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IF CChapter 6 & 7

The document explains key concepts in international finance, including Interest Rate Parity (IRP), Purchasing Power Parity (PPP), Fisher's Parity, and the Efficient Market Hypothesis (EMH). It covers types of IRP, the role of the International Money Market, and financial instruments like currency options and futures. Each concept illustrates the relationship between interest rates, exchange rates, and market efficiency, emphasizing the lack of arbitrage opportunities in foreign exchange markets.

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26 views11 pages

IF CChapter 6 & 7

The document explains key concepts in international finance, including Interest Rate Parity (IRP), Purchasing Power Parity (PPP), Fisher's Parity, and the Efficient Market Hypothesis (EMH). It covers types of IRP, the role of the International Money Market, and financial instruments like currency options and futures. Each concept illustrates the relationship between interest rates, exchange rates, and market efficiency, emphasizing the lack of arbitrage opportunities in foreign exchange markets.

Uploaded by

riyatalreja26
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Interest Rate Parity

Interest Rate Parity (IRP) is a fundamental concept in the field of


international finance that explains the relationship between interest rates,
spot exchange rates, and forward exchange rates.
It is based on the idea that there are no arbitrage opportunities in foreign
exchange markets.

Types of Interest Rate Parity:


Covered Interest Rate Parity
Uncovered Interest Rate Parity
Covered Interest Rate Parity
(CIRP):

Imagine you want to invest money, but you have two options:
1. Invest in your own country (domestic currency).
2. Convert your money to another country's currency, invest there, and then
lock in a future exchange rate (using a forward contract) to convert your
money back later.
CIRP says:
No matter which option you choose, the returns should be the same if you
hedge the exchange rate risk with a forward contract. This ensures
there’s no risk-free profit (arbitrage).
Uncovered Interest Rate
Parity (UIRP):

Now, imagine you skip the forward contract. You still have the same two
options:
Invest in your own country.
Convert your money, invest in another country, and bring it back later.
But this time, you don’t lock in the exchange rate. Instead, you just hope
the exchange rate in the future works in your favor.
UIRP says:
The expected change in the exchange rate should balance out the difference
in interest rates.
PPP Theory
Purchasing Power Parity (PPP) is an economic theory that explains the relationship between exchange
rates and the price levels of two countries.
It is based on the idea that in the absence of transportation costs, trade barriers, and other frictions, the price
of identical goods and services should be the same across countries when expressed in a common currency.
Simple Example:
Imagine you can buy a burger in the US for $5.
If the same burger costs ₹250 in India, then the exchange rate should be:
1 USD =50 INR (because 250÷5=50).1 \text{ USD } = 50 \text{ INR } \ (\text{because } 250 ÷ 5 =
50).1 USD =50 INR (because 250÷5=50).
So, PPP says the exchange rate should equal the price of the same thing in both countries
But what if prices are different?
If the burger costs ₹300 in India but $5 in the US, then ₹300 ÷ $5 = ₹60 per $1.
This means the Indian rupee is weaker than what PPP suggests.
Fisher’s Parity
Fisher’s Parity says:
The interest rate you see (called the nominal interest rate) is not the "real" return you
get. Why? Because inflation eats away some of your money’s value.
So, the nominal interest rate is made up of:
1. The real interest rate (your actual profit).
2. The inflation rate (the rising prices that reduce your purchasing power).
In Plain Words:
Imagine you invest ₹100 in a bank account that gives 8% interest.
After 1 year, you have ₹108. Sounds good, right?
But if prices (inflation) also went up by 5%, your ₹108 can only buy as much as ₹103 could
buy last year.
So, your real earning is only 3%.
The Fisher Effect helps us understand that the interest rates we see in the market include
inflation. To know how much you’re really earning, subtract inflation.
Efficient Market Hypothesis
(EMH)
The Efficient Market Hypothesis (EMH) applies to the foreign exchange
(FOREX) market. It explains how exchange rates respond to information and
why it’s challenging to consistently predict or profit from currency
movements.

