imply potential depreciation o these currencies. Yet, some investors still invest in oreign countries where nominal interest rates are high. This may suggest that some investors believe that (1) the anticipated inlation rate embedded in a high nominal interest rate is overestimated, or (2) the potentially high inlation will not cause substantial depreciation o the oreign currency (which could occur i adequate substitute products were not available elsewhere), or (3) there are other actors that can oset the possible impact o inlation on the oreign currency s value.

7 Inlation, Interest Rates, and Exchange Rates Changes in Inlation. Assume that the inlation rate in Brazil is expected to increase substantially. How will this aect Brazil s nominal interest rates and the value o its currency (called the real)? I the IFE holds, how will the nominal return to U.S. investors who invest in Brazil be aected by the higher inlation in Brazil? Explain. ANSWER: Brazil s nominal interest rate would likely increase to maintain the real return required by Brazilian investors. The Brazilian real would be expected to depreciate according to the IFE. I the IFE holds, the return to U.S. investors who invest in Brazil would not be aected. Even though they now earn a higher nominal interest rate, the expected decline in the Brazilian real osets the additional interest to be earned. 17. Comparing PPP and IFE. How is it possible or PPP to hold i the IFE does not? ANSWER: For the IFE to hold, the ollowing conditions are necessary: (1) investors across countries require the same real returns, (2) the expected inlation rate embedded in the nominal interest rate occurs, (3) the exchange rate adjusts to the inlation rate dierential according to PPP. I conditions (1) or (2) do not hold, PPP may still hold, but investors may achieve consistently higher returns when investing in a oreign country s securities. Thus, IFE would be reuted. 18. Estimating Depreciation Due to PPP. Assume that the spot exchange rate o the British pound is $1.73. How will this spot rate adjust according to PPP i the United Kingdom experiences an inlation rate o 7 percent while the United States experiences an inlation rate o 2 percent? ANSWER: According to PPP, the exchange rate o the pound will depreciate by 4.7 percent. Thereore, the spot rate would adjust to $1.73 [1 + (.0467)] = $ Forecasting the Future Spot Rate Based on IFE. Assume that the spot exchange rate o the Singapore dollar is $.70. The one-year interest rate is 11 percent in the United States and 7 percent in Singapore. What will the spot rate be in one year according to the IFE? What is the orce that causes the spot rate to change according to the IFE? ANSWER: $.70 ( ) = $ The orce that causes this expected eect on the spot rate is the inlation dierential. The anticipated inlation dierential can be derived rom interest rate dierential. 20. Deriving Forecasts o the Future Spot Rate. As o today, assume the ollowing inormation is available: U.S. Mexico Real rate o interest required by investors 2% 2% Nominal interest rate 11% 15% Spot rate $.20 One-year orward rate $.19

8 8 Inlation, Interest Rates, and Exchange Rates a. Use the orward rate to orecast the percentage change in the Mexican peso over the next year. ANSWER: ($.19 $.20)/$.20 =.05, or 5% b. Use the dierential in expected inlation to orecast the percentage change in the Mexican peso over the next year. ANSWER: (1.09)/(1.13) 1 = or -3.53%; the negative sign represents depreciation o the peso. c. Use the spot rate to orecast the percentage change in the Mexican peso over the next year. ANSWER: zero percent change 21. Inlation and Interest Rate Eects. The opening o Russia's market has resulted in a highly volatile Russian currency (the ruble). Russia's inlation has commonly exceeded 20 percent per month. Russian interest rates commonly exceed 150 percent, but this is sometimes less than the annual inlation rate in Russia. a. Explain why the high Russian inlation has put severe pressure on the value o the Russian ruble. ANSWER: As Russian prices were increasing, the purchasing power o Russian consumers was declining. This would encourage them to purchase goods in the U.S. and elsewhere, which results in a large supply o rubles or sale. Given the high Russian inlation, oreign demand or rubles to purchase Russian goods would be low. Thus, the ruble s value should depreciate against the dollar, and against other currencies. b. Does the eect o Russian inlation on the decline in the ruble s value support the PPP theory? How might the relationship be distorted by political conditions in Russia? ANSWER: The general relationship suggested by PPP is supported, but the ruble s value will not normally move exactly as speciied by PPP. The political conditions that could restrict trade or currency convertibility can prevent Russian consumers rom shiting to oreign goods. Thus, the ruble may not decline by the ull degree to oset the inlation dierential between Russia and the U.S. Furthermore, the government may not allow the ruble to loat reely to its proper equilibrium level. c. Does it appear that the prices o Russian goods will be equal to the prices o U.S. goods rom the perspective o Russian consumers (ater considering exchange rates)? Explain. ANSWER: Russian prices might be higher than U.S. prices, even ater considering exchange rates, because the ruble might not depreciate enough to ully oset the Russian inlation. The exchange rate cannot ully adjust i there are barriers on trade or currency convertibility. d. Will the eects o the high Russian inlation and the decline in the ruble oset each other or U.S. importers? That is, how will U.S. importers o Russian goods be aected by the conditions?

