MULTINATIONAL FINANCE

(1)

Multinational Finance, J

Multinational Finance, Jöörgen Hellstrrgen Hellströömm

MULTINATIONAL

FINANCE

Determinates and Forecasting of

Exchange Rates

(Chapter 2 & 4)

Outline of Lecture

1) Determination of exchange rates

Floating exchange rate system

¾The Asset Market Model ¾Parity Conditions

– Purchasing Power Parity (PPP) – International Fisher Effect (IFE) – Interest Rate Parity (IRP)

Fixed exchange rate system

¾Set by the government through negotiations with other countries ¾Exchange rates can change through renegotiations or due to

currency speculations

2) Forecasting of exchange rates

(2)

Definitions

Exchange rate – the price of one nation’s currency in terms of another

currency

Devaluation – decreasing the value of a currency (by a government) in a

fixed exchange rate regime

Revaluation – increasing of the value of a currency (by a government) in a

fixedexchange rate regime

Depreciation – lowering of the value of a currency (by the market) in a

floatingexchange rate regime

Appreciation – increasing of the value of a currency (by the market) in a

floatingexchange rate regime

Spot market – market for immediate delivery of currency

¾ Spot rate – the price of the currency in the spot market

Forward market– market for delivery of currency at a specified future date

¾ Forward rate – the price of the currency in the forward market

Determinates of Exchange Rates

The equilibrium exchange rate (supply = demand) is determined by the demand and supply of a currency from another country (currency)

The American demand for European goods and services and European financial assets determines the demand for Euro

The European demand for U.S goods and services and U.S financial assets determines the supply of Euro 0 1 2 Quantity of Euros D o ll a r p rice o f 1 E u ro Supply Demand D S e

(3)

Key factors affecting equilibrium

Exchange rates

Relative inflation rates

¾

Purchasing Power Parity (PPP)

Relative interest rates

¾

International Fisher Effect (IFE)

Relative Economic Growth Rates

¾

Nations with strong economic growth (home) will

attract foreign investment capital to acquire domestic

assets

– Increased demand for the home currency

– Stronger currency (e.g. fewer SEK/$)

– Empirical support

Key factors affecting equilibrium

Exchange rates

Political and Economic Risk

¾

In general investors prefer to hold lesser amounts of

riskier assets

¾

Low risk currencies (more politically and economically

stable nations) are in general more highly valued

(larger demand)

Expectations about future exchange rates

¾

Investors expectations about the future value of the

currency affects their willingness of holding the

currency and thus the spot rate today

(4)

The Asset Market Model

• The asset market model of exchange rate

determination:

– “the exchange rate between two currencies

represents

the price that just balances the

relative supplies of, and demand for, assets

denominated in those currencies

”

– Changes in preferences for assets leads to

changes in the exchange rate

The Asset Market Model

The factors that affect the relative demand and

supply of assets are:

¾

Store of value

– determined by the countries inflation rate – depends on the

countries monetary policy

– Central bank reputation important (central bank

independence)

– Expectations about the future important determinant

¾

Demand for liquidity

¾

Risk and returns on assets in a nation

– Depends on countries relative present and expected

economic growth

(5)

International Parity Conditions

The economic theories that link exchange rates,

price levels, and interest rates together are

called

international parity conditions.

Key idea that gives the theoretical parity

conditions is the concept of

Arbitrage

(i.e. the

assumption that arbitrage opportunities can not

exist for a long time – “The No-arbitrage

condition” )

The assumption of “No-arbitrage” leads to

the

law of one price

“

The Law of One Price

”

If identical products or services can be sold in two different markets

(A and B), and no restrictions exist on the sale or transportation

costs of moving the product between markets,

the products price

should be the same in both markets

.

If prices differ - agents can simply by in the cheaper market (A) and

sell in the market with a higher price (B) and earn a risk free profit

When agents buy in the cheaper market (A) the increased demand

on market A will increase the price in market A

When agents sell in the high-price market (B) the increased supply

on market B will lower the price in market B

Thus, the prices move toward equalization

International parity conditions are a consequence of this arbitrage

behavior

(6)

Purchasing Power Parity (PPP)

Absolute version

“Price levels should be equal

worldwide when expressed in

a common currency”