What EMH Says About Currency Markets:


1. The foreign exchange market is one of the most efficient markets in the
world because of its high liquidity and constant flow of global information.
2. Exchange rates already reflect all available information, such as interest
rates, inflation rates, trade balances, political events, and economic data.
Forms of Efficiency in Currency
Markets:
•Weak Form Efficiency:
Exchange rates already reflect all historical price data.
Implication: Analyzing past exchange rate trends (technical analysis) won’t help you
consistently predict future rates or profit.

•Semi-Strong Form Efficiency:


Exchange rates incorporate all publicly available information, like central bank policies,
interest rate decisions, or trade deficits.
Implication: Fundamental analysis, such as studying a country’s economy or news events,
won’t give you an advantage because the market already factors it in.

•Strong Form Efficiency:


Exchange rates include all information, even private or insider information (e.g., confidential
central bank decisions).
Implication: No one, not even insiders, can consistently profit from trading currencies.
International Money Market
The International Money Market is a part of the global financial system where short-term borrowing,
lending, and trading of financial instruments take place between countries. It is specifically focused on
short-term funds with maturities typically less than one year.
The Eurocurrency Market is a global market where currencies are deposited and borrowed outside
their home countries, primarily in offshore financial centers, to facilitate international trade, investment,
and financing. Despite the name "Eurocurrency," it refers to any currency held outside its domestic
country, not just the euro.
Global Money Market Instruments:
1. Euro Deposit: A deposit made in a currency outside its home country, such as USD deposited in a
European bank (commonly called Eurodollars).
2. Euro Credit: Medium-term loans provided by banks in the Eurocurrency market, typically with
flexible interest rates tied to benchmarks like LIBOR.
3. Euro Notes: Short-term debt instruments issued by multinational corporations in the Eurocurrency
market, typically with maturities of 1 to 6 months.
4. Euro Commercial Papers: Unsecured, short-term promissory notes issued by corporations or banks
in the Eurocurrency market to raise funds quickly.
Currency Options
Currency Options are financial derivatives that give the holder the right, but not the obligation, to buy
or sell a currency at a specified exchange rate (called the strike price) on or before a certain expiration
date.
Some Popular Concepts:
· Call Option: A call option gives the holder the right, but not the obligation, to buy an asset at a specified
price (strike price) before or on a certain expiration date.
· Put Option: A put option gives the holder the right, but not the obligation, to sell an asset at a specified
price (strike price) before or on a certain expiration date.
· Foreign Exchange Option (FX Option): A foreign exchange option gives the holder the right, but not
the obligation, to buy or sell a specific amount of foreign currency at a predetermined exchange rate before
or on a specified expiration date.
· Strike Price: The price at which an option holder can buy or sell the underlying asset when exercising
the option.
· Spot Price: The current market price at which an asset can be bought or sold for immediate delivery.
· Forward Price: The agreed-upon price for a transaction that will occur at a specified future date, based
on the current spot price adjusted for various factors.
Currency Futures
Currency Futures are standardized contracts traded on exchanges, where two parties agree to buy
or sell a specific amount of one currency for another at a predetermined exchange rate on a set
future date.
· Unlike options, currency futures come with an obligation to buy or sell the currency at the agreed
price when the contract expires.
· If you enter a contract to buy euros at 1.12 USD per euro, you must buy the euros at 1.12 on the
contract's expiration date, regardless of the current market rate.
Example:
Imagine you enter into a EUR/USD futures contract:
You agree to buy 100,000 euros at 1.12 USD per euro on a set future date (say, 3 months from
now).
If the exchange rate at that time is 1.15, you make a profit because you can buy euros at a lower
price than the market rate.
If the exchange rate is 1.10, you make a loss because you have to buy euros at a higher price than
the market rate.

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