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FINS3616-无代写
时间：2022-11-21
UNSW Sydney
FINS3616
International Business Finance
T3,2022
Lecture 3
Mohamad Mourad – Lecturer in Charge
(m.mourad@unsw.edu.au)
Lecture 3 –
Schedule
• The Fisher Effect (FE)
• International Fisher Effect (IFE)
• Uncovered Interest Rate Parity
(UIRP)
• Covered Interest Rate Parity
(CIRP)
• Unbiasedness Hypothesis
• Proof of PPP Theory
• Week 3 BONUS Exercise
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616
International Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any
way, shape or form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity
or individual, however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distributio d r -us of thes n tes outsid the cop f t e course, in any way, shape or form
is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual, however
defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
General Announcement: iLab Sessions in Week 3 – 4
- iLab sessions are on in Week 3 and 4.
- Students must only attend the iLab Session in which they are officially enrolled.
Attendance will be recorded. You will be asked to leave if you show up to the wrong
iLab session.
- The iLab assignment will be released at the end of the last iLab session in Week 4.
- Forecast exchange rates based on historical macro-economic data in FACTSET.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Recap of International Parity Condition 1 and 2
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Key Theoretical Relationships in International
Macroeconomics
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Recap of APPP and RPPP
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Parity Condition 3:
The Fisher Effect (FE)
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Fisher Effect (FE)
- The Fisher Effect expresses the relationship between the nominal interest rate, the
expected inflation rate and also the real interest rate in an economy.
- The Fisher Effect for a one-period investment horizon is expressed as:
1 + = (1 + )(1 + )
where
- represents the nominal interest rate per annum,
- represents the expected rate of inflation per annum,
- represents the real interest rate per annum.
- Note: The approximation to the Fisher Effect is: ≈ + . The approximation works
well when the rate of expected inflation is low. Why?
- Note: The Fisher Effect can be used in both a forecasting and historical orientation.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Fisher Effect (FE) – Example 1
- If an investor requires a real return of 3.50%, and the expected inflation rate is 2.50%,
then the expected rate of return is:
= 1 + 0.025 1 + 0.035 − 1
= 0.060875 6.0875%
- Using the approximation of the Fisher Effect, we arrive at:
3.50% + 2.50% = 6%
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Fisher Effect (FE) – Example 2 (For you)
- If an investor requires a real return of 5.89%, and the expected inflation rate is 1.83%,
then the expected rate of return is:
- Using the approximation of the Fisher Effect, we arrive at:
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Parity Condition 4:
The International Fisher Effect (IFE)
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The International Fisher Effect (IFE)
- Ceteris paribus, increases in the expected rate of inflation are associated with
increases in the nominal interest rate and a decrease in the future nominal exchange
rate.
- Thus, nominal interest rate increases are associated with currency value
depreciations.
- Specifically, the IFE predicts that:
o Currencies of countries where high interest rates exist should depreciate relative
to currencies with low interest rates.
o Currencies of countries with low interest rates should appreciate relative to
currencies with high interest rates.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The International Fisher Effect (IFE)
- The one-period expression for the International Fisher Effect is:
1 + ℎ
1 +
ℎ/ = ℎ/
- The multi-period expression for the International Fisher Effect is:
ς=1
1 + ℎ,
ς=1
1 + ,
ℎ/ = ℎ/,
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The International Fisher Effect (IFE) – Example 1
- If the one-year nominal interest rate in Australia is 4.50% and the one-year interest
rate in the US is 2%, then assuming a spot exchange rate of USD0.77/AUD, what is
the expected exchange rate at the end of one year?
1.02
1.045
0.77/ = 0.7516/
- What is the percentage change in the spot rate over this period?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The International Fisher Effect (IFE)
- In equilibrium, the nominal interest rate differential should equal the expected inflation
differential. Mathematically, we have:
1 + ℎ
1 +
=
1 + ℎ
1 +
- Economies with price levels exhibiting expectations of a higher inflation rate should
have higher nominal interest rates than other economies. The exchange rate must
reflect this difference in expected inflation rates.