¾ A unit of home currency should have the same purchasing power around the world

¾ Ignores: transportation costs tariffs, quotas and other trade restrictions product

differentiation

The foreign exchange rate

must differ by (approximately)

the difference between the

domestic and the foreign price

levels

Relative version

“The exchange rate between

the home currency and a

foreign currency will adjust to

reflect changes in the price

level (inflation) of the

countries”

t f t h t t f t h t

i

e

i

e

)

1 (

)

1 (

)

1 (

)

1 (

0 0

+

×

=

+

=

Example

10% 2%

USD appreciate, CAD depreciate

0.9 * (1.02)/(1.10)=0.8345 USD/CAD 1.1111* (1.10)/(1.02)=1.1983 CAD/USD New exchange rate (e_t)

If exchange rate unchanged: Canadians can by the car in USA for 9180/0.9 = 10200 CAD

If PPP holds the exchange rate will adjust due to the different inflation rates 11000 CAD

9180 USD New price

Inflation rate (i)

PPP holds (Price equal in USA and Canada)

10000 CAD 9000 USD Price (Car) 1 USD = 1.1111 CAD 1 CAD = 0.9 USD Exchange rate (e₀) Canada USA

(7)

Economic consequences

If the exchange rate remains unchanged meanwhile rates of inflation differ

between two currencies, for the country with a higher inflation rate

(Canada), exports of goods and services will become less competitive, and imports from abroad will also become more competitive than domestic products.

The country will develop a deficit in its balance of payments. The deficit will even worsen because of arbitrage and speculation in traded commodities. It will increase the demand of foreign currencies and the supply of the home currency. This will lead to a depreciation of the home currency. Economic adjustment should produce a new equilibrium exchange rate, respecting the purchasing power parity.

After the adjustment the relative competitive position of the countries are unchanged.

Changes in the nominal exchange rate (actual exchange rate) may be of little significance in determining the effects for firms and nations

Real Exchange Rate

“Nominal exchange rate adjusted for changes in the

relative purchasing power of each currency since

some base period”

period)

base

at

100 to

index

(both

t

time

at

levels

price

home

and

foreign

the

are

P

and

P

e

rate

Exchange

Real

h f h f n t r t

=

*

=

(8)

Example

119.2 152.4 CPI, 1995 91.0 82.4 CPI, 1980

The Yen appreciated with 58 % during the period measured in nominal terms Yen 93.96/$ $ 0.0106/Yen Exchange rate 1995 Yen 226.63/$ $ 0.0044/Yen Exchange rate 1980 Japan USA

Yen

e

Yen

e

r t r t

/

0044

.

0 $

)

100 (

)

100 (

*

0044

.

0 /

00754

.

0 $

)

4 .

82 /

4 .

152 (

)

0 .

91 /

2 .

119 (

*

0106

.

0

1995 1980

=

Example

In real terms the Yen appreciated by 71 %

This represents a large competitive pressure on

Japanese exporters as the dollar price of their export

rose far more than the U.S. rate of inflation

%

71 0044

.

0 /

)

0044

.

0 00754

.

0 (

−

=

(9)

Empirical Evidence

Empirical testing

of PPP and the law of one

price has been done, but has not proved PPP to

be accurate in predicting future exchange rates.

Two general conclusions can be made from

these tests:

¾

PPP holds up well over the very long run but

poorly for shorter time periods

¾

The theory holds better for countries with

relatively high rates of inflation and

underdeveloped capital markets

The Fisher Effect (FE)

Nominal interest rates in

each country are equal to

the

required real rate of

return plus

compensation for

expected inflation

.

r = a + i

¾

r = nominal interest rate,

¾

a = real interest rate

¾

i = expected inflation.

Generalized version of FE

“Real returns are (through

arbitrage) equalized

across countries”

f h f h f f h h f h f f f h h h

i

r

i

r

i

r

a

i

r

a

i

r

a

−

=

−

⇒

−

=

−

⇒

=

−

=

−

=

(10)

The Generalized Fisher Effect

In equilibrium the

nominal interest rate

difference

will approximately equal the differential between

anticipated inflation between the countries

The relationship is supported by empirical

evidence

f

h

f

h

r

i

r

−

=

−

International Fisher Effect (IFE)

“The expected return from investing at home should

equal the expected return from investing abroad in

terms of home currency”

“Currencies with low interest rates are expected to

appreciate relative to currencies with high interest rates”

0 period

rate

exchange

e

t

period

rate

exchange

expected

e

E

abroad

and

home

rates

interest

r

and

r

e

E

r

t f h t f h

=

−

=

−

0 0 0

)

(

)

(

(11)

Example: IFE

Equilibrium if the same rate of return for a one-year

investment:

¾

If I invest 1 SEK in Sweden, after one year I get 1.11 SEK.

