II JAI SRIGURUDEV II

Sri Adichunchanagiri Shikshana Trust

SJB INSTITUTE OF TECHNOLOGY

INTERNATIONAL FINANCIAL MANAGEMENT

20MBAFM406
Prepared by

Mrs. Lakshmi Priya M C

Assistant Professor
MBA Department
SJBIT

Department of MBA
BGS Health & Education City
Dr. Vishnuvardhana Road, Kengeri, Bengaluru - 560 060.
Tel.: 080 - 2861 2445 / 46 Fax : 080 - 2861 2651
Web.: www.sjbit.edu.in
 MODULE 5
FORECASTING FOREIGN EXCHANGE
RATES
 TOPICS TO BE COVERED
• International Parity Relationships
• Measuring exchange rate movements
• Exchange rate equilibrium
• Factors affecting foreign exchange rate
• Forecasting foreign exchange rates.
• Interest Rate Parity
• Purchasing Power Parity &
• International Fisher effects
• Arbitrage
• Types of Arbitrage – Locational, Triangular and Covered Interest Arbitrage
(Theory & Problems).
 ARBITRAGE

• Arbitrage is the act of simultaneously buying currency in one market and selling it in
another to make a profit by taking advantage of price or exchange rate differences in
the two markets.
• If the arbitrage operation are confined to two markets only they will be known as
“two-point arbitrage.
• If they extend to three or more markets, they are known as “three-point” or “multi-
point arbitrage”.
 TYPES OF ARBITRAGE

• Spatial Arbitrage
• Spatial arbitrage Without Cost of transaction
• Spatial arbitrage With cost of transaction
• Locational Arbitrage
• Triangular arbitrage

• Interest rate arbitrage

• Covered Interest rate Arbitrage
• Uncovered interest rate arbitrage
 SPATIAL ARBITRAGE WITHOUT COST OF
TRANSACTION
• When there is price quotation discrepancy of a currency at two disjoint markets exists, the arbitrage
possibility exist.
• The rule buy where the currency is selling cheap and sell where the currency is selling at higher
prices.
• The two transactions are simultaneously conducted.
• Ex: 1USD = Rs. 72.4550/72.4502 in India
• 1USD = Rs. 72.4546/72.4548 in Srilanka
• Then buy 100USD, at Rs.72.4548 in Srilanka(100*72.4548=Rs. 7,245.4800) and sell 100USD in India at
72.4500 = (100X72.4550=7245.5000)
• Difference is 7245.5000-7245.4800=Rs. 0.02
 LOCATIONAL ARBITRAGE

• If demand and supply conditions for different banks for a particular currency differ, in that
case the banks may quote different prices for the same currency and market forces will
force realignment of the prices so that price offered by banks for the currency become
equal.
• Ex: Suppose two banks are offering the following price for USD
• Bank A: Rs.72.60/65
• Bank B: Rs. 72.67/70
• One can buy USD from Bank A at Rs. 72.65 per USD and sell in Bank B at Rs. 72.67 per USD
• If ask price of one quote is less than the bid price of another quote then spatial arbitrage
is possible.
 ASSUME THE FOLLOWING INFORMATION:
Given the following information, is locational arbitrage possible? If so explain the steps
involved and compute the profit from this arbitrager if you had USD10,00,000 to use. What
market forces would occur to eliminate any further possibilities of locational arbitrage?

ABC Bank XYZ Bank

Bid Price of NZD USD0.401 USD0.398
Ask Price of NZD USD0.404 USD0.400

Buy 1 NZD = 0.40: 1USD = 1/0.40NZD = 2.5 from XYZ Bank

So, 10,00,000 USD = 2.5X10,00,000 = 25,00,000 NZD
Sell 25,00,000 NZD at USD 0.404 to ABC Bank = 25,00,000X0.401 = 10,02,500 USD
Therefore profit = 10,02,500-10,00,000 = 2,500 USD
The large demand for NZD at XYZ Bank forces the bank’s ask price for NSD to increase and large
sales of NZD to ABC Bank will force its bid price to come down.
Once the ask price of XYZ Bank is no longer less than the bid price of ABC Bank, locational
arbitrage will no longer be beneficial.
 TRIANGULAR ARBITRAGE

• Triangular arbitrage is the result of a discrepancy between three foreign currencies

that occurs when the currency's exchange rates do not exactly match up.
• A triangular arbitrage opportunity occurs when the exchange rate of a currency does
not match the cross-exchange rate.
• The price discrepancies generally arise from situations when one market is
overvalued while another is undervalued.
PROBLEM ON TRIANGULAR ARBITRAGE
 MEASURING EXCHANGE RATES