- For example, if the expected rate of inflation of the price level in Australia is 3% over
the next 12 months, while the expected rate of inflation of the price level in South
Korea is 7% over the same period, then on average, nominal interest rates in South
Korea should be approximately 400 basis points higher than in Australia.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The International Fisher Effect (IFE) In Practice
Source: The Economist, 2007
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Parity Condition 5:
Uncovered Interest Rate Parity (UIRP)
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Uncovered Interest Rate Parity (UIRP)
- Uncovered Interest Rate Parity (UIRP) assumes traders remain exposed to exchange
rate risk and make, on average, zero profits from trading.
- Conceptually, since traders do not hedge their exposure to exchange rate risk
according to UIRP, we do not identify the forward rate, ℎ/, but rather the spot rate
expected at the end of the investment period, ℎ/ .
- UIRP for a one-period investment horizon is:
1 + ℎ
1 +
ℎ/ = ℎ/
- UIRP for a -period investment horizon is:
ς=1
1 + ℎ,
ς=1
1 + ,
ℎ/ = ℎ/,
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Parity Condition 6:
Covered Interest Rate Parity (CIRP)
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Covered Interest Rate Parity (CIRP)
- Covered Interest Rate Parity (CIRP) implies that the currency of a nation with higher
nominal interest rates should trade at a forward discount relative to the currencies of
nations with comparatively lower nominal interest rates. CIRP, for a one-period
investment horizon is expressed as:
1 + ℎ
1 +
ℎ/ = ℎ/
where
- ℎ/ represents the forward exchange rate between the home country, ℎ, and the
foreign country, .
- The expression for CIRP in a -period investment horizon is:
ς=1
1 + ℎ,
ς=1
1 + ,
ℎ/ = ℎ/,
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Covered Interest Rate Parity (CIRP)
- Another way to think of CIRP is the return obtained from investing domestically must
equal the return on the covered, that is, hedged foreign investment.
- By approximation, forward differential = nominal interest rate differential.
- Thus, in equilibrium it does not matter where you invest since the returns are
equalized.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Covered Interest Rate Parity (CIRP) – Replicated
- CIRP also implies that a domestic investment (i.e. a loan) can be replicated by
combining a foreign investment (loan) with a forward contract.
1. An investor borrows an amount, , of AUD today for a period of 1 year at .
2. Once the proceeds are obtained, the investor sells AUD in the spot market and
receives /.
3. The USD-equivalent of AUD is then invested in US money markets for 1 year at a
rate of .
4. The investor then adds a forward contract to sell / 1 + , which is in
USD, next year in exchange for AUD at the forward rate, /.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Covered Interest Rate Parity (CIRP) – Replicated
5. At the end of the year, the investor sells 1 + in exchange for:
/ 1 +
/
6. The investor has to repay 1 + at the end of one year. The investor is then left
with:
=
/ 1 +
/
− 1 +
- When CIRP holds, arbitrage must be 0.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Covered Interest Rate Parity (CIRP) – Replicated
- When the hedged foreign return does not equal the domestic return:
• Scenario 1: If 1 + <
1+ /
/
funds will flow from Australia to the US,
until returns are equalized.
• Scenario 2: If 1 + >
1+ /
/
funds will flow from the US to Australia
until returns are equalized.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Covered Interest Rate Parity (CIRP) – Example 1
- You decide to borrow AUD10,000 and obtain the following information from an
analyst.
- Can you obtain an arbitrage?
Particulars Bid Rate Ask Rate
/ 0.76/ 0.77/
/ 0.50/ 0.57/
5.53% 6.28%
3.85% 4.13%
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Covered Interest Rate Parity (CIRP) – Example 2
- You have the following information from an analyst.
- Suppose it was USD10,000 that you borrowed. Can you obtain an arbitrage?
Particulars Bid Rate Ask Rate
/ 0.76/ 0.77/
/ 0.50/ 0.57/
5.53% 6.28%
3.85% 4.13%
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Transaction Approach to Establishing the Existence
of Arbitrage
- In practice, you will need to work out what currency to borrow in to obtain a riskless
profit.
- The following example is taken from Edition 2 of Bekaert and Hodrick (Chapter 6
Problem 6) and also from Peter Andersen’s notes.
- As a trader for Goldman Sachs in Kuala Lumpur you the see following prices. Is there
a possibility for arbitrage?
- We can test whether the two no-arbitrage conditions hold directly.