¾

If I invest 1 SEK in Europe, after one year, I get 1/8 x 1.04 EUR.

If market equilibrium,

¾

1.11 SEK = (0.125 * 1.04 EUR)* (SEK X/EUR), X=?

¾

(SEK X/EUR)=1.11/(0.125*1.04) = 8.54

Spot rate at the end of the year: SEK 8.54/EUR

The SEK has depreciated with (8.54-8)/8 = 7%

IFE Interest rate differential: 11-4 =7%

4% Eur 0.125/SEK Europe 11% SEK 8/EUR Sweden Interest rate Spot rate

Interest Rate Parity Theory

• Describes the relationship between

interest rate differentials and forward rate

differentials

between countries

• A

forward rate

is an exchange rate

(12)

Forward Premium/Discount

The

forward premium or discount

is the percentage

difference between the spot and forward exchange rate,

stated in annual percentage terms.

100 .

360 _×

×

=

+

Days

Nr

rate

Spot

rate

Spot

-rate

Forward

(-)

discount

or

)

(

premium

Forward

Interest Rate Parity (IRP)

)

0 0 f h t t 0 f h t f h

r

(1

r

(1

e

f

:

by

given

then

is

t

time

at

rate

forward

The

rate.

forward

period

of

end

the

f

and

rate

spot

current

the

e

t),

time

(until

abroad

and

home

rate

interest

the

are

r

and

r

where

e

f

r

(1

r

(1

have

we

hold

to

condition

arbitrage

-no

the

For

+

×

=

+

(13)

Forward rate

Forward rate vs

vs

Spot rate

The forward rate is calculated for any specific

maturity by adjusting the current spot exchange

rate by

the ratio of currency (countries)

interest rates

of the same maturity for the two

subject currencies.

According to IRP theory:

¾

The currency of the country with a lower interest rate

should be at a forward premium in terms of the

currency of the country with the higher rate

Example: IRP

IRP gives:

¾

Forward rate = Spot (1+ interest rate home) / (1+ interest rate

foreign) = 0.04755 x (1.07 / 1.08) = 0.047433

Assume actual forward rate = 0.045

Arbitrage possibility:

¾

Borrow X million SIT, turn them into DKK, invest in DKK and Buy

10 Million SIT in the forward market at 0.045.

SIT 21.03/DKK DKK 0.04755/SIT Spot rate 8% 7% Interest rate (r) Slovenia Denmark

(14)

Example: IRP

Borrow in SIT (Slovenian Tolar):

¾ 10,000,000 SIT/ 1.08 = 9,259,259 SIT (costs 10,000,000 in 1 year)

Exchange SIT to DKK:

¾ 9,259,259 SIT x 0.04755 DKK/SIT = 440,278 DKK

Invest in DKK:

¾ 440,278 x 1.07 = 471,097 DKK

Repayment of the loan (buy forward at 0.045):

¾ 10,000,000 SIT x 0.045 = 450,000 DKK

Profit after one year: (471,097 - 450,000) = 21,097 DKK

¾ Increased demand for loans: The Slovenian interest rate will increase ¾ Increased supply of investment: The Danish interest rate will decrease ¾ The spot rate will decrease (increased demand for DKK)

¾ The actual forward rate will go up (increased demand) ¾ Theoretically, the market should reach again the equilibrium.

Unbiased forward rate (UFR)

Forward exchange rates are unbiased

predictors of future spot exchange rates.

Intuitively this means that the distribution

of possible actual spot rates in the future is

centered on the forward rate.

Unbiased means “on average”

¾

Positive and negative prediction errors cancel

out in the long run

(15)

Forward Rate

-

an Unbiased

Predictor for Future Spot rate

Time t₁ t₂ t₃ t₄ Exchange rate S₁ S₂ S₃ S₄ F₁ F₂ F₃ Error Error Error

International Parity Conditions in

Equilibrium

Expected change in spot exchange rate +4% (apprec.) Expected inflation rate differential -4% Forward discount/premium on foreign currency +4% Nominal interest rate differential -4% PPP IRP UFR FE IFE

(16)

Fixed exchange rate system

The exchange rate is set through negotiations with other nations

Can change through re-negotiation or forced to change due to

speculative attacks

The fixed rate is maintained by active intervention (buy and sell

currency) by central banks

In order for a fixed systems to hold the economic development in the

participating countries must be similar (e.g. inflation rates)

Important for firms to monitor political and economic conditions in

participating countries.

