Taxmann’s International Financial Management | Text & Cases

ABOUT THE AUTHOR Prof. Madhu Vij is a former Senior Professor of Finance with over 4 decades of experience at the Faculty of Management Studies, University of Delhi. Her professional and teaching interests include the areas of International Finance, Risk Management, Banking and Financial Services, Corporate Finance and Accounting. At present she is the Academic Council Chair and President at Global Risk Management Institute, Gurugram. Currently, Prof. Vij also serves as the Government Nominee, The Institute of Company Secretaries of India and is an Independent Director for four private limited companies. She has been a Non-Executive Independent Director of MOIL Limited a Mini Ratna PSU from 25-6-2010 to 24-6-2013. She is a member, Board of Governors, Arun Jaitley National Institute of Financial MADHU VIJ Management (NIFM), Lal Bahadur Shastri Institute of Management, member Academic Advisory Body, Indian Institute of Management, Sirmaur, to name a few. Prof. Vij has received the Alumni Excellence award from Shri Ram College of Commerce, University of Delhi. Dr. Vij has participated and attended the Global Colloquium on ‘Participant Centred Learning’ at Harvard Business School, Boston, USA. She was on the Panel of Judges for award of PM’s trophy for selecting the best steel plant for 2 years (2011-2013) and has also been a member of Ad-Hoc Task Force, Results Framework Document (2011-2013).

Prof. Vij is ... actively involved in research, consultancy and training for several leading public and private organizations in the areas of Risk management, Project management, Strategic financial management, Case based method of learning and teaching, Finance for Non finance managers. She is on the editorial board of several Journals and has participated in Conferences and presented research papers both in India and abroad. Prof. Vij’s research interests include credit ratings and financial crisis, enterprise risk management and corporate sustainability, country risk analysis, foreign exchange risk management, treasury management, corporate valuation, asset liability management and corporate governance. She has completed a number of projects sanctioned by National bodies like UGC, RBI, ICSSR, SAIL and Delhi University. She serves on the editorial board and is also a reviewer for several academic journals, national and international conferences. Dr. Vij has extensively published research papers in International and national Journals of repute and has presented papers globally in the field of banking and finance. She has authored four books namely Multinational Financial Management, Management Accounting, Management of Financial Institutions and a book on Corporate Finance for NIIT for MBA participants for ITT, USA. She has also co-authored two books – one on ‘Merchant Banking and Financial Services’ and the second one on ‘Women’s Studies in India: A Journey of 25 Years’.

Prof. Vij had been the Director, Women’s Studies and Development Centre, University of Delhi for one year (June 2012 to July 2013) and is actively involved in working on Gender issues, has delivered special talks in this area and has also worked on a project on ‘Microfinance and Gender’.

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PREFACE TO FOURTH EDITION The Fourth edition has been thoroughly revised to help students understand the internationalization and globalization discipline of International Finance and understand the economic conditions and financial relations across borders. The focus of the book is on a wide range of issues covering global financial markets including the Foreign exchange markets and risk management, Currency futures and option, Interest rate and currency swaps, Multinational capital budgeting, working capital management, International monetary system and country risk analysis.

Keeping up with the earlier editions, the fourth edition continues to have case studies, project work and substantive illustrative practical application of concepts and techniques discussed in the chapter.

We invite Suggestions, Comments and readings from the readers for further development of this book at madhuvij@hotmail.com; madhufms@gmail.com.

MADHU VIJ

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PREFACE The importance of International Finance as a discipline has evolved significantly in the last three decades due to deregulation of financial markets and product and technological developments. The world has entered an era of unprecedented internationalisation and globalisation of economic activity. Each nation is economically related to the other nations of the world through a complex network of international traditions and financial relationships. In this context, International Finance has also become increasingly important as it links world trade and foreign investment.

The focus of the book is on decision making in an international context and it provides a thorough conceptual framework of the key decision areas in International Finance. The text offers a comprehensive analysis of the international financial markets including the foreign exchange market, the international financial system and the eurocurrency market. It also covers other important areas like currency futures and options, swaps, country risk analysis and capital budgeting in a multinational context. The book uses a number of examples containing both numerical and theoretical aspects that highlight the applications of various dimensions of international finance.

The book is appropriate for use in MBA, M Com, MBE, MIB, Post Graduate Diploma in Risk Management and other post-graduate specialised disciplines. An understanding of International Financial Management is crucial not only to large MNCs but also to the smaller companies who are now realising the need to understand International Finance since International Business is not necessarily restricted to large corporations. International Business is very relevant to even those companies that have no intention of engaging in it since these companies must recognise how their foreign counterparts will be affected by economic conditions in foreign countries – specially the movements of the exchange rates, foreign interest rates and inflation.