Particulars Bid Rate Ask Rate
EUR Interest Rate 6.000% 6.125%
MYR Interest Rate 10.500% 10.625%
Spot Rate MYR4.6602/EUR MYR4.6622/EUR
1-year Forward Rate MYR4.9500/EUR MYR4.9650/EUR
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Condition 1: No Inward Arbitrage
- There exists no inward arbitrage if and only if the quoted forward ask rate satisfies:
>
1 + ,
1 + ,
4.9650/ >
1 + 0.10500
1 + 0.06125
4.6602/ = 4.8523/
- The right-hand side of the inequality specifies the minimum forward ask rate. Above
that, no arbitrage can be made by borrowing EUR to invest in MYR.
Particulars Bid Rate Ask Rate
EUR Interest Rate 6.000% 6.125%
MYR Interest Rate 10.500% 10.625%
Spot Rate MYR4.6602/EUR MYR4.6622/EUR
1-year Forward Rate MYR4.9500/EUR MYR4.9650/EUR
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Condition 2: No Outward Arbitrage
- There exists no outward arbitrage if and only if the quoted forward bid rate satisfies:
<
1 + ,
1 + ,
4.9500/ ≮
1 + 0.10625
1 + 0.06000
4.6622/ = 4.8656/
- The right-hand side of the inequality specifies the maximum forward bid rate. Below
that, no arbitrage can be made by borrowing MYR to invest in EUR.
Particulars Bid Rate Ask Rate
EUR Interest Rate 6.000% 6.125%
MYR Interest Rate 10.500% 10.625%
Spot Rate MYR4.6602/EUR MYR4.6622/EUR
1-year Forward Rate MYR4.9500/EUR MYR4.9650/EUR
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Unbiasedness Hypothesis
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Unbiasedness Hypothesis
- What can we assume, in theory at least, about the forward rate investors want to lock
in should they want NO exposure to exchange rate risk?
- According to mainstream financial theory, investors are unbiased and rational agents.
- In more technical terms, the mean forecast error of investors’ models is 0.
Mathematically, we have:
σ=1
[(ℎ/,) − ℎ/,]
= 0
- The Unbiasedness Hypothesis indicates that no systematic differences exist between
the expected future spot rate and the forward rate. Thus, mathematically we have:
ℎ/, = ℎ/,
on average implying equality between the forward rate and the expected spot rate.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Unbiasedness Hypothesis in Practice – Carry Trade
- Empirically, the unbiasedness hypothesis is weak.
- Profitable carry trade by hedge funds is to go long in foreign currencies that trade at a
discount and go short in currencies that trade at a premium.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Currency Forecasting
- If exchange rates can be forecasted perfectly, then exchange rate risk is eliminated.
- Unfortunately, it is not easy or straightforward to do. The iLab session worksheet and
iLab assignment will give you a sense of the work involved in forecasting exchange
rates.
- Research studies have identified that random walk models are superior than most
structural models.
- Market efficiency:
o All publicly available information is incorporated in the market price.
o Future exchange rate changes should be unpredictable.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Market-Based Forecasts
- If market efficiency holds, then market participants have already incorporated
expected currency changes in interest rates and forward rates.
- UFR: forward rate is an unbiased estimate of the future expected spot rate:
+1 = +1
- However, forward contracts > 1 year are limited.
- IFE and PPP do not always hold in practice.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Proof of Purchasing Power Parity (PPP) Theory
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Key Theoretical Relationships in International
Macroeconomics
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Proof of PPP
- In what follows is a proof that I personally have constructed.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Proof of PPP
- Writing space.
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Proof of PPP
- Writing space.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Proof of PPP
- Writing space.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Proof of PPP
- Writing space.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Some Final Thoughts for Consideration
- Economists argue that although PPP theory holds poorly in practice and in the short
run, it is theoretically aimed at holding over the long run.
- Does RPPP and IFE provide roughly the same estimate of the expected spot rate?
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Week 3 BONUS Exercise
Deloitte Access Economics has published 10-year forecasts for
the rate of inflation in Australia and France.
Find the latest closing quote of the AUD/EUR and forecast the
exchange rate, 5 years from now. Repeat for 10 years from now.
You should be using Excel for this exercise.