9 Inlation, Interest Rates, and Exchange Rates 9 ANSWER: U.S. importers will likely experience higher prices, because the Russian inlation may not be completely oset by the decline in the ruble s value. This may cause a reduction in the U.S. demand or Russian goods. 22. IFE Application to Asian Crisis. Beore the Asian crisis, many investors attempted to capitalize on the high interest rates prevailing in the Southeast Asian countries although the level o interest rates primarily relected expectations o inlation. Explain why investors behaved in this manner. Why does the IFE suggest that the Southeast Asian countries would not have attracted oreign investment beore the Asian crisis despite the high interest rates prevailing in those countries? ANSWER: The investors' behavior suggests that they did not expect the international Fisher eect (IFE) to hold. Since central banks o some Asian countries were maintaining their currencies within narrow bands, they were eectively preventing the exchange rate rom depreciating in a manner that would oset the interest rate dierential. Consequently, superior proits rom investing in the oreign countries were possible. I investors believed in the IFE, the Asian countries would not attract a high level o oreign investment because o exchange rate expectations. Speciically, the high nominal interest rate should relect a high level o expected inlation. According to purchasing power parity (PPP), the higher interest rate should result in a weaker currency because o the implied market expectations o high inlation. 23. IFE Applied to the Euro. Given the recent conversion o several European currencies to the euro, explain what would cause the euro s value to change against the dollar according to the IFE. ANSWER: I interest rates change in these European countries whose home currency is the euro, the expected inlation rate in those countries change, so that the inlation dierential between those countries and the U.S. changes. Thus, there may be an impact on the value o the euro, because a change in the inlation dierential aects trade lows and thereore aects the exchange rate. Advanced Questions 24. IFE. Beth Miller does not believe that the international Fisher eect (IFE) holds. Current one-year interest rates in Europe are 5 percent, while one-year interest rates in the U.S. are 3 percent. Beth converts $100,000 to euros and invests them in Germany. One year later, she converts the euros back to dollars. The current spot rate o the euro is $1.10. a. According to the IFE, what should the spot rate o the euro in one year be? b. I the spot rate o the euro in one year is $1.00, what is Beth s percentage return rom her strategy? c. I the spot rate o the euro in one year is $1.08, what is Beth s percentage return rom her strategy? d. What must the spot rate o the euro be in one year or Beth s strategy to be successul?

10 10 Inlation, Interest Rates, and Exchange Rates ANSWER: a. e (1 i (1 i h ) 1 ) (1.03) % (1.05) I the IFE holds, the euro should depreciate by 1.90 percent in one year. This translates to a spot rate o $1.10 (1 1.90%) = $ b. 1. Convert dollars to euros: $100,000/$1.10 = 90, Invest euros or one year and receive 90, = 95, Convert euros back to dollars and receive 95, $1.00 = $95, The percentage return is $95,454.55/$100,000 1 = 4.55%. c. 1. Convert dollars to euros: $100,000/$1.10 = 90, Invest euros or one year and receive 90, = 95, Convert euros back to dollars and receive 95, $1.08 = $103, The percentage return is $103,090.91/$100,000 1 = 3.09%. d. Beth s strategy would be successul i the spot rate o the euro in one year is greater than $ Integrating IRP and IFE. Assume the ollowing inormation is available or the U.S. and Europe: U.S. Europe Nominal interest rate 4% 6% Expected inlation 2% 5% Spot rate $1.13 One-year orward rate $1.10 a. Does IRP hold? b. According to PPP, what is the expected spot rate o the euro in one year? c. According to the IFE, what is the expected spot rate o the euro in one year? d. Reconcile your answers to parts (a). and (c).