The text has been organised around five major areas.

Part I of the book presents an overview of the International Financial System (emphasising its institutional set up) and discusses why it is important to study International Finance and also gives the salient features of international finance. Chapter 1 gives an overview of international financial management.

Chapter 2 surveys the history of the international monetary system from the time period of the gold standard to the present time. It also gives particular attention to the period of the Bretton Woods System.

The International financial institutions with special focus on the World Bank, the International Monetary Fund and the European Monetary System are discussed in Chapter 3. Chapter 4 presents the balance of payments concepts and accounting.

Part II is devoted entirely to the forex market. Chapter 5 deals with derivatives, Chapters 6 and 7 of this part deal with foreign currency futures and option contracts that are traded on organised stock exchanges in a detailed manner. Chapter 8 provides an overview of the forex market with emphasis on the fundamentals of forex trading. It gives an overview of the operations of the spot and foreign exchange markets and also discusses how the foreign exchange is quoted and traded worldwide. Chapter 9 presents the fundamental parity relationships among exchange rates, interest rates and inflation rates. It is important to understand these relationships for practising financial managers in an international setting.

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PREFACE

Part III consists of 4 Chapters and deals with the management of foreign exchange exposure. Chapter 10 covers the management of foreign exchange risk and discusses the three kinds of exposures that MNCs face. Chapter 11 covers translation exposure or accounting exposure as it is generally called. The chapter discusses the various methods for translating financial statements. Chapter 12 deals with the management of transaction exposure that arises from contractual obligations denominated in a foreign currency. Chapter 13 covers the management of economic exposure.

Part IV provides a thorough discussion of the financial management of the multinational firm. Chapter 14 deals with foreign direct investment. Chapter 15 is concerned with the cost of capital and capital structure of the multinational firm. Chapter 16 is devoted to the application and interpretation of multinational capital budgeting. It explains the various methods of capital budgeting with the help of numerical examples and case studies. Chapter 17 discusses the multinational cash management. Chapter 18 identifies and analyses the various dimensions of country risk analysis. Chapter 19 provides an extensive treatment of the eurocurrency and Eurobond market.

Finally, Part V consists of 2 Chapters and deals with the financing of foreign operations. Chapter 20 discusses the interest rate and currency swaps and explains how they can be used to reduce financing costs and risks. Chapter 21 deals extensively with GDRs and ADRs. I would like to take this opportunity to thank all my friends, readers and colleagues who have helped me in this journey of revising the book. Special thanks to the entire team at TAXMANN, specially Mr. Mitrapal Yadav and Mr. Sumit Dwivedi for his constant patience and motivation.

MADHU VIJ

CONTENTS PAGE

About the Author

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Preface to fourth edition

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Preface I-9

PART I INTERNATIONAL FINANCIAL ENVIRONMENT Chapter 1 International Financial Management: An Overview

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Chapter 2 International Monetary System

26

Chapter 3 International Financial Institutions/Development Banks

48

Chapter 4 Balance of Payment

74

PART II THE FOREIGN EXCHANGE MARKETS Chapter 5 Derivative

97

Chapter 6 Foreign Currency Futures

110

Chapter 7 Foreign Currency Options

123

Chapter 8 The Foreign Exchange Market

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CONTENTS

Chapter 9 Theories of Foreign Exchange Rate Movement and International Parity Conditions

PAGE

192

PART III MANAGING FOREIGN EXCHANGE EXPOSURE Chapter 10 Management of Foreign Exchange Risk

205

Chapter 11 Management of Translation Exposure

213

Chapter 12 Management of Transaction Exposure

265

Chapter 13 Management of Economic Exposure

285

PART IV FINANCIAL MANAGEMENT OF THE MULTINATIONAL FIRM Chapter 14 Foreign Direct Investment

333

Chapter 15 Cost of Capital and Capital Structure of the Multinational Firm

342

Chapter 16 Multinational Capital Budgeting – Application and Interpretation

374

Chapter 17 Multinational Cash Management

410

Chapter 18 Country Risk Analysis

439

Chapter 19 Eurocurrency Market

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CONTENTS

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PART V MANAGING FOREIGN OPERATIONS Chapter 20 Interest Rate and Currency Swaps

493

Chapter 21 Depository Receipts – Global Depository Receipts and American Depository Receipts 551 GLOSSARY

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SUBJECT INDEX

589

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CHAPTER

Theories of Foreign Exchange Rate Movement and International Parity Conditions

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CONTEXT

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he present International Monetary System is characterised by a mix of freely floating, managed floating and fixed exchange rates. As such, no single theory is available to forecast exchange rates under all conditions. This chapter provides a systematic discussion of the key international parity relationships which help to explain exchange rate movements. A thorough understanding of parity relationships is essential for efficient financial management and helps the financial manager in understanding: 1. How to determine foreign exchange rates; and

2. The process by which foreign exchange rates can be forecasted.

The two theories discussed in this chapter are the Purchasing Power Parity (PPP) theory and the International Fisher Effect (IFE). If the PPP and IFE theories hold consistently, decision making by MNCs would be much easier. Because these theories do not hold consistently, an MNC’s decision making becomes very challenging.