Year 1 2 3 4 5 6 7 8 9 10
AUS 2% 5% 3% 2% 3% 4% 5% 5% 3% 2%
EUR 2% 8% 4% 1% 2% 3% 1% 2% 2% 3%
FINS3616
International Business Finance
T3,2022
Lecture 3
Mohamad Mourad – Lecturer in Charge
(m.mourad@unsw.edu.au)
Lecture 3 –
Schedule
• The Fisher Effect (FE)
• International Fisher Effect (IFE)
• Uncovered Interest Rate Parity
(UIRP)
• Covered Interest Rate Parity
(CIRP)
• Unbiasedness Hypothesis
• Proof of PPP Theory
• Week 3 BONUS Exercise
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International Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any
way, shape or form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity
or individual, however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distributio d r -us of thes n tes outsid the cop f t e course, in any way, shape or form
is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual, however
defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
General Announcement: iLab Sessions in Week 3 – 4
- iLab sessions are on in Week 3 and 4.
- Students must only attend the iLab Session in which they are officially enrolled.
Attendance will be recorded. You will be asked to leave if you show up to the wrong
iLab session.
- The iLab assignment will be released at the end of the last iLab session in Week 4.
- Forecast exchange rates based on historical macro-economic data in FACTSET.
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Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Recap of International Parity Condition 1 and 2
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Key Theoretical Relationships in International
Macroeconomics
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Recap of APPP and RPPP
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Parity Condition 3:
The Fisher Effect (FE)
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The Fisher Effect (FE)
- The Fisher Effect expresses the relationship between the nominal interest rate, the
expected inflation rate and also the real interest rate in an economy.
- The Fisher Effect for a one-period investment horizon is expressed as:
1 + = (1 + )(1 + )
where
- represents the nominal interest rate per annum,
- represents the expected rate of inflation per annum,
- represents the real interest rate per annum.
- Note: The approximation to the Fisher Effect is: ≈ + . The approximation works
well when the rate of expected inflation is low. Why?
- Note: The Fisher Effect can be used in both a forecasting and historical orientation.
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The Fisher Effect (FE) – Example 1
- If an investor requires a real return of 3.50%, and the expected inflation rate is 2.50%,
then the expected rate of return is:
= 1 + 0.025 1 + 0.035 − 1
= 0.060875 6.0875%
- Using the approximation of the Fisher Effect, we arrive at:
3.50% + 2.50% = 6%
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The Fisher Effect (FE) – Example 2 (For you)
- If an investor requires a real return of 5.89%, and the expected inflation rate is 1.83%,
then the expected rate of return is:
- Using the approximation of the Fisher Effect, we arrive at:
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Parity Condition 4:
The International Fisher Effect (IFE)
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The International Fisher Effect (IFE)
- Ceteris paribus, increases in the expected rate of inflation are associated with
increases in the nominal interest rate and a decrease in the future nominal exchange
rate.
- Thus, nominal interest rate increases are associated with currency value
depreciations.
- Specifically, the IFE predicts that:
o Currencies of countries where high interest rates exist should depreciate relative
to currencies with low interest rates.
o Currencies of countries with low interest rates should appreciate relative to
currencies with high interest rates.
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The International Fisher Effect (IFE)
- The one-period expression for the International Fisher Effect is:
1 + ℎ
1 +
ℎ/ = ℎ/
- The multi-period expression for the International Fisher Effect is:
ς=1
1 + ℎ,
ς=1
1 + ,
ℎ/ = ℎ/,
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The International Fisher Effect (IFE) – Example 1
- If the one-year nominal interest rate in Australia is 4.50% and the one-year interest
rate in the US is 2%, then assuming a spot exchange rate of USD0.77/AUD, what is
the expected exchange rate at the end of one year?
1.02
1.045
0.77/ = 0.7516/
- What is the percentage change in the spot rate over this period?
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The International Fisher Effect (IFE)
- In equilibrium, the nominal interest rate differential should equal the expected inflation
differential. Mathematically, we have:
1 + ℎ
1 +
=
1 + ℎ
1 +
- Economies with price levels exhibiting expectations of a higher inflation rate should
have higher nominal interest rates than other economies. The exchange rate must
reflect this difference in expected inflation rates.