11 Inlation, Interest Rates, and Exchange Rates 11 ANSWER: a. (1 i p (1 i h (1.04) 1 (1.06) 1.89% ) 1 ) Thereore, the orward rate o the euro should be $1.13 (1.0189) = $ IRP does not hold in this case. b. e (1 I (1 I h ) 1 ) (1.02) 1 (1.05) 2.86% According to PPP, the expected spot rate o the euro in one year is $1.13 (1 2.86%) = $ c. e (1 i (1 i h 1.89% ) 1 ) (1.04) 1 (1.06) According to the IFE, the expected spot rate o the euro in one year is $1.13 (1 1.89%) = $ Parts a and c combined say that the orward rate premium or discount is exactly equal to the expected percentage appreciation or depreciation o the euro. 26. IRP. The one-year risk-ree interest rate in Mexico is 10%. The one-year risk-ree rate in the U.S. is 2%. Assume that interest rate parity exists. The spot rate o the Mexican peso is $.14. a. What is the orward rate premium? b. What is the one-year orward rate o the peso? c. Based on the international Fisher eect, what is the expected change in the spot rate over the next year?

12 12 Inlation, Interest Rates, and Exchange Rates d. I the spot rate changes as expected according to the IFE, what will be the spot rate in one year? e. Compare your answers to (b) and (d) and explain the relationship. ANSWER: a. According to interest rate parity, the orward premium is (1.02) (1.10) b. The orward rate is $.14 ( ) = $ c. According to the IFE, the expected change in the peso is: (1.02) (1.10) or 7.273% d. $.14 ( ) = $.1298 e. The answers are the same. When IRP holds, the orward rate premium and the expected percentage change in the spot rate are derived in the same manner. Thus, the orward premium serves as the orecasted percentage change in the spot rate according to IFE. 27. Testing the PPP. How could you use regression analysis to determine whether the relationship speciied by PPP exists on average? Speciy the model, and describe how you would assess the regression results to determine i there is a signiicant dierence rom the relationship suggested by PPP. ANSWER: A regression model could be applied to historical data to test PPP. The model is speciied as: 1+ I U.S. e a 0 a 1 1 u 1 + I where e is the percentage change in the oreign currency s exchange rate, I U.S. and I are U.S. and oreign inlation rates, a 0 is a constant, a 1 is the slope coeicient, and u is an error term. I PPP holds, a 0 should equal zero, and a 1 should equal 1. A t-test on a 0 and a 1 is shown below.

13 Inlation, Interest Rates, and Exchange Rates 13 t - test or a : t = 0 a0 0 s.e. o a 0 t - test or a : t = 1 a 1 1 s.e. o a 1 The t-statistic can be compared to the critical level (rom a t-table) to determine whether the values o a 0 and a 1 dier signiicantly rom their hypothesized values. 28. Testing the IFE. Describe a statistical test or the IFE. ANSWER: A regression model could be applied to historical data to test IFE. The model is speciied as: e = a 0 1+ I + a1 1+ I U.S. 1 + u where e is the percentage change in the oreign currency s exchange rate, I U.S. and I are U.S. and oreign interest rates, a 0 is a constant, a 1 is the slope coeicient, and u is an error term. I IFE holds, a 0 should equal zero and a 1 should equal 1. A t-test on a 0 and a 1 is shown below: t - test or a 0 : t = a 0 0 s.e. o a 0 t - test or a 1 : t = a1 1 s.e. o a 1 The t-statistic can be compared to the critical level (rom a t-table) to determine whether the values o a 0 and a 1 dier signiicantly rom their hypothesized values. 29. Impact o Barriers on PPP and IFE. Would PPP be more likely to hold between the United States and Hungary i trade barriers were completely removed and i Hungary s currency were allowed to loat without any government intervention? Would the IFE be more likely to hold between the United States and Hungary i trade barriers were completely removed and i Hungary s currency were allowed to loat without any government intervention? Explain. ANSWER: Changes in international trade result rom inlation dierences and aects the exchange rate (by aecting the demand or the currency and the supply o the currency or sale). The eect on the exchange rate is more likely to occur i (a) ree trade is allowed and (b) the currency s exchange rate is allowed to luctuate without any government intervention. The underlying orce o IFE is the dierential in expected inlation between two countries, which can aect trade and capital lows. The eects on the exchange rate are more likely to occur i (a)