CONTENT u u u u u

Introduction

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Comparison of PPP, IFE and IRP Theories

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Purchasing Power Parity (PPP)

International Fisher Effect (IFE)

u u

Summary

INTENT

T

Solved Problems

Review Questions Project Work Case

his chapter discusses the several key international parity relationships such as IRP and PPP that have profound implications for international financial management. The relationship between inflation and exchange rates according to the PPP theory is discussed first. The graphic analysis, along with the empirical testing of PPP, is discussed.

The PPP theory is discussed thoroughly as this is one of the most important and popular areas in international finance. The chapter then discusses the IFE. The IFE suggests that the exchange rate adjusts to cover the interest rate differential between two countries. This theory suggests that in efficient markets, 192

CH. 9 : THEORIES OF FOREIGN EXCHANGE RATE MOVEMENT AND INTERNATIONAL PARITY CONDITIONS

193

with rational expectations, the forward rate is an unbiased forecast of the future spot rate. Finally, the chapter presents a comparison of the three theories – PPP, IFE and IRP.

INTRODUCTION

The phenomenon of exchange rates movement is an important issue in international finance and managers of multinational firms, international investors, importers and exporters and government officials attach enormous importance to it. In fact, they have to deal with the issue of exchange rates every day. Yet, the determination of exchange rates remains something of a mystery. Forecasters with the most impressive records frequently go wrong in their calculations by substantial margins. However, many times poor forecasting is due to unforeseeable events. For example, at the beginning of 1984, all forecasters uniformly predicted that the dollar would decline against other major currencies. But the dollar proceeded to rise throughout the year although in other respects the general performance of the world economy did not radically depart from forecasts. This clearly shows that the theoretical models or other models used by forecasters were not correct and also that the mechanics of exchange rate determination needs to studied thoroughly.

The tremendous increase in international mobility of capital as a result of marked improvements in telecommunications all over and also lesser restrictions on international financial transactions has made the concept of exchange rate determination more complicated and difficult to understand. The above factors have often resulted in the forex market behaving like a volatile stock market. In fact, economists now have been forced to reverse their thinking about exchange rate determination.

Thus, while much remains to be learned about exchange rates, a lot is also understood about them.

Exchange rates forecasts have often been wrong, though many times they have also met with impressive success. Also, when exchange rate determination has been matched against historical records, it has had much explanatory power.

Are changes in exchange rates predictable? How does inflation affect exchange rates? How are interest rate related to exchange rates? What is the ‘proper exchange rate’ in theory? For an answer to these fundamental issues, it is essential to understand the different theories of exchange rate determination.

The three theories of exchange rate determination are:

1. Purchasing Power Parity (PPP), which links spot exchange rates to nations’ price levels.

3. The International Fisher Effect (IFE) which links exchange rates to nations’ nominal interest rate levels.

2. The Interest Rate Parity (IRP), which links spot exchange rates, forward exchange rates and nominal interest rates. (Already discussed in chapter 8)

PURCHASING POWER PARITY (PPP)

The PPP theory focuses on the inflation-exchange rate relationships. If the law of one price were true for all goods and services, we could obtain the theory of PPP. There are two forms of the PPP theory.

Absolute Purchasing Power Parity

The absolute PPP theory postulates that the equilibrium exchange rate between currencies of two countries is equal to the ratio of the price levels in the two nations. Thus, prices of similar products of two different countries should be equal when measured in a common currency as per the absolute version of PPP theory.

A Swedish economist, Gustav Cassel, popularised the PPP in the 1920s. When many countries like Germany, Hungary and Soviet Union experienced hyperinflation in those years, the purchasing power of

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the currencies in these countries sharply declined. The same currencies also depreciated sharply against the stable currencies like the US dollar. The PPP theory became popular against this historical backdrop.

Let Pa refer to the general price level in nation A, Pb the general price level in nation B and Rab to the exchange rate between the currency of nation A and currency of nation B. Then the absolute purchasing power parity theory postulates that Rab = Pa/Pb

For example, if nation A is the US and nation B is the UK, the exchange rate between the dollar and the pound is equal to the ratio of US to UK Prices. For example, if the general price level in the US is twice the general price level in the UK, the absolute PPP theory postulates the equilibrium exchange rate to be Rab = $2/£1.