• An exchange rate measures the value of one currency in units of another

currency.
• As economic conditions change exchange rates change substantially.
• A decline in a currency’s value is often referred to as depreciation.
• A increase in a currency value is often referred to as appreciation
MEASURING EXCHANGE RATE MOVEMENTS
MEASURING EXCHANGE RATE MOVEMENTS

• Ex: if 1CND = $0.71 spot rate at the earlier date and

1CND=$0.697 is the most recent spot rate then
• Percentage change in CND is =0.697-0.71/0.71 = -0.979%
• CND has depreciated against USD
 EXCHANGE RATE EQUILIBRIUM
• At any point in time, a currency should exhibit the price at which the demand for that
currency is equal to supply, and this represents the equilibrium exchange rate
 FACTORS AFFECTING FOREIGN
EXCHANGE RATE
• The equilibrium exchange rate will change over time as demand and supply
schedules change. f(ΔINF, ΔINT, ΔINC, ΔGC, ΔEXP)
• Where e= percentage change in the spot rate
• ΔINF=change in the differential between US inflation rate and the foreign
country’s inflation
• ΔINT= change in the differential between US interest rate and the foreign
country’s interest
• ΔINC= change in the differential between US income level and the foreign
country’s income level
• ΔGC=change in government controls
• ΔGC=change in expectations of future exchange rates
 FACTORS AFFECTING FOREIGN
EXCHANGE RATE
• Relative inflation rates
• Relative interest rates
• Relative Income Levels
• Government Controls
• Imposing foreign exchange barriers
• Imposing foreign trade barriers
• Intervening in he foreign exchange market
• Affecting macro variables such as inflation, interest rate and income levels

• Expectations
 FACTORS AFFECTING FOREIGN EXCHANGE
RATE
• Relative Inflation rate
• If inflation rate in one country increases the corresponding currency will depreciate
• If inflation rate in India increases relative to US inflation rate, the demand for USD in
India will increase as the Indians starts buying products in USA as buying in India
become expensive for Indians. Hence supply of rupees increase and the value of
Indian rupees will depreciate.
• On the other hand US people stops buying in India and supply of USD will decrease
in USA.
• The demand curve shift upwards and the supply curve shift inwards.
 FACTORS AFFECTING FOREIGN EXCHANGE
RATE
• Interest Rate
• If interest rate in India increases, the currency value of rupees will increase, i.e., rupee
appreciates.
• Demand for USD will decrease in India as people tend to invest rupees in India for higher
interest rate
• On the other hand, supply of US dollars in US will increase as the US people exchange US
dollars for rupees for making investment in India
• So the supply curve move upwards and demand curve move inwards
• But it is important to calculate real interest rate which is the difference between Nominal
interest rate and the inflation rate.
• If real interest is positive then only it is advantageous to make investment
 FACTORS AFFECTING FOREIGN EXCHANGE
RATE
• Income level
• If the income level of the people increases, people tend to buy foreign goods and the
demand for foreign currency will increase but it will not affect the supply curve.
• As people start buying in us, demand for US dollars in India will increase and hence
demand curve move upwards.
 FACTORS AFFECTING FOREIGN EXCHANGE
RATE
• Government Control
• The government of foreign countries can influence the equilibrium exchange rate in
many ways.
• Imposing foreign exchange barriers
• Imposing foreign trade barriers
• Intervening in foreign exchange markets and
• Affecting macro variables such as inflation, interest rates, and income levels
Suppose when US people invest in India for higher interest rates, if US government imposes
higher taxes on income earned by USA from India by way of interest, it would discourage the
exchange of rupees for dollars.
 FACTORS AFFECTING FOREIGN EXCHANGE
RATE
• Expectations:
• Another factor affecting exchange rates in market is expectations of future exchange rates.
• Like any other financial markets, foreign exchange markets react to any news that may have a future
effect.
• News of a potential surge in US inflation may cause currency traders to sell dollars anticipating a
future decline in dollars value.
• This response place immediate downward pressure on the dollar.
• Many institutional investors take currency position based on anticipated movements in interest rates
in various countries.
• Just as speculators can place upward pressure on a currency’s value when they expect that the
currency will appreciate, they can place downward pressure on a currency when they expect it to
depreciate.
 FORECASTING FOREIGN EXCHANGE RATE
MOVEMENTS
• Banks Speculation based on expected appreciation
• Banks Speculation based on expected depreciation
• Speculation by individuals
 FORECASTING FOREIGN EXCHANGE RATE
MOVEMENTS
• Banks Speculation based on expected appreciation
• When commercial banks believe that a particular currency is presently valued lower than
it should be in the foreign exchange market, they may consider investing in that currency
now before it appreciates.
• They would hope to liquidate their investment in that currency after it appreciates so that
they benefit from selling the currency for a higher price than they paid for it.
 FORECASTING FOREIGN EXCHANGE RATE
MOVEMENTS
• Banks Speculation based on expected depreciation
• When commercial banks believe that a particular currency is presently valued higher than
it should be in the foreign exchange market, they may borrow funds in that currency
now(and convert to their local currency now) before currency’s value declines to its
proper level.
• They would hope to repay the loan in that currency after it depreciates so that they would
be able to buy that the currency for a lower price than the price at which they initially
converted that currency in their own currency.
 INTERNATIONAL PARITY RELATIONSHIPS
• Exchange rate movements cannot be forecasted with accuracy.
• Many a times forecasts have been wrong, though many times it has been forecasted
with success.
• Also when exchange rates determination has been matched against historical
records it has had much explanatory power.
• It is essential to understand different theories of exchange rate determination to get
an answer to the fundamental questions like
• Are changes in exchange rate predictable?
• How does inflation affects exchange rates?
• How are interest rates related to exchange rates?
• What is the ‘proper exchange rte’ in theory?
 INTERNATIONAL PARITY RELATIONSHIPS