14 14 Inlation, Interest Rates, and Exchange Rates ree trade is allowed, and (b) the currency s exchange rate is allowed to luctuate without government intervention. 30. Interactive Eects o PPP. Assume that the inlation rates o the countries that use the euro are very low, while other European countries that have their own currencies experience high inlation. Explain how and why the euro s value could be expected to change against these currencies according to the PPP theory. ANSWER: According to the PPP theory, the euro s value would increase against the value o the other European currencies, because the trade patterns would shit in response to the inlation dierential. There would be an increase in demand or the euro by these other European countries that experienced higher inlation because they will increase their importing o products rom those European countries whose home currency is the euro. 31. Applying IRP and IFE. Assume that Mexico has a one-year interest rate that is higher than the U.S. one-year interest rate. Assume that you believe in the international Fisher eect (IFE), and interest rate parity. Assume zero transactions costs. Ed is based in the U.S. and he attempts to speculate by purchasing Mexican pesos today, investing the pesos in a risk-ree asset or a year, and then converting the pesos to dollars at the end o one year. Ed did not cover his position in the orward market. Maria is based in Mexico and she attempts covered interest arbitrage by purchasing dollars today and simultaneously selling dollars one year orward, investing the dollars in a risk-ree asset or a year, and then converting the dollars back to pesos at the end o one year. Do you think the rate o return on Ed s investment will be higher than, lower than, or the same as the rate o return on Maria s investment? Explain. ANSWER: Maria s rate o return will be higher. Since interest rate parity exists, she will earn whatever the local risk-ree interest rate is in Mexico. Ed s expected rate o return is whatever the risk-ree rate is in the U.S. (based on the IFE). 32. Arbitrage and PPP. Assume that locational arbitrage ensures that spot exchange rates are properly aligned. Also assume that you believe in purchasing power parity. The spot rate o the British pound is $1.80. The spot rate o the Swiss ranc is.3 pounds. You expect that the one-year inlation rate is 7 percent in the U.K., 5 percent in Switzerland, and 1 percent in the U.S. The one-year interest rate is 6% in the U.K., 2% in Switzerland, and 4% in the U.S. What is your expected spot rate o the Swiss ranc in one year with respect to the U.S. dollar? Show your work. ANSWER: SF spot rate in $ = = $.54. Expected % change in SF in one year = (1.01)/(1.05) 1 = 3.8% Expected spot rate o SF in one year = $.54 (1.038) = $.5194