In reality, the exchange rate between the dollar and the pound could vary considerably from $2/£1 due to various factors like transportation costs, tariffs, or other trade barriers between the two countries.

This version of the absolute PPP has a number of defects. First, the existence of transportation costs, tariffs, quotas or other obstructions to the free flow of international trade may prevent the absolute form of PPP. The absolute form of PPP appears to calculate the exchange rate that equilibrates trade in goods and services so that a nation experiencing capital outflows would have a deficit in its BOP while a nation receiving capital inflows would have a surplus. Finally, the theory does not even equilibrate trade in goods and services because of the existence of non-traded goods and services.

Non-traded goods such as cement and bricks, for which the transportation cost is too high, cannot enter international trade except perhaps in the border areas. Also, specialised services like those of doctors, hairstylists, etc., do not enter international trade. International trade tends to equate the prices of traded goods and services among nations but not the prices of non-traded goods and services. The general price level in each nation includes both traded and non-traded goods and since the prices of non-traded goods are not equalised by international trade, the absolute PPP will not lead to the exchange rate that equilibrates trade and has to be rejected.

Relative Purchasing Power Parity

The relative form of PPP theory is an alternative version which postulates that the change in the exchange rate over a period of time should be proportional to the relative change in the price levels in the two nations over the same time period. This form of PPP theory accounts for market imperfections such as transportation costs, tariffs and quotas. Relative PPP theory accepts that because of market imperfections prices of similar products in different countries will not necessarily be the same when measured in a common currency. What it specifically states is that the rate of change in the prices of products will be somewhat similar when measured in a common currency as long as the trade barriers and transportation costs remain unchanged.

Specifically, if subscript ‘0’ refers to the base period and ‘1’ to a subsequent period then relative PPP theory postulates that Rab1 =

Pai / Pa0

Pbi / Pb0

Rab0

where Rab1 and Rab0 refer to the exchange rates in period 1 and in the base period respectively.

If the absolute PPP were to hold true, the relative PPP would also hold. However, the vice versa need not hold. For example, obstructions to the free flow of international trade like transportation costs, existence of capital flows, government intervention policies, etc. would lead to the rejection of the absolute PPP. However, only a change in these factors would lead to the rejection of the relative PPP.

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Other problems with the relative PPP theory are: first, ratio of prices of non-traded goods to the prices of traded goods and services is consistently higher in developed nations than in developing nations, e.g., the 206 International Financial Management services of beauticians, hairstylists, etc., are more costly in developed nations than in developing nations. services of beauticians, hairstylists, etc., are more costly for in developed in developing nations.

This is partly due to the fact that in developed nations, labour to nations remain than in these occupations, it must This is partly due to the fact that in developed nations, for labour to remain in these occupations, it must receive wages somewhat comparable to the high wages in the production of traded goods and services. receive wages somewhat comparable to the high wages in the production of traded goods and services.

The result is that prices of non-traded goods and services is much higher in developed than in developThe result is that prices of non-traded goods and services is much higher in developed than in developing ing countries. Second, the general price level index includes the prices of both traded and non-traded countries. Second, the general price level index includes the prices of both traded and non-traded goods goods services andprices the prices of non-traded goods are not equalised by international but are andand services and the of non-traded goods are not equalised by international trade but aretrade relatively relatively higher in developed nations.

The result of the above is that the relative PPP theory will tend to higher in developed nations. The result of the above is that the relative PPP theory will tend to undervalue undervalue exchange rates fornations developed nations and overvalue exchange rates for developing nations exchange rates for developed and overvalue exchange rates for developing nations with distortions with distortions being greater the greater the differences in the levels of development.

Finally, since being greater the greater the differences in the levels of development. Finally, since various factors other thanvariousrelative factors other than levelsrates canininfluence short that run,the it can hardly price levels canrelative influenceprice exchange the short exchange run, it can rates hardlyinbethe expected relative be expected that in theanrelative will result in an accurate forecast.

PPP will result accuratePPP forecast.

In spite theofabove deficiencies, empirical tests that the therelative relativePPP PPPtheory theory often gives In of spite the above deficiencies, empirical testshave haveindicated indicated that often gives fairly good approximations rate,particularly particularly periods high inflation. fairly good approximationsofofthe theequilibrium equilibrium exchange exchange rate, in in periods of of high inflation.

Second, the PPP holds well over the very long run but poorly for shorter time periods.

Second, the PPP holds well over the very long run but poorly for shorter time periods.

Graphic Analysis of PPP

Graphic Analysis of PPP

Exhibit 9.1 shows the Purchasing Power Parity theory which helps us to assess the potential impact of Exhibiton9.1 shows the Purchasing Power axis Parity theory. which helps us toappreciation assess the potential impact of of inflation exchange rates.

