International Financial Management Topic 3: Parity Conditions
- Discuss the implications of interest rate parity for exchange rate determination.
- Explain purchasing power parity, both the absolute and relative version. What causes deviations from purchasing power parity?
- Discuss the implications of the deviations from purchasing power parity for countries’ competitive positions in the world market.
- Suppose that the treasurer of IBM has an extra cash reserve of $100 million to invest for six months. The six-month interest rate is 8 percent per annum in the United States and 7 percent per annum in Germany. Currently, the spot exchange rate is €1.01 per dollar and the six-month forward exchange rate is €0.99 per dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should he or she invest to maximize the return?
- Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The interest rate is 8.0 percent per annum in the U.S. and 5.8 percent per annum in the U.K. Assume that you can borrow as much as $1.5 million or £1 million.
(a) Determine whether interest rate parity is currently holding.
(b) If IRP is not holding, how would you carry out covered interest arbitrage?
Show all the steps and determine the arbitrage profit.
(c) Explain how IRP will be restored as a result of covered arbitrage activities. - The annual inflation of Netherlands is given to be 4.22% and that of the US is 3.8%. According to purchasing power parity (PPP) will the US dollar appreciate or depreciate? And by how much?
- When PPP fails, does it imply the presence of profit making opportunities?
- In July, the one-year interest rate is 12% on British pounds and 9% on US dollars
(a) If the current exchange rate is $1.63: 1 GBP. What is the expected future exchange rate in one year?
(b) Suppose a change in expectations regarding future US inflation causes the expected future spot rate to decline to $1.52: GBP 1. What should happen to the U.S. interest rate? - Derive the relative PPP formula using Absolute PPP.
International Financial Management
Page 2 of 3 - Assume the interest rate is 16% on Pounds and 7% on Deutsche marks. At the same time, inflation is running at an annual rate of 3% in Germany and 9% in England.
(a) If the Deutsche mark is selling at a one-year forward premium of 10% against the pound, is there an arbitrage opportunity? Explain.
(b) What is the real interest rate in Germany? In England? - If the USD/Yen spot rate is Yen 218/USD and the interest rates in Tokyo and NY are 6% and 12% respectively. What is the expected USD/Yen exchange rate one year hence?
- Discuss the impact of transaction costs on the interest rate parity condition.
- In France in 1994, short-term interest rates and bond yields remained higher than in Germany, despite a better outlook for inflation in France. Does this situation indicate a violation of the Fisher effect? Explain.
- The Economist constructs the Big Mac index (compares the relative prices of the Big Mac) on a quarterly basis. This index is used to determine if the Law of One Price holds across countries in which McDonalds operates.
Comment on the usefulness of the index. Describe the characteristics of an index that will overcome the shortcomings of the Big Mac index. [Past exam question] - Tomoko Matsubara, is a currency arbitrager for Sumitomo in Tokyo. The spot rate this morning is Yen 120.50/$ and the early indications are that the 90-day interest rates in the US will rise from their current level of 4.1250% per annum. The US Federal Reserve is worried about rising inflation and has been considering raising interest rates by 25 basis points (0.25%). The 90-day forward exchange rate quoted to Matsubara-san by local banks such as Daichi-Kangyo are all Yen 119.60/$. The current 90-day Yen interest rate is 0.5% (half of one percent) per annum. Matsubara-san has Yen 300 million at her disposal.
Can Matsubara-san make a profit through covered interest arbitrage? If so, what is her profit in Yen in 90 days? [Past exam question] - Past exam question
(a) General Motors exports cars to Korea. Suppose that the Korean Won/US$ exchange rate changes from Won 172/$ to Won 215/$ over one year. Over the same period the inflation rate in the US is 4% and the inflation rate in Korea is 30%. Is GM less competitive at the end of the year assuming that currencies of key competitors remain unchanged against the Won? Show your workings and briefly explain.
International Financial Management
Page 3 of 3
(b) If PPP held exactly, then the Won would trade at one Won to the dollar. True or False? Explain. - Past exam question
Assume that today the following rates of exchange of the Swedish Krona against the U.S. dollar are being quoted:
Spot Krona 1.65/$
3-month forward Krona 1.67/$
In addition, the 3-month CD rate in the U.S. is 4% per annum.
As a result of an export transaction, your company has a receivable outstanding in Krona from a company in Sweden, which is due today. The Krona amount of the receivable was sold forward three months ago to your bank at a rate of Krona 1.68/$ when the spot rate was Krona 1.65/$. The delivery on the forward contract is also due today.
Suppose that your Swedish customer is on the phone right now asking for an extension of the credit period for another three months and is offering to pay 14% interest on the outstanding balance in Krona. When your firm borrows in U.S. dollars from the bank, it pays the CD rate plus 2%.
(a) If your Swedish customer is considered to be of about the same credit-worthiness as yourself, what annual rate of interest would he approximately have to pay today for a three-month credit in Krona?
(b) Given the circumstances, would you agree to provide the extension of the credit at the terms offered? Why? Why not?
Purchasing Power Parity
Q9 Derivation of PPP
Q2, Q3 Theories
Q7 When fails
Q14 Theory
Q6 Simple Calculation
Q16
Fisher Effect
Q13, Q10b
IRP
Q1, Q12 Theories
Q8 Calculation (IFE)
Q10 Calculation (IFE)
Q11 Tricky
Q4 Calculation
Q5 Calculation
Q15 Calculation
Q17 Past Exam question
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