Tài chính doanh nghiệp - Finance 407: Multinational financial management - Topic 7: Interest rate parity

Topic #7: Interest rate paritYL. GattisThe Pennsylvania State University1Finance 407: Multinational Financial ManagementReview: No Calculator Estimate2Annual inflation in the U.S. and Japan is 5% and 1%. The spot price of the Yen is ¥100.00/$. What is the expected spot price in 3 months?1041031019996Review: No Calculator Estimate3The euro is expected to devalue by 2% against the British pound in one year. British inflation is forecasted to be 5%. What is euro area inflation according to PPP?7%5%3% 1%Review: No Calculator4An Ipad costs $699 in the U.S. and ¥6,999 in China. The spot price of the yuan is ¥6.42/$. Is the yuan undervalued or overvalued according to PPP?UndervaluedOvervaluedLearning Objectives5Learning ObjectivesStudents can forecast exchange rates and expected appreciations using interest rate parity and unbiased forward rate.Relative PPP and Interest Rate Parity 6Relative PPP allows for differences in absolute prices, but changes in prices will affect future exchange ratesIf you assume differences in international interest rates reflect only differences in inflation, then changes in interest rates will also affect exchange rates.Assumes real interest rates and risk premiums are the same in both countriesYou could also flip all the h’s and f’s to get indirect quoteIRP Caveats7Nominal Rate ≈ Real Rate + Inflation+ Default Risk Premium + Liquidity Risk PremiumDifferences in nominal rates may reflect differences inInflationLiquidity RiskCredit RiskIt is most appropriate to apply IRP to two currencies with similar credit risk and liquidity.Euro IRP for the EURUSD generally use yields on German bonds because of similar credit and liquidity risk of U.S. bonds.Forecasting Using PPP or IRP for more or less than one year 8For forecasting Interest Rates for t yearsFor forecasting exchange rates exchange rates for less than one year – n months, where r or i is still annualized Poll The spot price of the euro is $1.25. U.S and German sovereign yields are 5% and 8%. What is the expected exchange rate in 6-months.1.181521.26831.21531.2857None of the Above9PollThe dollar is selling for 115 yen today and the expected exchange rate is 120 in one year. If the U.S. interest rate is 5%, what is the Japanese one year interest rate according to IRP?A. 8.73%B. 6.21%C. 6.25%D. 9.57%10Unbiased Forward Rate (UFR)11UFR states that forward exchange rates are unbiased predictors of future spot rates. This implies that if a financial manager would like a forecast of spot rates, she could simply look up forward exchange rates on Bloomberg.What does this imply for the hedging of expected currency revaluations?Example: A U.S. exporter to Mexico is concerned about an expected devaluation of the Peso of 20% -- which would reduce the USD value of exports by 20%. How could he use forward contracts to eliminated this exposure?Unbiased Forward Rate (UFR)12UFR states that forward exchange rates are unbiased predictors of future spot rates. UFR also implies that the expected appreciation is equal the forward premiumAdding the PPP and IRP parity conditions Parity (Equality) Conditions13The parity conditions in foreign exchange refers to the relationships between inflation, interest rates, currency appreciation, and forward premiums.Expected Currency Appreciation = Relative Inflation Rates = Relative Interest Rates =Forward Discount or Premium1 + expected appreciation of currency h in terms of to currency fRatio or inflation rates=Ratio or Interest rates=1 + forward premium of currency h in terms of currency f=e.g., 3% € appreciation ≈ 3% lower € inflation ≈ 3% lower € Interest Rates ≈ 3% € Fwd Prem.Parity Conditions14The dollar is selling at 5% forward