Same economic factors (inflation-, interest rate differentials,

economic growth) as in a floating exchange rate system will put

pressure on the fixed exchange rate

Forecasting Exchange Rates

Market-Based Forecasts

Forecasts can be obtained by using market expectations

- that are given by the current

interest rates

and

forward

exchange rates

¾

The forward rate for 90 days shows the spot exchange rate that

the market expects to prevail in 90 days, i.e.

E(e

₁

)=f

₁

.

¾

Forward rates limited to 1 year (absence of longer-term forward

contracts)

¾

Relative interest rate differentials can be used for longer term

forecasts:

– Forward ratet_{= Spot (1+ interest rate home)}t_{/ (1+ interest rate} foreign)t

– Example: 5 year interest rate Europe: 5 %, USA: 6%, Spot rate: $ 0.9/EUR →f₅=0.9*(1.06)5_/(1.05)5_{= $ 0.9437/EUR}

(17)

Forecasting Exchange Rates

Model-based forecasts

Fundamental Analysis

¾

Based on analysis of macroeconomic variables (relative inflation,

interest rates, national income growth, changes in money supply

etc.) that are likely to influence the currency

¾

Based on theoretical relationships as PPP etc.

– Example: Expected inflation rate annually USA: 4 %, South Africa: 9 %, Spot rate: $ 0.008/RAND

– PPP: e₂=e₀* (1+i_US)2_{/ (1+i}

SA)2→e2= 0.008*(1.04)2/ (1.09)2= $0.00728/RAND (depreciation of the RAND, appreciation of $)

¾

Econometric models may be used

¾

Common forecasting approach – particular for longer forecasting

horizons

Forecasting Exchange Rates

Model-based forecasts

Technical analysis

¾

Technical analysts, (chartists)

, focus on

price and volume data

to

determine past trends that are expected to continue into the

future. (do not use other economic variables)

¾

The single most important element of technical analysis is that

future exchange rates are based on the current exchange rate

¾

In practice most commonly used for short-term forecasts

¾

Exchange rate movements can be subdivided into different

periods:

– Intra daily variation – Day-to-day

– Short-term (several days to several months) – Long-term

(18)

Technical Analysis

SEK/$ Time Actual rate ¾ Different methods: To find trends, systematic patterns and turning points

MULTINATIONAL FINANCE

MULTINATIONAL

MULTINATIONAL

FINANCE

FINANCE

Determinates and Forecasting of

Determinates and Forecasting of

Exchange Rates

Exchange Rates

(Chapter 2 & 4)

(Chapter 2 & 4)

Outline of Lecture

Outline of Lecture

1) Determination of exchange rates



Floating exchange rate system



Fixed exchange rate system

2) Forecasting of exchange rates

Definitions

Definitions

Determinates of Exchange Rates

Determinates of Exchange Rates

Key factors affecting equilibrium

Key factors affecting equilibrium

Exchange rates

Exchange rates



Relative inflation rates

¾

Purchasing Power Parity (PPP)



Relative interest rates

¾

International Fisher Effect (IFE)



Relative Economic Growth Rates

¾

Nations with strong economic growth (home) will

attract foreign investment capital to acquire domestic

assets

– Increased demand for the home currency

– Stronger currency (e.g. fewer SEK/$)

– Empirical support

Key factors affecting equilibrium

Key factors affecting equilibrium

Exchange rates

Exchange rates



Political and Economic Risk

¾

In general investors prefer to hold lesser amounts of

riskier assets

¾

Low risk currencies (more politically and economically

stable nations) are in general more highly valued

(larger demand)



Expectations about future exchange rates

¾

Investors expectations about the future value of the

currency affects their willingness of holding the

currency and thus the spot rate today

The Asset Market Model

The Asset Market Model

• The asset market model of exchange rate

determination:

– “the exchange rate between two currencies

represents

the price that just balances the

relative supplies of, and demand for, assets

denominated in those currencies

”

– Changes in preferences for assets leads to

changes in the exchange rate

The Asset Market Model

The Asset Market Model



The factors that affect the relative demand and

supply of assets are: