International Finance: Exchange Rates, Parity, and Derivatives
Chapter 6: Fundamental Questions in International Finance
Determinants of Exchange Rates and Predictability
This chapter explores the economic theories connecting exchange rates, price levels, and interest rates, known as international parity conditions.
Law of One Price
The Law of One Price states that, assuming no transaction costs or restrictions, a product’s price should be the same in all markets.
For prices in different currencies:
- P$: Price of the product in US dollars
- S: Spot exchange rate (yen per dollar)
- P¥: Price of the product in Japanese yen
The relationship is represented as: (P$ x S = P¥)
Conversely, in efficient markets, the exchange rate can be deduced from relative local product prices: (S = P¥/P$)
Purchasing Power Parity (PPP)
If the Law of One Price held true for all goods, the purchasing power parity (PPP) exchange rate could be determined from any set of prices. Comparing identical product prices in different currencies would reveal the “real” or PPP exchange rate in efficient markets. This concept is known as the absolute theory of purchasing power parity.
Absolute PPP posits that the relative prices of similar baskets of goods determine the spot exchange rate.
Big Mac Index
- Calculation: Cost Country 1 / Exchange rate = Terms of Country 1 OR Cost Country 1 / Cost Country 2 = Terms of Country 2
- Undervalued/Overvalued: Country 2 Terms – Exchange Rate / Exchange Rate
Relative PPP
Relative PPP helps determine the exchange rate over a period of time but is not useful for determining the current spot rate.
While PPP holds well in the long term, it is less accurate for short-term exchange rate predictions.
Exchange Rate Pass-Through
Exchange rate pass-through refers to the extent to which import and export prices change due to exchange rate fluctuations.
Fisher Effect
The Fisher Effect states that a country’s nominal interest rate equals the required rate of return plus compensation for expected inflation.
Formula:
- I = (1 + Real Rate Interest)(1 + π) – 1 = Real Rate Interest (r) + π + rπ
- OR I = r + π
The international Fisher effect, or Fisher-open, suggests that the spot exchange rate should change in the opposite direction of the interest rate differential between countries. The expected change in the spot rate between the dollar and yen (indirect quote, FC/D) should be (approximately):
Forward Rates
A forward rate is an exchange rate quoted for settlement at a future date. A forward exchange agreement specifies the exchange rate for buying or selling a foreign currency on a specific future date.
The forward premium or discount, expressed as an annual percentage, represents the difference between spot and forward rates.
Formula: FFC = (Spot – Forward) / Forward x 360 / Days x 100
Interest Rate Parity (IRP)
The Interest Rate Parity (IRP) theory states that the difference in national interest rates for securities with similar risk and maturity should equal the forward rate discount or premium for the foreign currency, accounting for transaction costs.
Since spot and forward markets may not always be in equilibrium as per IRP, opportunities for “risk-less” or arbitrage profit can arise.
Covered Interest Arbitrage (CIA)
Arbitrageurs can exploit imbalances by investing in the currency offering a higher covered return (covered interest arbitrage).
Rule of Thumb
- If the interest rate differential exceeds the forward premium (or expected spot rate change), invest in the higher-yielding currency.
- If the interest rate differential is less than the forward premium (or expected spot rate change), invest in the lower-yielding currency.
Uncovered Interest Arbitrage (UIA)
Uncovered interest arbitrage (UIA) involves borrowing in currencies with relatively low interest rates and converting the proceeds into currencies offering higher interest rates, deviating from CIA.
Chapter 7: Financial Derivatives
Hedging and Speculation
Hedging occurs when someone uses derivatives to reduce their economic risk. The person engaging in hedging is called a hedger.
Speculation involves accepting the risk that a hedger wants to avoid. A speculator believes the potential return outweighs the risk.
Foreign Currency Futures Contracts
A foreign currency futures contract, traded on exchanges like the International Monetary Market (Chicago Mercantile Exchange), is an alternative to a forward contract. It involves the future delivery of a standard amount of currency at a predetermined time and price.
Features of Futures Contracts
- Traded on organized exchanges
- Require upfront margin payments
- Eliminate credit risk and guarantee performance
Futures contracts offer similar risk reduction capabilities as forwards but involve upfront cash outflows (margin requirements) and potential margin calls. Their standardized nature may not allow hedging the exact desired quantity.
- Short position: Selling a futures contract based on the expectation of currency depreciation
- Long position: Buying a futures contract based on the expectation of currency appreciation
Foreign Currency Options
A foreign currency option grants the purchaser the right, but not the obligation, to buy or sell a specific amount of currency at a fixed price (strike price) on or before a certain date (expiration date).
- Call: Buyer’s right to purchase currency
- Put: Buyer’s right to sell currency
The buyer is the holder, while the seller is the writer or grantor.
- Strike or exercise price: Fixed price for buying or selling the currency
- Expiration date: Last day to exercise the option
- Option premium: Price paid to the writer for the right
Types of Options
- American option: Exercisable on or before the expiration date
- European option: Exercisable only on the expiration date
Option Moneyness
- In the Money
- Call: Spot price > Exercise price
- Put: Exercise price > Spot price
- Out of the Money
- Exercising would result in a negative payoff
- Call: Spot price
- Put: Exercise price
Swaps
Swaps are contracts to exchange (swap) a series of cash flows.
- Interest rate swap: Exchange of fixed and floating interest payments
- Currency swap: Exchange of debt service obligation currencies
Interest Rate Swaps
- Pay fixed, receive floating: Protection against rising debt service payments
- Pay floating, receive fixed: Advantage of lower debt service payments
Interest rate swaps involve exchanging interest payments on a notional principal amount, not the principal itself.
Currency Swaps
Used to replace cash flows scheduled in an undesired currency with flows in a desired currency
The desired currency is probably the currency in which the firm’s future operating revenues (inflows) will be generated
Firms often raise capital in currencies in which they do not possess significant revenues