discount to the Swiss franc. This implies that Swiss inflation is 5% higher/lower, Swiss interest rates are 5% higher/lower, and the franc is expected to appreciation/depreciate by 5%.Poll15Suppose annual inflation in the Eurozone and Sweden are 3% and 0.5%. The Spot price of the Swedish kronor is Kr5.35/€. What is the one year forward exchange rate?A. 5.22B. 5.48C. 0.19D. 0.18Poll16Interest rates in the U.S. and Australia are 3% and 5%. What is the Australian dollar forward premium?A. -1.94%B. +1.94%C. +1.9%D. - 1.9%E. 98.1%Poll17The Mexican peso is selling at a 3% discount to the USD for a one year delivery. U.S. inflation is forecasted to by 2.56%. What is Mexican inflation according to PPP and UFR? A. 0.4%B. 5.4% C. 5.7%D. 4.27%E. 3.75%Exchange Rate Determinants and Parity18Supply and Demand Determinants (exports+,i-,r+,g+)1. Relative Demand for Goods and Services (Net Exports)2. Relative Inflation3. Relative real interest rate: High rates, causes currency apprec.4. Relative economic growth5. Monetary Policy and Fiscal Policy 6. Direct Currency InterventionParity Conditions (i-,r-)Why the inconsistent treatment of r?High nominal rates causes currency depreciation – because it is just caused by inflationAssigned Problems19Annual interest rates in Argentina and the United States are 15% and 5%, respectively. What is the expected appreciation of the Argentina dollar in one year, five years, and ten years? 1-year Arg app = e1,($/A$)/e0($/A$) -1 = (1+r$)/(1+rA$)– 1 = 1.05/1.15-1 =-8.7%; 5-year = (1.05/1.15)^5 - 1 =-36.5%; 10-year = (1.05/1.15)^10 - 1 =-59.7%The annual interest rates in the U.S. and Mexico are 2% and 8%. The spot exchange rate is 12 pesos per dollar. What is the expected 3-month peso appreciation % and exchange rate?3-month P/$ rate = e0,P/$*(1+rP/4)/(1+r$/4); Expected Peso Appreciation e1,$/P/e0,$/P-1= (1+r$/4)/(1+rP/4)-13-month P/$ rate = 12*(1+.08/4)/(1+.02/4)=12.179; Peso App = (1.005/1.02)-1=-1.47% or (12-12.179)/12.179The South African rand is selling at a 5% discount for one year delivery. U.S. inflation is 3%. What is South African inflation according to relative PPP?From PPP; f1,($/R)/e0($/R)=1+Premium=(1+i$)/(1+iR); 1+(-.05) =.95 = 1.03/(1+iR); i = 8.4211% U.S. inflation and nominal interest rates are 3% and 4%. Japanese inflation and interest rates are 1% and 0.5%. What are the real interest rates in Japan and the U.S.?Real Interest Rate = (1+nominal)/(1+inflation); Real US = 1.04/1.03-1=.97%; Real JPY = 1.005/1.01-1=-.495%The two-year forward kroner is selling at 9% above the spot price. If inflation in the U.S. is 6% per year, what is the expected Danish inflation?f1,($/Kr)/e0($/Kr)=1+Premium=(1+i$)/(1+iKr); 1.09=(1.06/(1+iKr))^2; 1.09^.5=1.06/(1+iKr); iKr = 1.5296% Assigned Problems20If annualized interest rates in the U.S. and Switzerland are 9% and 13%, respectively, and the spot value of the franc is $.1109, then at what 180‑day forward rate will interest rate parity hold? Assume a 360 day year.e(180,$/Sf)=e(0,$/Sf)*(1+r$/1+rSf); e(180)=$.1109*(1.045/1.065)=$.108817The spot yen is selling at ¥85 and one year forward is ¥87. What is the expected appreciation of the Yen (vs. the dollar) ? What is the expected appreciation of the Dollar (vs the yen)?$ app = (e1-e0)/e0 = (87-85)/85 = 2.35%; Yen App = (e0-e1)/e1 =(85-87)/87=-2.3%What factors besides nominal interest rates and inflation affect interest rates?Expected exchange rate changes cannot be hedged using forwards. Explain.What is the major assumption about real interest rates in IRP?Textbook21Shapiro and Sarin’s Foundation of Multinational Finance 6th Ed. Chapter 4 covers purchasing power parity, interest rate parity, unbiased forward rate, and currency forecastingiClicker: Class Evaluation22How would you rate today’s class? Highest Lowest