- For example, if the expected rate of inflation of the price level in Australia is 3% over
the next 12 months, while the expected rate of inflation of the price level in South
Korea is 7% over the same period, then on average, nominal interest rates in South
Korea should be approximately 400 basis points higher than in Australia.
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The International Fisher Effect (IFE) In Practice
Source: The Economist, 2007
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Parity Condition 5:
Uncovered Interest Rate Parity (UIRP)
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Uncovered Interest Rate Parity (UIRP)
- Uncovered Interest Rate Parity (UIRP) assumes traders remain exposed to exchange
rate risk and make, on average, zero profits from trading.
- Conceptually, since traders do not hedge their exposure to exchange rate risk
according to UIRP, we do not identify the forward rate, ℎ/, but rather the spot rate
expected at the end of the investment period, ℎ/ .
- UIRP for a one-period investment horizon is:
1 + ℎ
1 +
ℎ/ = ℎ/
- UIRP for a -period investment horizon is:
ς=1
1 + ℎ,
ς=1
1 + ,
ℎ/ = ℎ/,
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Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Parity Condition 6:
Covered Interest Rate Parity (CIRP)
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Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Covered Interest Rate Parity (CIRP)
- Covered Interest Rate Parity (CIRP) implies that the currency of a nation with higher
nominal interest rates should trade at a forward discount relative to the currencies of
nations with comparatively lower nominal interest rates. CIRP, for a one-period
investment horizon is expressed as:
1 + ℎ
1 +
ℎ/ = ℎ/
where
- ℎ/ represents the forward exchange rate between the home country, ℎ, and the
foreign country, .
- The expression for CIRP in a -period investment horizon is:
ς=1
1 + ℎ,
ς=1
1 + ,
ℎ/ = ℎ/,
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Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Covered Interest Rate Parity (CIRP)
- Another way to think of CIRP is the return obtained from investing domestically must
equal the return on the covered, that is, hedged foreign investment.
- By approximation, forward differential = nominal interest rate differential.
- Thus, in equilibrium it does not matter where you invest since the returns are
equalized.
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Covered Interest Rate Parity (CIRP) – Replicated
- CIRP also implies that a domestic investment (i.e. a loan) can be replicated by
combining a foreign investment (loan) with a forward contract.
1. An investor borrows an amount, , of AUD today for a period of 1 year at .
2. Once the proceeds are obtained, the investor sells AUD in the spot market and
receives /.
3. The USD-equivalent of AUD is then invested in US money markets for 1 year at a
rate of .
4. The investor then adds a forward contract to sell / 1 + , which is in
USD, next year in exchange for AUD at the forward rate, /.
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Covered Interest Rate Parity (CIRP) – Replicated
5. At the end of the year, the investor sells 1 + in exchange for:
/ 1 +
/
6. The investor has to repay 1 + at the end of one year. The investor is then left
with:
=
/ 1 +
/
− 1 +
- When CIRP holds, arbitrage must be 0.
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Covered Interest Rate Parity (CIRP) – Replicated
- When the hedged foreign return does not equal the domestic return:
• Scenario 1: If 1 + <
1+ /
/
funds will flow from Australia to the US,
until returns are equalized.
• Scenario 2: If 1 + >
1+ /
/
funds will flow from the US to Australia
until returns are equalized.
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Covered Interest Rate Parity (CIRP) – Example 1
- You decide to borrow AUD10,000 and obtain the following information from an
analyst.
- Can you obtain an arbitrage?
Particulars Bid Rate Ask Rate
/ 0.76/ 0.77/
/ 0.50/ 0.57/
5.53% 6.28%
3.85% 4.13%
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Covered Interest Rate Parity (CIRP) – Example 2
- You have the following information from an analyst.
- Suppose it was USD10,000 that you borrowed. Can you obtain an arbitrage?
Particulars Bid Rate Ask Rate
/ 0.76/ 0.77/
/ 0.50/ 0.57/
5.53% 6.28%
3.85% 4.13%
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Transaction Approach to Establishing the Existence
of Arbitrage
- In practice, you will need to work out what currency to borrow in to obtain a riskless
profit.
- The following example is taken from Edition 2 of Bekaert and Hodrick (Chapter 6
Problem 6) and also from Peter Andersen’s notes.