15 Inlation, Interest Rates, and Exchange Rates IRP Versus IFE. You believe that interest rate parity and the international Fisher eect hold. Assume the U.S. interest rate is presently much higher than the New Zealand interest rate. You have receivables o 1 million New Zealand dollars that you will receive in one year. You could hedge the receivables with the one-year orward contract. Or you could decide to not hedge. Is your expected U.S. dollar amount o the receivables in one year rom hedging higher, lower, or the same as your expected U.S. dollar amount o the receivables without hedging? Explain. ANSWER: The expected amount is the same, because the orward rate relects the interest rate dierential, and the expected spot rate (i you do not hedge) according to IFE relects the interest rate dierential. 34. IRP, PPP, and Speculating in Currency Derivatives. The U.S. three-month interest rate (unannualized) is 1%. The Canadian three-month interest rate (unannualized) is 4%. Interest rate parity exists. The expected inlation over this period is 5% in the U.S. and 2% in Canada. A call option with a three-month expiration date on Canadian dollars is available or a premium o $.02 and a strike price o $.64. The spot rate o the Canadian dollar is $.65. Assume that you believe in purchasing power parity. a. Determine the dollar amount o your proit or loss rom buying a call option contract speciying C$100,000. ANSWER: The expected change in the Canadian dollar s spot rate is: (1.05)/(1.02) 1 = 2.94%. Thereore, the expected spot rate in 3 months is $.65 (1.0294) = $ The net proit per unit on a call option is $ $.64 $.02 = $ For the contract, the net proit is $ ,000 = $911. b. Determine the dollar amount o your proit or loss rom buying a utures contract speciying C$100,000. ANSWER: According to IRP, the utures rate premium should be (1.01)/(1.04) 1 = 2.88% Thereore, the utures rate should be $.65 (1.0288) = $ Recall that the expected spot rate in 3 months is $.65 (1.0294) = $ The expected net proit per unit rom buying a utures contract is $ $.6313 = $ For the contract, the net proit is $ ,000 = $4, Implications o PPP. Today s spot rate o the Mexican peso is $.10. Assume that purchasing power parity holds. The U.S. inlation rate over this year is expected to be 7%, while the Mexican inlation over this year is expected to be 3%. Wake Forest Co. plans to import rom Mexico and will need 20 million Mexican pesos in one year. Determine the expected amount o dollars to be paid by the Wake Forest Co. or the pesos in one year.

16 16 Inlation, Interest Rates, and Exchange Rates ANSWER [(1.07)/(1.03)] -1 = %. So the expected uture spot rate is $ Wake Forest Co. will need to pay $ x 20 million pesos = $2,077, Investment Implications o IRP and IFE. The Argentine one-year CD (deposit) rate is 13%, while the Mexico one-year CD rate is 11% and the U.S. one-year CD rate is 6%. All CDs have zero deault risk. Interest rate parity holds, and you believe that the international Fisher eect holds. Jamie (based in the U.S.) invests in a one-year CD in Argentina. Ann (based in the U.S.) invests in a one-year CD in Mexico. Ken (based in the U.S.) invests in a one-year CD in Argentina and sells Argentina pesos one year orward to cover his position. Juan (who lives in Argentina) invests in a one-year CD in the U.S. Maria (who lives in Mexico) invests in a one-year CD in the U.S. Nina (who lives in Mexico) invests in a one-year CD in Argentina. Carmen (who lives in Argentina) invests in a one-year CD in Mexico and sells Mexican pesos one year orward to cover her position. Corio (who lives in Mexico) invests in a one-year CD in Argentina and sells Argentina pesos one year orward to cover his position. Based on this inormation, which person will be expected to earn the highest return on the unds invested? I you believe that multiple persons will tie or the highest expected return, name each o them. Explain. ANSWER: Jose and Carmen will earn the highest return. When the IFE holds, the expected return rom international investing is what the investor would earn domestically. When IRP holds, covered interest arbitrage will achieve the same return as what the investor could earn domestically. 37. Investment Implications o IRP and the IFE. Today, a U.S. dollar can be exchanged or 3 New Zealand dollars. The one-year CD (deposit) in New Zealand is 7% and the one-year CD rate in the U.S. is 6%. Interest rate parity exists between the U.S. and New Zealand. The international Fisher eect exists between the U.S. and New Zealand. Today a U.S. dollar can be exchanged or 2 Swiss rancs. The one-year CD rate in Switzerland is 5%. The spot rate o the Swiss ranc is the same as the one-year orward rate. Karen (based in the U.S.) invests in a one-year CD in New Zealand and sells New Zealand dollars one year orward to cover her position. James (based in the U.S) invests in a one-year CD in New Zealand and does not cover his position. Brian (based in the U.S.) invests in a one-year CD in Switzerland and sells Swiss rancs one year orward to cover his position. Eric (who lives in Switzerland) invests in a one-year CD in Switzerland. Tonya (who lives in New Zealand) invests in a one-year CD in the U.S. and sells U.S. dollars one year orward to cover her position.

17 Inlation, Interest Rates, and Exchange Rates 17 Based on this inormation, which person will be expected to earn the highest return on the unds invested? I you believe that multiple persons will tie or the highest expected return, name each o them. Explain. ANSWER: Tonya will earn 7 percent, which is higher than the returns that are expected or any other investor. 38. Real Interest Rates, Expected Inlation, IRP, and the Spot Rate. The U.S. and the country o Rueland have the same real interest rate o 3%. The expected inlation over the next year is 6 percent in the U.S. versus 21% in Rueland. Interest rate parity exists. The one-year currency utures contract on Rueland s currency (called the ru) is priced at $.40 per ru. What is the spot rate o the ru? ANSWER FR premium = (1.09)/(1.24) 1 = SR x (1 +premium) = FR SR = FR/ (1 + premium) =$.40/(.87) =$ PPP and Real Interest Rates. The nominal (quoted) U.S. one-year interest rate is 6%, while the nominal one-year interest rate in Canada is 5%. Assume you believe in purchasing power parity. You believe the real one-year interest rate is 2% in the U.S, and that the real one-year interest rate is 3% in Canada. Today the Canadian dollar spot rate at $.90. What do you think the spot rate o the Canadian dollar will be in one year? ANSWER: Expected inlation in the U.S. = 6% - 2%=4%. Expected inlation in Canada = 5% - 3% =2%. Expected % change in C$ = [(1 +.04)]/[(1 +.02)] 1 =.0196 or 1.96%. Future spot rate o C$ in one year = $.90 x ( ) = $ IFE, Cross Exchange Rates, and Cash Flows. Assume the Hong Kong dollar (HK$) value is tied to the U.S. dollar and will remain tied to the U.S. dollar. Assume that interest rate parity exists. Today, an Australian dollar (A$) is worth $.50 and HK$3.9. The one-year interest rate on the Australian dollar is 11%, while the one-year interest rate on the U.S. dollar is 7%. You believe in the international Fisher eect. You will receive A$1 million in one year rom selling products to Australia, and will convert these proceeds into Hong Kong dollars in the spot market at that time to purchase imports rom Hong Kong. Forecast the amount o Hong Kong dollars that you will be able to purchase in the spot market one year rom now with A$1 million. Show your work. ANSWER: Expected change in A$ against US $ =(1.07)/ = -3.6% The HK $ is tied to U.S. $ so A$ should depreciate by 3.6% against HK $.

18 18 Inlation, Interest Rates, and Exchange Rates In one year, A$= HK$3.9 x ( ) = HK$ So in 1 year, A$1 million = HK$3,759, PPP and Cash Flows. Boston Co. will receive 1 million euros in one year rom selling exports. It did not hedge this uture transaction. Boston believes that the uture value o the euro will be determined by purchasing power parity (PPP). It expects that inlation in countries using the euro will be 12% next year, while inlation in the U.S. will be 7% next year. Today the spot rate o the euro is $1.46, and the one-year orward rate is $1.50. a. Estimate the amount o U.S. dollars that Boston will receive in one year when converting its euro receivables into U.S. dollars. b. Today, the spot rate o the Hong Kong dollar is pegged at $.13. Boston believes that the Hong Kong dollar will remain pegged to the dollar or the next year. I Boston Co. decides to convert its 1 million euros into Hong Kong dollars instead o U.S. dollars at the end o one year, estimate the amount o Hong Kong dollars that Boston will receive in one year when converting its euro receivables into Hong Kong dollars. ANSWER: a. Expected appreciation o euro = (1+.07)/(1+.12)-1= Expected spot rate o euro in one year = 1.46 x ( ) = $ Expected dollars received rom receivables = 1,000,000 units x $1. = $1,394,800. b. Expected spot rate o H.K. $ in one year = $.13 since it will remain pegged. Expected cross rate in one year = $1.3948/$.13 = HK$ per euro. So 1 million euros will convert to 1,000,000 x = HK$10,729, PPP and Speculating with Currency Futures. Assume that you believe purchasing power parity (PPP) exists. You expect that inlation in Canada during the next year will be 3%, and inlation in the U.S. will be 8%. Today the spot rate o the Canadian dollar is $.90 and the one-year utures contract o the Canadian dollar is priced at $.88. Estimate the expected proit or loss i an investor sold a oneyear utures contract today on one million Canadian dollars and settled this contract on the settlement date. ANSWER: Expected appreciation o C$ = (1+.08)/(1+.03)-1= Expected spot rate in one year = x $.90 = $ Expected proit = [$.88 - $.94369] x 1 million = -$63,689.

19 Inlation, Interest Rates, and Exchange Rates PPP and Changes in the Real Interest Rate. Assume that you believe exchange rate movements are mostly driven by purchasing power parity. The U.S. and Canada presently have the same nominal (quoted) interest rate. The central bank o Canada just made an announcement that causes you to revise your estimate o Canada s real interest rate downward. Nominal interest rates were not aected by the announcement. Do you expect that the Canadian dollar to appreciate, depreciate, or remain the same against the dollar in response to the announcement? Briely explain your answer. A decrease in the real interest rate (with no change in the nominal interest rate) means that Canada s expected inlation rate is increased. This new inormation causes an expected decrease in U.S. demand or Canadian dollars and/or an increased supply o Canadian dollars to be exchanged or U.S. dollars (due to international trade with the U.S.), which results in a weaker Canadian dollar. 44. IFE and Forward Rate. The one-year Treasury (risk-ree) interest rate in the U.S. is presently 6%, while the one-year Treasury interest rate in Switzerland is 13%. The spot rate o the Swiss ranc is $.80. Assume that you believe in the international Fisher eect. You will receive 1 million Swiss rancs in one year. a. What is the estimated amount o dollars you will receive when converting the rancs to U.S. dollars in one year at the spot rate at that time? b. Assume that interest rate parity exists. I you hedged your uture receivables with a one-year orward contract, how many dollars will you receive when converting the rancs to U.S. dollars in one year? a. Expected movement in Swiss ranc = [(1.06)/(1.13) - 1]= -6.19% $.80 x ( ) = $ ,000,000 x $.7504 = $744,400 b. The orward rate premium = [(1.06)/(1.13) - 1]= -6.19% $.80 x ( ) = $ ,000,000 x $.7504 = $744, PPP. You believe that the uture value o the Australian dollar will be determined by purchasing power parity (PPP). You expect that inlation in Australia will be 6% next year, while inlation in the U.S. will be 2% next year. Today the spot rate o the Australian dollar is $.81, and the one-year orward rate is $.77. What is the expected spot rate o the Australian dollar in one year? ANSWER: Expected spot rate o A$ in one year = $.81 x ( ) = $.779. Solution to Continuing Case Problem: Blades, Inc. 1. What is the relationship between the exchange rates and relative inlation levels o the two countries? How will this relationship aect Blades Thai revenue and costs given that the baht is reely loating? What is the net eect o this relationship on Blades?