The vertical measures the percentage or depreciation on exchange rates. to The measures thethe percentage appreciation or depreciation of the by theinflation foreign currency relative thevertical home axis currency while horizontal axis measures the percentage foreign the home currency while or thelower horizontal axis to measures the percentage by which which the currency inflationrelative in the to foreign country is higher relative the home country. The points in inflation in the country is higher or lowerbetween relative to home country.

The points in say the by thethe diagram show thatforeign given the inflation differential thethe home and the foreign country, diagram show that given the inflation differential between the home and the foreign country, say by X per X per cent, the foreign currency should adjust by X per cent due to the differential in inflation rates. The cent, the foreign currency X per cent due to the differential inand inflation rates. the Theequilibrium diagonal diagonal line connecting allshould these adjust pointsby together is known as the PPP line it depicts line connecting all these points together is known as the PPP line and it depicts the equilibrium position position between a change in the exchange rates and relative inflation rates. between a change in the exchange rates and relative inflation rates.

EXHIBIT 9.1:9.1: PURCHASING PURITY THEORY Exhibit Purchasing POWER Power Purity Theory Ih – If (%) PPP line

A

4

2

–4

–2

B

2

–2

–4

4

% change in the % D in the foreign foreign currency currency spot rate spot rate

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For example, point A represents an equilibrium point where inflation in the foreign country, say UK, is 4% lower than the home country, say India, so that Ih – If = 4%. This will lead to an appreciation of the British pound by 4% per annum with respect to the Indian rupee.

Point B in the diagram shows a point where the difference in the inflation rates in India and Mexico is assumed to be 3% so that Ih – If = – 3%. This will lead to an anticipated depreciation of the Mexican peso by 3 per cent, as depicted by point B. If the exchange rate responds to inflation differentials according to the PPP, the points will lie on or close to the PPP line.

Empirical Testing of PPP Theory

Substantial empirical research has been done to test the validity of PPP theory. The general conclusions of most of these tests have been that PPP does not accurately predict future exchange rates and that there are significant deviations from PPP persisting for lengthy periods.

INTERNATIONAL FISHER EFFECT (IFE)

The IFE uses interest rates rather than inflation rate differential to explain the changes in exchange rates over time. IFE is closely related to the PPP because interest rates are significantly correlated with inflation rates. The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the ‘International Fisher Effect.’

The IFE suggests that given two countries, the currency in the country with the higher interest rate will depreciate by the amount of the interest rate differential. That is, within a country, the nominal interest rate tends to approximately equal the real interest rate plus the expected inflation rate. Both, theoretical considerations and empirical research, had convinced Irving Fisher that changes in price level expectations cause a compensatory adjustment in the nominal interest rate and that the rapidity of the adjustment depends on the completeness of the information possessed by the participants in financial markets.

The proportion that the nominal interest rate varies directly with the expected inflation rate, known as the ‘Fisher effect’, has subsequently been incorporated into the theory of exchange rate determination.

Applied internationally, the IFE suggests that nominal interest rates are unbiased indicators of future exchange rates.

A country’s nominal interest rate is usually defined as the risk free interest rate paid on a virtually costless loan. Risk free in this context refers to risks other than inflation.

In an expectational sense, a country’s real interest rate is its nominal interest rate adjusted for the expected annual inflation rate. It can be viewed as the real amount by which a lender expects the value of the funds lent to increase on an annual basis. For a firm using its own funds, it can be viewed as the expected real cost of doing so. The nominal interest rate consists of a real rate of return and anticipated inflation. The nominal interest rate would also incorporate the default risk of an investment.

It is often argued that an increase in a country’s interest rates tends to increase the exchange value of its currency by inducing capital inflows. However, the IFE argues that a rise in a country’s nominal interest rate relative to the nominal interest rates of other countries indicates that the exchange value of the country’s currency is expected to fall. This is due to the increase in the country’s expected inflation and not due to the increase in the nominal interest rate. The IFE implies that if the nominal interest rate does not sufficiently increase to maintain the real interest rate, the exchange value of the country’s currency tends to decline even further.

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Graphic Analysis of the International Fisher 208 International Financial Management

Exhibit 9.2 illustrates the IFE. The X axis shows the percentage change in the foreign currency’s spot rate while the Y axis shows the difference between the home interest rate and the foreign interest rate (Ih-If).

Graphic Analysis of the International Fisher The diagonal line indicates the IFE line and depicts the exchange rate adjustment to offset the differential Exhibit rates.

9.2 illustrates the IFE.onThe axisline, shows the percentage change in the foreign currency’s rate in interest For all points theXIFE an investor will end up achieving the same yieldspot (adjusted -I ).

The while the Y axis shows the difference between the home interest rate and the foreign interest rate (I h f for exchange rate fluctuations) whether investing at home or in a foreign country. diagonal line indicates the IFE line and depicts the exchange rate adjustment to offset the differential in Point A in the showsona the situation where the foreign interest exceeds home interest rates.diagram For all points IFE line, an investor will end up achieving thethe same yieldinterest (adjustedrate for by 4 percentage points, yet, the foreign currency depreciates by 4 per cent to offset its interest rate advanexchange rate fluctuations) whether investing at home or in a foreign country. tage. This would mean that an investor setting up a deposit in the foreign country would have achieved Point A in the diagram a situation where thePoint foreign interest exceeds the home interest by cent 4 a return similar to what wasshows possible domestically.

B represents a home interest raterate 3 per percentage points, yet, the foreign currency depreciates by 4 per cent to offset its interest rate advantage. above the foreign interest rate. If investors from the home country establish a foreign deposit, they will This would mean that an investor upinterest a depositrate. in the foreign country would have achieved return be at a disadvantage regarding thesetting foreign But the IFE theory suggests that thea currency similar to what was possible domestically. Point B represents a home interest rate 3 per cent above the foreign should appreciate by 3 per cent to offset the interest rate disadvantage. interest rate. If investors from the home country establish a foreign deposit, they will be at a disadvantage Also, the IFE the suggests if a company regularly makes foreign takeappreciate advantagebyof3higher regarding foreignthat interest rate. But the IFE theory suggests thatinvestments the currency to should per foreign interest rates, it will achieve a yield that is sometimes below and sometimes above the domestic cent to offset the interest rate disadvantage. yield.

Also, the IFE suggests that if a company regularly makes foreign investments to take advantage of higher foreign interest rates, it will achieve a yield that sometimes below and sometimes above the domestic yield.

EXHIBIT 9.2: ILLUSTRATION OFisIFE LINE (WHEN EXCHANGE RATE CHANGES PERFECTLY OFFSET INTEREST RATE DIFFERENTIALS) Exhibit 9.2: Illustration of IFE Line (When exchange rate changes perfectly offset interest rate differentials) Ih-If (%) IFE line 5

3

B

F 1

–5

–3

–1

1

3

–1

E

5

% change in the % D in the foreign foreign currency’s currency’s spot rate spot rate

–3 Y

A –5

the line IFE like line like E and F reflect lower returnsfrom fromforeign foreign deposits deposits than thatthat PointsPoints aboveabove the IFE E and F reflect lower returns thanthe thereturns returns are possible domestically.

For example, point E represents a foreign interest rate that is 3 per cent above the are possible domestically. For example, point E represents a foreign interest rate that is 3 per cent above home interest rate.

Yet, point E suggests that the exchange rate of the foreign currency depreciated by 5 per the home interest rate. Yet, point E suggests that the exchange rate of the foreign currency depreciated more interest disadvantage. by 5cent pertocent tothan moreoffset thanitsoffset its rate interest rate disadvantage.

Points below the IFE line show that the firm earns higher returns from investing in foreign deposits. For example, consider point Y in the diagram. The foreign interest rate exceeds the home interest rate by 4 per

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Points below the IFE line show that the firm earns higher returns from investing in foreign deposits. For example, consider point Y in the diagram. The foreign interest rate exceeds the home interest rate by 4 per cent. The foreign currency also appreciated by 2 per cent. The combination of the higher foreign interest rate plus the appreciation of the foreign currency will cause the foreign yield to be higher than what was possible domestically. If an investor were to compile and plot the actual data and if a majority of the points were to fall below the IFE, this would suggest that the investors of the home country could have consistently increased their investment returns by investing in foreign bank deposits. Such results refute the IFE theory.

COMPARISON OF PPP, IFE AND IRP THEORIES

Table 9.1 compares three related theories of international finance, namely (i) Interest Rate Parity (IRP) (ii) Purchasing Power Parity (PPP) and (iii) the International Fisher Effect (IFE). All three theories relate to the determination of exchange rates. Yet, they differ in their implications. The theory of IRP focuses on why the forward rate differs from the spot rate and the degree of difference that should exist. This relates to a specific point in time. The, PPP theory and IFE theory focus on how a currency’s spot rate will change over time. While PPP theory suggests that the spot rate will change in accordance with inflation differentials, IFE theory suggests that it will change in accordance with interest rate differential.

