21.2 Foreign Exchange Markets and Exchange Rates
The foreign exchange (forex) market is where one country's currency is traded for another's. An exchange rate is the price of one currency in terms of another. Rates can be quoted in two ways:
- Direct Quote (American Quote): The price of a foreign currency in U.S. dollars (e.g., \$1.10 per €).
- Indirect Quote (European Quote): The amount of foreign currency per U.S. dollar (e.g., €0.91 per \$).
Trades can be either spot trades (for immediate settlement) or forward trades (an agreement to exchange currency at a future date at a pre-determined rate).
Triangle Arbitrage
The use of the U.S. dollar as a common currency for quotes prevents arbitrage opportunities. If the quoted cross-rate between two non-U.S. currencies is inconsistent with their individual exchange rates against the dollar, a risk-free profit can be made through triangle arbitrage by trading through the three currencies.
21.3 Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP) is the idea that the exchange rate adjusts to keep purchasing power constant among currencies.
- Absolute PPP: Suggests that a commodity should cost the same regardless of the currency used to purchase it (the "law of one price"). It rarely holds in practice due to transaction costs, trade barriers, and product differences.
- Relative PPP: This is a more practical version which states that the change in the exchange rate is determined by the difference in the inflation rates between two countries. Specifically, the expected percentage change in the exchange rate is equal to the foreign inflation rate minus the U.S. inflation rate ($h_{FC} - h_{US}$).
Relative PPP Formula Components:
- $h_{FC}$: The inflation rate in the foreign country.
- $h_{US}$: The inflation rate in the United States (or the domestic country).
21.4 International Parity Conditions
There are several key relationships that link exchange rates, interest rates, and inflation.
Interest Rate Parity (IRP)
The Interest Rate Parity (IRP) condition states that any difference in interest rates between two countries is offset by the difference between the spot and forward exchange rates. This prevents risk-free profits from covered interest arbitrage. The approximate IRP relationship is:
$\frac{F_1 - S_0}{S_0} \approx R_{FC} - R_{US}$
IRP Formula Components:
- $F_1$: The forward exchange rate for a future period (e.g., 1 year).
- $S_0$: The current spot exchange rate.
- $R_{FC}$: The nominal risk-free interest rate in the foreign country.
- $R_{US}$: The nominal risk-free interest rate in the U.S. (domestic country).
Unbiased Forward Rates (UFR) and Uncovered Interest Parity (UIP)
The Unbiased Forward Rates (UFR) condition says that the forward rate ($F_1$) is an unbiased predictor of the future spot rate ($E(S_1)$). Combining IRP and UFR gives us Uncovered Interest Parity (UIP), which states that the expected change in the spot rate is driven by the interest rate differential.
The International Fisher Effect (IFE)
Combining PPP and UIP leads to the International Fisher Effect (IFE): $R_{US} - h_{US} = R_{FC} - h_{FC}$. This powerful result states that real interest rates are equal across countries. This means capital should flow between countries until real returns are equalized.
IFE Formula Components:
- $R_{US}$: The nominal interest rate in the U.S.
- $h_{US}$: The inflation rate in the U.S.
- $R_{FC}$: The nominal interest rate in the foreign country.
- $h_{FC}$: The inflation rate in the foreign country.
21.5-21.7 International Capital Budgeting and Risk
Evaluating an overseas investment requires converting foreign cash flows to the home currency. There are two equivalent methods:
- Home Currency Approach: Forecast future exchange rates (using UIP), convert all foreign cash flows to the home currency, and then discount at the home currency required return.
- Foreign Currency Approach: Determine the required return in the foreign currency (using IFE), discount the foreign cash flows to find the NPV in the foreign currency, and then convert this NPV to the home currency at the spot rate.
Exchange Rate and Political Risk
International firms face unique risks:
- Exchange Rate Risk: This is the risk that the value of a firm's cash flows will be affected by fluctuating exchange rates. It can be short-run (transaction exposure), long-run (economic exposure), or accounting-based (translation exposure). Short-run risk can be hedged with forward contracts.
- Political Risk: The risk that changes in value arise from political actions, such as changes in tax laws, restrictions on repatriating profits, or, in the extreme, expropriation of assets.
Chapter Review and Critical Thinking Questions
Solution:
a. It takes more francs to buy a dollar in the forward market (1.53) than in the spot market (1.50). Therefore, the dollar is selling at a premium relative to the franc.
b. Yes. Because the dollar is expected to be worth more francs in the future, the market expects the franc to weaken relative to the dollar.
Solution: I am relying on Relative Purchasing Power Parity. Because inflation is higher in Mexico, the Mexican peso is expected to depreciate relative to the dollar. The exchange rate, quoted as pesos per dollar, will increase.
Solution:
a. The exchange rate is quoted as Australian dollars per U.S. dollar. If it is expected to rise, it means it will take more Australian dollars to buy one U.S. dollar. Therefore, the Australian dollar is expected to get weaker.
b. According to Relative PPP, if the Australian dollar is weakening, it suggests that the inflation rate in Australia is higher than in the United States.
Solution: The correct answer is (d) A bond issued by Toyota in the United States with the interest payable in dollars. A Yankee bond is a type of foreign bond issued by a non-U.S. company in the U.S. market and denominated in U.S. dollars.
Solution: Not necessarily. It depends on whether the company is primarily an exporter or an importer. A U.S. exporter would benefit from a weaker dollar (a falling exchange rate), as it makes their goods cheaper for foreign buyers. A U.S. importer would benefit from a stronger dollar (a rising exchange rate), as it makes foreign goods cheaper to buy.
Solution: Additional advantages could include lower labor costs and closer proximity to growing Asian markets. The primary risks are political risk (e.g., changes in government policy, risk of expropriation) and exchange rate risk (fluctuations in the value of the Chinese yuan and Indian rupee against the dollar).
Solution: The domestic currency is relevant primarily for accounting and reporting purposes. The consolidated financial statements of the multinational must be presented in its home currency. It is also the currency in which dividends are typically paid to the parent company's shareholders.
Solution:
a. False. Higher inflation in Great Britain means the purchasing power of the pound is falling. We would expect the pound to depreciate relative to the dollar.
b. False. An expansionary monetary policy and higher inflation would cause the euro to depreciate. As an exporter invoicing in foreign currency, this would be beneficial, as each foreign currency unit would convert to more euros.
c. True. If you could accurately predict relative inflation rates, you could predict the direction of spot exchange rate movements according to Relative PPP, allowing for profitable speculation.
Solution:
a. Rising Euro: This means a weaker dollar. This is good for U.S. exporters (their goods become cheaper in Europe) and bad for U.S. importers (European goods become more expensive).
b. Stronger Pound: This is good for U.S. exporters and bad for U.S. importers.
c. Printing Reais: This will lead to high inflation and a rapidly depreciating real. This is bad for U.S. exporters to Brazil and good for U.S. importers from Brazil.
Solution: Interest Rate Parity (IRP) is expected to hold most closely. It is a no-arbitrage condition that applies to financial markets, which are highly integrated and efficient. Any deviation would be quickly eliminated by arbitrageurs. The other relationships, especially PPP, rely on the movement of goods and services, which face many more frictions and barriers.