• In international exchange, parity refers to the exchange rate between the

currencies of two countries making the purchasing power of both currencies
substantially equal.

• Theoretically, exchange rates of currencies can be set at a parity or par level and
adjusted to maintain parity as economic conditions change.
 THEORIES OF EXCHANGE RATE
DETERMINATION

• The three theories of exchange rate determination are:

• Purchasing power parity

• Interest rate parity

• International Fisher Effect

 PURCHASING POWER PARITY
• Consider basket of goods
• These goods are available both in India and USA
RICE
• In India to purchase this basket of goods is Rs. 100 WHEAT
• In USA to purchase this basket of goods it is VEGETABLE
FRUITS
• USD 2$ (purchasing power) CLOTHES

• 2$=Rs.100
• 1$=100/2= Rs. 50/-
• Therefore 1$ Rs. 50/- is the exchange rate at purchasing power parity
 PPP - ASSUMPTIONS

• PPP theory explains the determination of long-run equilibrium exchange rate based
on relative price level of two countries
• No trade barriers(NO quota, no tariff –no trade barriers)
• Same basket of goods to calculate price index
• Identical goods(Features in both countries should be same)
• All the prices should be indexed to the same year
• Law of one price(identical basket of goods will ne sold at same price in both the
countries)
 PPP ABSOLUTE VERSION

• Identical basket of goods in two different countries must sell for the same price when
expressed in the same currency.
• The exchange rate is equal to the ratio of the price index of the basket of commodities in
the home market to the price index of the basket of commodities in the foreign market
• R=P/P*
• R = exchange rate
• P = Price index of basket of goods in home country in domestic currency
• P* = Price index of basket of goods in foreign country in foreign currency
 ABSOLUTE VERSION

• Price of basket of goods in India Rs. 100; In USA = 2$

• 1$= Rs. 50; PPP Exchange rate
• In India inflation rate increases, Price of basket of goods is Rs. 130
• There is no inflation in USA; The price of basket of goods is 2$
• 2$=Rs.130/-
• 1$= 130/2 = Rs.65; Rupees has depreciated
• In USA there is inflation; same basket of goods price is 4$
• 4$=Rs. 100; 1$=100/4 = Rs.25; Rupee has appreciated; USD has depreciated
 CRITISISM OF PPP

• Purchasing power of money cannot be measured in absolute term

• Different quality of goods in two different goods
• Difficult to select basket of commodities
• Problems associated with index number
• No direct and precise link between purchasing power of the currencies off the two
countries and their exchange rates(Based on demand and supply exchange rate ill be
decided in reality)
• Capital account transactions are neglected(Basket of goods are taken based on current
account)
 RELATIVE VERSION OF PPP

• It is propounded by Gustav Cassel as a means for measuring changes in equilibrium

exchange rate.
• Changes in the equilibrium rate of exchange rate between two currencies will be
governed by the changes in the rate of their respective purchasing power.
• The primary focus is the comparison between past(base rate) equilibrium exchange
rate with the current equilibrium exchange rate.
• Change between two equilibrium rates is primarily due to changes in the internal
purchasing power of the two currencies over a period of time.
• R1=Ro(Ph1/Pho) / (Pf1/pfo)
• R1=change in equilibrium exchange rate for current period
• Ro=Rs.50/$; Ph1=180; Ph0=100; Pf1=120; Pfo=100
• R1= 50X{(180/100)/(120/100)}=Rs.75/-
 PURCHASING POWER PARITY

• An increase in inflation decrease the value of currency. Why?

