International Financial Management

P G Apte

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 Introduction
• An exchange rate is the relative price of one
currency in terms of another
• It influences allocation of resources within and
across countries
• During the Bretton Woods era exchange rate was
treated as an exogenous variable
• With the advent of floating rates in 1973, attention
once again shifted to determinants of exchange
rates themselves
• Basics of exchange rate economics to be able to
evaluate forecasts given by “experts”
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Some Fundamental Relationships
•Absolute Purchasing Power Parity (PPP)
Law of one price: Price of a specified bundle of goods
and services, denominated in a given currency is same
everywhere
St = Pt/P*t
St is the spot rate expressed as number of units of
home currency per unit of foreign currency
Pt is the price index in the home country and Pt* is the
price index in the foreign country, both price indices
with reference to a common base year
•This "law" is not valid in practice- transport costs,
tariffs, quality differences etc.
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 Some Fundamental Relationships
• Relative Purchasing Power Parity and Exchange Rates
Proportionate change in exchange rate equals inflation
differential
[1+(∆S/S)] = (1+π)/(1+π *)

This will be true if St = k(Pt/P*t) k : Some constant

(∆S/S) denotes the proportionate change in the exchange
rate; π and π * denote inflation rates at home and the
foreign country respectively over the same period.
Faster inflation at home Home currency
depreciates at a rate equal to its excess inflation rate.

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Some Fundamental Relationships
– Real Exchange Rate is a measure of exchange rate
between two currencies adjusted for relative purchasing
power of the currencies
– Rt(B/A) = St(B/A)(PtB/PtA)
– St(B/A) denotes the nominal exchange rate at time t
expressed as units of A per unit of B while PtA and PtB
are price indices (say CPIs) in countries A and B with
reference to a common base year. The real exchange
rate Rt is also expressed as an index with reference to
the same base year
– Increase in Rt implies real depreciation of currency A
while a decrease implies real appreciation
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Some Fundamental Relationships
– If Relative PPP holds, Real Exchange rate would
remain constant
– The nominal and real exchange rates we have
considered are bilateral rates
– The concept of Effective Exchange Rate (EER) is
utilized to make multilateral comparisons
– Nominal EER (NEER) captures movements in a
currency vis-à-vis a basket of currencies.
– Real Effective Exchange Rate (REER) attempts to
capture changes in competitiveness vis-a-vis a group of
competitors in world markets rather than pair-wise
comparisons. It is NEER adjusted for inflation
differences between home and basket currency
countries
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 Some Fundamental Relationships
• Purchasing Power Parity (PPP) as a Model of
Exchange Rate Behaviour and Predictor
• Absolute PPP does not hold in practice. Reasons are
transport costs, non-homogeneous goods, non-traded
goods, trade barriers, non-homogeneous tastes etc.
• Relative PPP is found to hold approximately over long
periods of time – several years.
• Not very useful for short-term prediction of exchange rates
• Can provide an indication of long term trends if inflation
trends can be reasonably assessed.

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Some Fundamental Relationships
– Relative PPP often tested by estimating an equation
like P P t t -1
lnSt - lnSt -1 = a + b[ln( ) - ln( )]
* *
Pt P t -1

– And testing the hypotheses that a=0 and b=1

– An estimated
1993equation using1993
a cross section sample
/ 1973
log( Ei ) = a + b log( Pi Pi )
1973 1993 / 1973
Ei P US P US

– Gives reasonably good fit.

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 Some Fundamental Relationships
• Covered Interest Parity
– Covered interest parity relation in the absence of
transaction costs
(1 + niA ) Fn (B / A)
=
(1 + niB) S( B / A)
– iA and iB are annualized euromarket interest rates on n-
year deposits, Fn(B/A) is the n-year forward rate and
S(B/A) is the spot rate both expressed as units of A per
unit of B. This has been analyzed in Chapter 8

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 Some Fundamental Relationships
• Uncovered Interest Rate Parity
– In a world of perfect capital mobility the following
condition, known as Uncovered Interest Parity (UIP)
must hold
Se ( B/A) - S( B/A)
n
niA - niB =
S( B/A)

– Sne is the spot rate expected to rule n-years from now

and iA and iB are interest rates on A and B assets. This
says that interest rate differential equals expected
proportionate change in exchange rate. Investors must
be risk neutral.
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Some Fundamental Relationships
– UIP condition is not a causal relationship
– Combine UIP with relative PPP
– Let Ŝe denote the expected proportionate change in the
exchange rate
e= e - e
Ŝ π A π B
– Take UIP with n=1.
– iA – iB = Ŝe = πAe - πBe
– iA - πAe = rA = iB - πBe = rB
– This implies that with free capital flows and risk neutral
investors real interest rates are equalized between A
and B
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Some Fundamental Relationships
– UIP condition with n=1, can be re-written as
e
S (A/B)
S(A/B) =
1 + (iA - iB)

– Current spot rate is determined by the expected future

spot rate and the interest rate differential
– Suppoe country A raises its interest rate; what will
happen to S(B/A)? If iB remains unchanged and
expected spot rate Se(B/A) does not change, currency A
will appreciate.
– Will expectations remain unchanged?
– Four reasons why the UIP condition would be violated
in practice

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Some Fundamental Relationships
• Investors are risk averse and therefore would not be
guided only by expected returns
• Even if all investors are risk neutral, they could have
differing views about future exchange rate
movements
• Transaction costs and liquidity needs would force
people to hold some of their wealth in the currency
of their operating habitat even though the expected
return on a foreign currency is higher
• Exchange controls may prohibit portfolio shifts
between currencies and interfere with realization of
UIP

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 Structural Models of Exchange Rate
Demand for currency A arises from:
1 Rest of the World purchasing goods and services from A
and making payments in A’s currency(including payments
for factor services) or making unilateral transfers to
residents of A
2 ROW wishing to hold financial assets denominated in
currency A; ROW wishing to make direct investments in A
Supply of currency A arises from:
1 Residents of country A wishing to buy goods and services
from ROW or make unilateral transfers to ROW
2 Residents of country A wishing to make direct and
portfolio investments abroad including central bank of A

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 Structural Models of Exchange Rate
• Exchange rate is the equilibrium price that equates these
demands and supplies
• Different models of exchange rates differ in the emphasis
they put on the different components of demand for and
supply of a currency
• Flow models focus on flow demands and supplies arising
out of foreign trade. May also include some exogenous
capital flows.
• Asset market models focus on portfolio decisions of global
investors and consequent demand for assets denominated
in a particular currency

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 Structural Models of Exchange Rate
• Flow Models of Exchange Rate Determination
– A simple model of exchange rate determination with
floating rates is depicted in figures 1,2,3
– Figure 1shows the equilibrium in the Euro/$ market
when the supply curve is normal upward sloping
– Figures 2 and 3 show the case when the supply curve of
dollars is “backward bending”
– In the later case the equilibrium may be unstable.
– This is related to the Marshall-Lerner conditions of
International Economics
– The basic flow model ignores capital flows, lags and
expectations

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Structural Models of Exchange Rate

D S E: Equilibrium Exchange
Rate
Exchange
Rate
EUR/$

S
D

No. of Dollars

Figure 1

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Structural Models of Exchange Rate

Exchange
Rate
EUR/$

D
S

No.of Dollars

Figure 2

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Structural Models of Exchange Rate

Exchange
Rate
EUR/$
E

S
D

No.of Dollars

Figure 3

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 Structural Models of Exchange Rate
– Mundell-Fleming model attempts to correct the first of
these omissions by including capital flows.
– It makes capital flows dependent on interest rate
differential; the foreign interest rate is taken as given
– With “small country” and Standard Keynesian
assumptions it determines exchange rate, interest rate
and income level.
– More sophisticated versions dispense with these
assumptions.
• Asset Market Models
– Equilibrium exchange rate is that rate at which the
market as a whole is willing to hold the given stocks of
assets denominated in different currencies

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Structural Models of Exchange Rate
– The Current Account Monetary Model
• Reformulation of the famous monetary approach to balance of
payments
• There is only one asset viz. money. Residents of a country
hold only that country’s money
• Purchasing Power Parity holds
• In each country, there is a stable demand-for- money function
• The core of the model is the assertion that domestic residents,
when faced with a discrepancy between the stock of
(domestic) money they wish to hold and the actual stock of
money created by the monetary authority, will attempt to
correct it by running a balance of payments deficit or surplus

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Structural Models of Exchange Rate
• The final equation

s = k + (mA - mB) - φ( yA - yB) + λ(iA - iB)

• s denotes the (natural) logarithm of the exchange
rate stated as amount of home currency (currency of
country A) per unit of foreign currency (currency of
B), m, y and i with appropriate subscripts denote
respectively, logarithms of nominal money stock,
real income and nominal interest rate in countries A
and B

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Structural Models of Exchange Rate
• When money supply in country A rises, other things
remaining the same, s rises i.e. currency of A depreciates
• An increase in domestic interest rate iA depreciates the A-
currency (Contradicts UIP?)
• The model can be extended
– Capital Account Monetary Model
• PPP holds in the long run
• There is a stable demand-for-money function in each country
• Uncovered interest parity and the Fisher open conditions hold
• Expected change in the exchange rate in the short run depends
upon perceived departures from long run equilibrium
exchange rate and expected inflation differentials

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Structural Models of Exchange Rate
• The Frankel Model

s = m̂A - m̂B - θϕ ( ŷA - ŷB) + αα (iA - iB) + β (π eA - ππ eB)

• Symbols with a "ˆ" over them denote the long run
values of the corresponding variables
• The Frankel model predicts that an increase in
money supply will depreciate the exchange rate in
the long run while an increase in real income will
lead to an appreciation
• The effect of an increase in interest rate depends
upon whether it is caused by "monetary tightness"
or by an upward revision of inflationary
expectations

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Structural Models of Exchange Rate

– Portfolio Balance Models

• Asset choice must be modeled as a portfolio
diversification problem
• Various versions of the portfolio balance theories of
exchange rate utilize the well-known mean-variance
portfolio selection framework
• Empirical performance in predicting exchange rate
movements has also been not significantly better
than other structural model

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Structural Models of Exchange Rate
– Expectations, the Efficient Markets Hypothesis
and the Role of "News"
– Any new pertinent information alters traders'
views regarding future course of prices and is
immediately reflected in the current price
– Efficient Markets Hypothesis (EMH)
– Importance of expectations and unanticipated
events

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Structural Models of Exchange Rate
– The total change (st+1-st) can be decomposed into two
parts
St+1 - St = Et(St+1) - St + St+1 - Et(St+1)
= Expected change + Unanticipated change
– The expected change in the spot rate is the discounted
sum of expected changes in the fundamentals (both
expectations formed at time t i.e. now) from t to t+1,
t+2, t+3 ….
– The unanticipated change in exchange rate from t to
t+1 is due to the changes in expectations, between t
and t+1, about future values of the fundamentals

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Structural Models of Exchange Rate
The expected changes in fundamentals are already
impounded in the current spot rate.
The changes in these expectations are due to the
“news” that arrives between t and t+1 – events that
were not anticipated at time t.
This accounts for high volatility of exchange rates and
the positive correlation between spot and forward
rates.

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 Exchange Rate Forecasting
• Exchange rate forecasts are an important input
into a number of corporate financial decisions
• Forecasting methodologies can be divided into
two broad categories
– Structural economic models of exchange rate
determination such as the PPP or the monetarist model
– “Pure forecasting models" that includes time series
methods and "technical analysis"
– Recent developments in modeling and predicting
financial time series have applied mathematical tools
like Chaos Theory and Neural Networks
– Composite Forecasts – A combination of different
forecasts
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 Exchange Rate Forecasting
• The value of a forecast depends upon
– The use to which the forecast is put
– The corporation's "loss function" i.e. the cost incurred
when forecasts turn out to be wrong
– How much does the forecast contribute to better
decision making given that the firm has its own sources
of information and is able to generate its own forecasts
– The forward rate is always available as a forecast free
of charge. Any forecast paid for must do considerably
better than forward rate in predicting direction and
magnitude of movement

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 The Exchange Rate of the Rupee
• The exchange rate system in India has had a chequered
history
• Determinants of exchange rate movements in India are
difficult to assess during the period of managed float
• The RBI policy in 2000 : No fixed target for exchange rate
nominal or real. RBI acts to moderate excessive
fluctuations and prevent panics.
• Behavior of the spot rate in India is largely governed by
trade related flows since the capital account continues to
be strictly controlled
• In the very short run, portfolio decisions of FIIs can
generate significant volatility in the rupee exchange rate

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