International Financial

Management

Assignment 2

Submitted by:-
Sruthi Ramachandran
b2356
  Introduction

An exchange rate is the value of one country’s currency in relation to another

currency. It could also be interpreted as the price paid for a unit of foreign
currency in terms of the home currency. For example, 1 USD equals 68.88
Indian Rupees as on July 1, 2019.

Changes in exchange rates may affect the relative position of a country in the
international trade. The percentage change in the value of the foreign currency
is computed as follows:

A positive percentage change indicates that the foreign currency has

appreciated, while a negative percentage change indicates that it has depreciated
 How international exchange rates are set?

The amount of money obtained for a specified amount in terms of home

currency is based on internationally determined exchange rates. To be more
precise, exchange rates are of two types:-

 Fixed Rate (gold/other precious metals and each unit of the currency
corresponds to a fixed quantity of that standard)
 Floating Rate (indicates that each currency need not be compulsorily backed by
a resource. Current international market rates are determined by this rate which
majorly depends on actions of its Government/Central Bank.)

Major factors which lead to fluctuation in exchange rates are as follows:-

1) Inflation and higher Interest Rates

2) Unemployment Rates

3) GDP Figures and Government Debt

 4) Trade and Capital Movements

5) Stock Exchange Operations

6) Speculative Transactions

7) Banking Operations and Political Conditions

8) Monetary Policies

9) Country’s Current account and Balance of payments

 Theories of Exchange Rates

These theories are generally based on the flow of goods and services. An
equilibrium exchange rate where the imports balance the exports of the country
is chosen. If the imports exceeds exports, then the exchange rates will fall i.e.;
depreciation of the home currency happens.

The top four theories are as follows:-

a) Purchasing Power Parity Theory (PPP)

b) Interest Rate parity Theory (IRP)

c) International Fischer Effect Theory (IFE)

d) Unbiased Forward Rate Theory (UFR)

The first three of them are discussed in detail, below.

a) Purchasing Power Parity Theory

This is a commodity based theory. It attempts to quantify the inflation–

exchange rate relationship. It states that there exists a link between the prices in
two countries and the exchange rates between the currencies of these countries.

For example, the relatively high U.S. inflation causes the U.S. consumers to
increase imports from the United Kingdom and British consumers are ought to
 lower their demand for U.S. goods. Such forces place upward pressure on the
British pound’s value. The shifting in consumption from the United States to the
United Kingdom will continue until the British pound’s value has appreciated to
the extent that (1) the prices paid for British goods by U.S. consumers are no
lower than the prices for comparable products made in the United States and (2)
the prices paid for U.S. goods by British consumers are not higher than the
prices for comparable products made in the United Kingdom.

According to PPP, the foreign currency will adjust as follows:

Simplified but less precise relationship based on PPP is

Here ef is the percentage change, Ih is the interest rate on the home deposit and If
is the interest rate on foreign deposit..
Even though exchange rates deviate from the levels predicted by PPP in the
short run, their deviations are reduced over the long run.

b) Interest Rate parity Theory (IRP)

The IRP Theory indicates the existence of a link between the nominal interest
rates in two countries and exchange rate between their currencies. It follows
certain assumptions as under:
1) The transaction costs related to conversion of a currency in to another/selling or
buying of a financial security are zero.
2) The cash flow between different countries is free and there is full mobility of
capital.
3) An investor may choose to invest in financial securities, denominated in one’s
home currency or to invest in financial securities that are denominated in
foreign currency.
Understanding forward rates is fundamental to IRP as it pertains to arbitrage.
For example, if the spot rate for 1 USD= 1.065 Canadian Dollars, the forward
rate could be computed as follows:-

1USD=1.065*[(1+3.64%)/ (1+3.15%)]= 1.0700 CAD

Here,
(1USD = forward rate, 1.065 = spot rate, 3.64% = interest rate of overseas
country and 3.15 = interest rate of domestic country.)
The difference between spot rate and forward rate is known as swap points.
Here the swap points equal to 50. If the difference is positive, it is called
forward premium; a negative difference results in a forward discount.

However, the implications of the theory are as below;

 When domestic interest rate is below foreign interest rates, the foreign currency
must trade at a forward discount.
 If a foreign currency does not have a forward discount or when the forward
discount is not large enough to offset the interest rate advantage, arbitrage
opportunity is available for the domestic investors.
 When domestic rates exceed foreign interest rates, the foreign currency must
trade at a forward premium.
 When the foreign currency does not have a forward premium or when the
forward premium is not large enough to nullify the domestic country advantage,
an arbitrage opportunity will be available for the foreign investors.

c) International Fischer Effect Theory (IFE)

The international Fisher effect uses interest rates to explain why exchange rates
change over time, but it is closely related to the PPP theory because interest
rates are often highly correlated with inflation rates. If investors of all countries
require the same real return, interest rate differentials between countries may be
the result of differentials in expected inflation.
The IFE theory suggests that foreign currencies with relatively high interest
rates will depreciate because the high nominal interest rates reflect expected
inflation. The foreign investors will be adversely affected by the effects of a
relatively high U.S. inflation rate if they try to capitalize on the high U.S.
interest rates. The IFE theory can be applied to any exchange rate, even
exchange rates that involve two non-U.S. currencies. According to the IFE, the
effective return on a foreign investment should, on average be equal to the
interest rate on a local money market investment:

where r is the effective return on the foreign deposit and ih is the interest rate on
the home deposit.
We can also determine the degree by which the foreign currency must change in
order to make investments in both countries generate similar returns by the
formula:

The IFE theory contends that when ih> if , ef will be positive because the
relatively low foreign interest rate reflects relatively low inflationary
expectations in the foreign country. That is, the foreign currency will appreciate
when the foreign interest rate is lower than the home interest rate. This
appreciation will improve the foreign return to investors from the home country,
making returns on foreign securities similar to returns on home securities.