20 20 Inlation, Interest Rates, and Exchange Rates ANSWER: The relationship between exchange rates and relative inlation rates is summarized by the purchasing power parity (PPP) theory. When one country s inlation rate rises relative to that o another, the demand or the ormer country s currency declines as its exports decline (due to its higher prices). Furthermore, consumers and irms in the country with higher inlation tend to increase their importing. Thus, the absolute orm o PPP states that prices o similar products o two dierent countries should be equal when measured in a common currency. The relative orm o PPP states that prices o similar products o dierent countries will not necessarily be the same when measured in a common currency because o market imperections. However, it states that the rate o change in the prices o products should be similar. Both orms o the theory suggest that the currency o the country with the higher level o inlation should depreciate to oset the inlation dierential. Since the baht has become a reely loating currency, the currency should be expected to depreciate due to the high inlation levels prevailing in Thailand. Blades revenue generated in Thailand will be negatively aected by PPP. Because o Blades export arrangement, it is unable to increase its prices in line with Thai levels o inlation. However, since Blades exports are denominated in baht, a depreciation o the baht will result in a conversion o baht into ewer dollars. Blades cost o goods sold generated in Thailand will increase as Thai exporters adjust their prices according to Thai inlation rates. However, the high prices resulting rom high levels o inlation in Thailand may be somewhat oset by a depreciation o the baht. Since Blades generates net cash inlows rom its Thai operations, it will be negatively aected by PPP. 2. What are some o the actors that prevent PPP rom occurring in the short run? Would you expect PPP to hold better i countries negotiate trade arrangements under which they commit themselves to the purchase or sale o a ixed number o goods over a speciied time period? Why or why not? ANSWER: PPP may not hold because exchange rates are aected by other actors in addition to the inlation dierential between two countries, such as relative interest rates, national income levels, and government controls. Furthermore, certain goods may not be aected by PPP because no suitable substitutes are available in the home country. Thus, the trade relationships between two countries or these goods may not be aected by inlation rate dierentials in the manner suggested by PPP. Arrangements whereby irms with diering inlation commit themselves to the purchase o a ixed number o goods over a speciied period o time will cause PPP not to hold, at least in the short run. This is because contractual agreements are not easily terminated, causing a delayed impact o inlation rates on trade relationships and, consequently, exchange rates. 3. How do you reconcile the high level o interest rates in Thailand with the expected change o the baht-dollar exchange rate according to PPP? ANSWER: High levels o real interest rates in a given country may increase the demand or that country s currency as oreign investors can earn higher rates o return in the oreign country than may be available domestically. This would place upward pressure on the currency o the country with the higher level o real interest rates. However, the high level o nominal interest rates in Thailand are primarily the result o high expected levels o Thai inlation. Thereore, according to the

21 Inlation, Interest Rates, and Exchange Rates 21 international Fisher eect (IFE), the Thai baht should depreciate by an amount suicient to oset the nominal interest rate dierential between Thailand and the U.S. 4. Given Blades uture plans in Thailand, should the company be concerned with PPP? Why or why not? ANSWER: Although PPP may not hold well in the short run, it has been ound to hold reasonably well in the long run. Since Blades is under a three-year export arrangement with Entertainment Products, Inc. and since it is considering the expansion into Thailand, the company should be concerned with PPP; in the long run, the relatively high level o Thai inlation may result in a depreciation o the baht suicient to oset the inlation dierential. Yet, Blades will be able to renegotiate its arrangement once the three-year period or the existing arrangement is over. 5. PPP may hold better or some countries than or others. The Thai baht has been reely loating or more than a decade. How do you think Blades can gain insight into whether PPP holds or Thailand? Oer some logic to explain why the PPP relationship may not hold here. ANSWER: One possible way to determine whether PPP holds between two countries is to regress historical exchange rate changes on the inlation dierential between two countries. The PPP relationship may not hold because other actors also inlence the baht exchange rate. Solution to Supplemental Case: Flame Fixtures, Inc. a. I the peso depreciates by more than the inlation dierential, then the dollar cost to Flame will be even lower than expected. b. I the peso depreciates by less than the inlation dierential, then the dollar cost to Flame will be even higher than expected. Consider a scenario in which the Mexican inlation rate is 80 percent or so, causing the bill in pesos to be 80 percent higher. Yet, i the peso depreciated by a relatively small amount over this period (say 20 percent or so), the dollar cost to Flame will increase substantially. Since there are other actors in addition to inlation that also aect the peso s exchange rate, the peso will not necessarily depreciate by an amount that ully osets the high inlation. c. Stable dollar payments would only occur i the peso depreciated by an amount that oset its high inlation rate. It is unlikely that there will be a perect oset in any given period. Thereore, Flame s dollar payments would be unstable, and so would its proits. d. The risk would increase, because its payments or parts would now be more volatile, and so would its proits. Given that it does not have much liquidity, it will suer a cash squeeze i the peso does not depreciate much while Mexican inlation is high. Over the long run, there may be periods in which this happens. Flame would be locked into this arrangement with Coron or ten years, and thereore cannot back out, even i the peso s depreciation does not oset the inlation dierential.