TABLE 9.1: COMPARISON OF HRP, PPP AND IFE THEORIES

Theory

Key Variables of Theory

Interest rate party Forward rate premi- Interest differential (IRP) um (or discount)

Summary of Theory The forward rate of one currency with respect to another will contain a premium (or discount) that is determined by the differential in interest rates between the two countries. As a result, covered interest arbitrage will provide a return that is no higher than a domestic return.

Purchasing Power Percentage change Inflation rate differ- The spot rate of one currency with respect (Parity (PPP)) in spot exchange rate ential to another will change in reaction to the differential in inflation rates between the two countries. Consequently, the purchasing power for consumers when purchasing goods in their own country will be similar to their purchasing power when importing goods from the foreign country.

International Fisher Percentage change Interest rate differ- The spot rate of one currency with respect Effect (IFE) in spot exchange rate ential to another will change in accordance with the differential in interest rates between the two countries. Consequently, the return on uncovered foreign money market securities will, on an average, be no higher than the return on domestic money market securities from the perspective of investors in the home country.

Source: Jeff Madura, ‘International Financial Management”.

SUMMARY

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At the cornerstone of international finance relations, are the three international interest parity conditions, viz., the covered interest parity, the PPP doctrine and the international fisher effect.

CH. 9 : THEORIES OF FOREIGN EXCHANGE RATE MOVEMENT AND INTERNATIONAL PARITY CONDITIONS

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These parity conditions indicate degree of market integration of the domestic economy with the rest of the world.

The PPP theory focuses on the inflation-exchange rate relationship. Substantial empirical research has been done to test the validity of PPP theory. The general consensus has been that PPP does not accurately predict future exchange rates and there are significant deviations from PPP persisting for lengthy periods.

The IFE uses interest rates rather than inflation rate differential to explain the changes in exchange rates over time. IFE is closely related to PPP because interest rates are significantly correlated with inflation rates.

SOLVED PROBLEMS

Q1. Explain the rationale behind Purchasing Power Parity.

Ans. When inflation is high in a particular country foreign demand for goods in that country will decrease.

In addition, that country’s demand for foreign goods should increase. Thus, the home currency of that country will weaken; this tendency should continue until the currency has weakened to the extent that a foreign country’s goods are no more attractive than the home country’s goods.

Inflation differentials are offset by exchange rate changes.

Q2. Explain how you could determine whether Purchasing Power Parity exists.

Ans. One method is to choose two countries and compare the inflation differential to the exchange rate change for several different periods. Then determine whether the exchange rate changes were similar to what would have been expected under PPP theory.

A second method is to choose a variety of countries and compare the inflation differential of each foreign country relative to the home country for a given period. Then, determine whether the exchange rate changes of each foreign currency were what would have been expected based on the inflation differentials under PPP theory.

Q3. Explain why Purchasing Power Parity does not hold.

Ans. PPP does not consistently hold because there are other factors besides inflation that influence exchange rates. Thus, exchange rates will not move in perfect tandem with inflation differentials.

In addition, there may not be substitutes for traded goods. Therefore, even when a country’s inflation increases, the foreign demand for its products may not necessarily decrease (in the manner suggested by PPP) if substitutes are not available.

Q4. How is it possible for Purchasing Power Parity to hold if the International Fisher Effect does not?

Ans. For the IFE to hold, the following conditions are necessary:

(a) Investors across countries require the same real returns.

(b) The expected inflation rate embedded in the nominal interest rate occurs.

(c) The exchange rate adjusts to the inflation rate differential according to PPP

If conditions (i) or (ii) do not hold, PPP may still hold, but investors may achieve consistently higher returns when investing in a foreign country’s securities. Thus, IFE would be refuted.

Q5. Explain why the International Fisher Effect may not hold.

Ans. Exchange rate movements react to other factors in addition to interest rate differentials. Therefore, an exchange rate will not necessarily adjust in accordance with the nominal interest rate differentials, so that IFE may not hold.

200

REVIEW QUESTIONS

PART II : THE FOREIGN EXCHANGE MARKETS

1. Explain the Purchasing Power Parity theory and the rationale behind it.

4. Give reason as to why Purchasing Power Parity does not hold true?

2. What is the rationale for the existence of the International Fisher Effect?

3. Compare and contrast the Purchasing Power Parity theory, Covered Interest Arbitrage theory and the International Fisher Effect theory.

5. Differentiate between Absolute and Relative Purchasing Power Parity theory.

PROJECT WORK

1. Examine the relationship between relative inflation rates and exchange rate movements over time to test whether PPP exists or is their evidence to suggest that there are significant deviations over time. The exercise could be performed for different currencies.

2. Examine the relationship between interest rate differential and exchange rate changes for a few currencies over time to determine whether the International Fisher Effect (IFE) appears to hold over time for the currencies examined.