• The PPP theory focuses on the inflation-exchange rate relationships.
• It attempts to quantify inflation-exchange rate relationship.
• There are two popular forms of PPP theory:
• Absolute form of PPP
• Relative form of PPP
 ABSOLUTE FORM OF PURCHASING POWER
PARITY
• It is based on the notion that without international barriers, consumers
shift their demand to wherever prices are lower.
• It suggests that prices of the same basket of products in two different
countries should be equal when measured in a common currency.
• If discrepancy in prices as measured by a common currency exists,
the demand should shift so that these prices converge.
• Realistically the existence of transportation cost, tariffs, quotas may
prevent the absolute form of PPP.
 RELATIVE FORM OF PPP

• The relative form of PPP accounts for the possibility of market imperfections such as
transportation cost, tariffs and quotas.
• It acknowledges that because of these market imperfections, prices of the same
basket of goods in different countries will not necessarily be the same when
measured in a common currency.
• However it does state the rate of change in the prices of the baskets of goods should
somewhat be similar when measured in a common currency, as long as the
transportation costs and trade barriers are unchanged.
RATIONALE BEHIND RELATIVE PPP
USING PPP TO ESTIMATE EXCHANGE RATE
EFFECTS
 WHY PPP DOES NOT OCCUR

• Confounding effects
• Since the exchange rate movement is not driven solely by change in inflation rate, the
relation between the inflation differential and the exchange rte movement is not as simple
as suggested by PPP

• No substitutes for traded goods

 INTEREST RATE PARITY

• IRP that is responsible for exchange rate difference is the prevailing interest rate in both the countries.
• Interest rate prevailing in India is generally higher than interest rate in US
• It is Indian rupee that devalues against USD
• FFR=SR X (1+Ih)/(1+If)
• Interest rate in India=12%
• In USA=7%
• Borrow in US Convert to India and Invest in India. You would earn a differential of 5%
• Do you think this is so simple?
• As per IRP, it is not possible only
• At the time you borrowed exchange rate would be 1$ =70; But at the time of
repayment it would not be the same. It would have changed adversely in such a way
that the interest differential so earned shall be compensated by the exchange loss
arising on repayment of US loan
• Spot Rate 1$=Rs.64
• Resulting Gain = 100000$x64x5%=Rs. 3,20,000
• 100000 x 64 = Rs. 64,00,000/-
• 1 year forward rate
• FFR = S(1+il)/(1+if) = 64(1+0.12)/(1+0.07) = 66.9907
• Amount Borrowed 100000 + 70000 = 1,07,000
• Total amount payable by year end = 1,07,000x66,9907 = 71,68,000
• Amount payable = 1,07,000x64=Rs. 68,48,000 if exchange rate would not have changed.
• Excess amount paid = 71,68,000-68,48,000 = 3,20,000 due to changes in exchange rate
• As per IRP, the resulting exchange loss has completely offset the gain made through
interest rate differential
 INTEREST RATE PARITY

• Once market force cause interest rates and exchange rates to adjust such that
covered interest arbitrage is no longer feasible, there is an equilibrium state referred
to as interest rate parity.
• In equilibrium the forward rate differs from the spot rate by a sufficient amount to
offset the interest rate differential between two currencies.
 INTERNATIONAL FISHER EFFECT

• Along with PPP theory, another major theory in international finance is International Fisher effect.
• It uses interest rate rather than inflation rate differentials 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.
• International Fisher effect suggests that nominal interest rates of two countries differ because of the
difference in expected inflation between two countries.
• The theory suggests that the real interest rate is assumed to be the same in the two countries, the
difference in the nominal interest rates between two countries is completely attributed to the
difference in the expected inflation between the two countries.
• This theory is very useful because it only requires data on the nominal risk-free interest rates of the
two countries of concern to derive an expected movement in the exchange rate.
IMPLICATIONS OF INTERNATIONAL FISHER
EFFECT
• The international fisher effect theory suggest that currencies with high interest rates will have
high expected inflation and therefore will be expected to depreciate.
• Therefore MNC's and investors based in the United states may not necessarily attempt to invest
in interest bearing securities in those countries because the exchange rate effect could offset
the interest rate advantage.
• The exchange rate effect is not expected to perfectly offset the interest rate advantage in every
period.
• It could be less pronounced in some periods and more pronounced in other periods but
advocates of the IFE would suggest that on average, MNCs and investors that attempt to invest
in interest bearing securities with high interest rates would not benefit because the best guess
of the return (after accounting for the exchange rate effect) in any period would be equal to
what they could earn domestically.