CASE 9.1

Parity Conditions in International Finance At the cornerstone of international finance relations, lie the PPP doctrine and the three international interest parity conditions, viz. the Covered Interest Parity (CIP), the Uncovered Interest parity (UIP) and the Fisher’s Real Interest Parity (RIP). These parity conditions indicate the degree of market integration of the domestic economy with the rest of the world.

Indian Evidence

Empirical estimates of parity conditions are plagued with theoretical and econometric difficulties that make conclusions difficult even in the case of well developed markets. Differences in estimates arise primarily from model specifications, choice techniques and due to sample periods over which the models are estimated. Theoretical difficulties arise from the existence of trade restrictions, transport and transaction costs, as also from rate consumption and interest rate smoothing behaviour. In practice, persistent swings in real exchange rate are observed. For India, Pattanaik (1999) finds that PPP over the long run defines the presence of a co-integrated relationship between exchange rate and relative prices and the misalignment at any point of time is corrected by 7.7 per cent per quarter through nominal exchange rate adjustments. Bhoi and Dhal (1998) tested for the relevance of UIP and CIP and concluded that neither holds true.

Other Countries

Much research has been conducted to test whether PPP exists. Various studies in US have found evidence of significant deviations from PPP, persistently for lengthy periods.

Whether the IFE holds true in reality depends on the particular time period examined. In 1978-79, the US interest rates were generally higher than foreign interest rates and the foreign currency values strengthened during this period, supporting IFE theory to an extent. However, during the 1980-84 period, the foreign currencies consistently weakened far beyond what would have been anticipated according to IFE theory. Also, during the 1985-87 period, foreign currencies strengthened to a much greater degree than suggested by the interest differential. Thus, IFE may hold for sometime, but there is evidence that it does not consistently hold true.

Questions

CH. 9 : THEORIES OF FOREIGN EXCHANGE RATE MOVEMENT AND INTERNATIONAL PARITY CONDITIONS

201

1. Explain the rationale for the deviations from the interest rate parity conditions in India. Do you think market imperfections also have a bearing on the parity conditions?

2. How important is the time varying risk premia in explaining the deviations?

International Financial Management Text & Cases

AUTHOR : MADHU VIJ PUBLISHER : TAXMANN DATE OF PUBLICATION : DECEMBER 2021 EDITION : 4TH EDITION

ISBN NO : 9789392211805 NO. OF PAGES : 608 BINDING TYPE : PAPERBACK

Rs. 995 | USD 50

Description International Financial Management provides an effective and detailed presentation of important concepts and practical application in today’s global business environment, which includes: u Foreign Exchange Market u International Financial System u Eurocurrency Market u Currency Futures & Options u Swaps u Country Risk Analysis u Capital Budgeting The key highlight of this book is that it uses several examples (both numerical & theoretical) to highlight the applications of various dimensions of international finance.

This book aims to fulfil the requirement of students of PGDM, MBA, M.Com., Master of Economics, Master of Finance & Control (MFC), MIB, other Post Graduate Diploma in Risk Management & other post-graduate specialized disciplines.

The Present Publication is the 4th Edition, authored by Prof. Madhu Vij. The book has been organized around five major areas, namely: u [International Financial Environment] emphasizing its institutional set-up while discussing why is it important to study international finance. This area is further subdivided into four chapters, namely:

n Overview of the International Financial Management n History of International Monetary System; Emphasis on Bretton Woods System n International Financial Institutions with a particular focus on the World Bank, International Monetary Fund (IMF), and European Monetary System

n Balance of Payment Concepts and Accounting u

u

u

u

[The Foreign Exchange Markets] n Derivatives n Foreign Currency Futures and Options Contracts that are traded on Stock Exchanges n Forex Markets with an emphasis on Fundamentals of Forex Trading, Overview of Operations of the Spot and Foreign Exchange Markets, How is Foreign Exchange Quoted and Traded Worldwide

[Managing Foreign Exchange Exposure] n Management of Foreign Exchange Risk with a discussion on kinds of exposure MNCs face n Translation Exposure or Accounting Exposure, which discusses the various methods for translating financial statements n Management of Transaction Exposure that arises from contractual obligations denominated in a foreign currency n Management of Economic Exposure

[Financial Management of the Multinational Firm] n Foreign Direct Investment n Cost of Capital and Capital Structure of the MNC n Application and Interpretation of MNC Capital Budgeting explaining various methods with the help of numerical examples and case studies n Multinational Cash Management n Identifies and Analyses the Various Dimensions of Country Risk Analysis n Eurocurrency and Eurobond Market

[Managing Foreign Operations] n n

Interest Rate and Currency Swaps explaining how they can be used to reduce financing costs and risks Global Depository Receipts and American Depository Receipts

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