- As a trader for Goldman Sachs in Kuala Lumpur you the see following prices. Is there
a possibility for arbitrage?
- We can test whether the two no-arbitrage conditions hold directly.
Particulars Bid Rate Ask Rate
EUR Interest Rate 6.000% 6.125%
MYR Interest Rate 10.500% 10.625%
Spot Rate MYR4.6602/EUR MYR4.6622/EUR
1-year Forward Rate MYR4.9500/EUR MYR4.9650/EUR
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Condition 1: No Inward Arbitrage
- There exists no inward arbitrage if and only if the quoted forward ask rate satisfies:
>
1 + ,
1 + ,
4.9650/ >
1 + 0.10500
1 + 0.06125
4.6602/ = 4.8523/
- The right-hand side of the inequality specifies the minimum forward ask rate. Above
that, no arbitrage can be made by borrowing EUR to invest in MYR.
Particulars Bid Rate Ask Rate
EUR Interest Rate 6.000% 6.125%
MYR Interest Rate 10.500% 10.625%
Spot Rate MYR4.6602/EUR MYR4.6622/EUR
1-year Forward Rate MYR4.9500/EUR MYR4.9650/EUR
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Condition 2: No Outward Arbitrage
- There exists no outward arbitrage if and only if the quoted forward bid rate satisfies:
<
1 + ,
1 + ,
4.9500/ ≮
1 + 0.10625
1 + 0.06000
4.6622/ = 4.8656/
- The right-hand side of the inequality specifies the maximum forward bid rate. Below
that, no arbitrage can be made by borrowing MYR to invest in EUR.
Particulars Bid Rate Ask Rate
EUR Interest Rate 6.000% 6.125%
MYR Interest Rate 10.500% 10.625%
Spot Rate MYR4.6602/EUR MYR4.6622/EUR
1-year Forward Rate MYR4.9500/EUR MYR4.9650/EUR
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Unbiasedness Hypothesis
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The Unbiasedness Hypothesis
- What can we assume, in theory at least, about the forward rate investors want to lock
in should they want NO exposure to exchange rate risk?
- According to mainstream financial theory, investors are unbiased and rational agents.
- In more technical terms, the mean forecast error of investors’ models is 0.
Mathematically, we have:
σ=1
[(ℎ/,) − ℎ/,]
= 0
- The Unbiasedness Hypothesis indicates that no systematic differences exist between
the expected future spot rate and the forward rate. Thus, mathematically we have:
ℎ/, = ℎ/,
on average implying equality between the forward rate and the expected spot rate.
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however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Unbiasedness Hypothesis in Practice – Carry Trade
- Empirically, the unbiasedness hypothesis is weak.
- Profitable carry trade by hedge funds is to go long in foreign currencies that trade at a
discount and go short in currencies that trade at a premium.
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Currency Forecasting
- If exchange rates can be forecasted perfectly, then exchange rate risk is eliminated.
- Unfortunately, it is not easy or straightforward to do. The iLab session worksheet and
iLab assignment will give you a sense of the work involved in forecasting exchange
rates.
- Research studies have identified that random walk models are superior than most
structural models.
- Market efficiency:
o All publicly available information is incorporated in the market price.
o Future exchange rate changes should be unpredictable.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Market-Based Forecasts
- If market efficiency holds, then market participants have already incorporated
expected currency changes in interest rates and forward rates.
- UFR: forward rate is an unbiased estimate of the future expected spot rate:
+1 = +1
- However, forward contracts > 1 year are limited.
- IFE and PPP do not always hold in practice.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Proof of Purchasing Power Parity (PPP) Theory
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Key Theoretical Relationships in International
Macroeconomics
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Proof of PPP
- In what follows is a proof that I personally have constructed.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Proof of PPP
- Writing space.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Proof of PPP
- Writing space.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Proof of PPP
- Writing space.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Proof of PPP
- Writing space.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Some Final Thoughts for Consideration
- Economists argue that although PPP theory holds poorly in practice and in the short
run, it is theoretically aimed at holding over the long run.
- Does RPPP and IFE provide roughly the same estimate of the expected spot rate?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2022. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Week 3 BONUS Exercise
Deloitte Access Economics has published 10-year forecasts for
the rate of inflation in Australia and France.
Find the latest closing quote of the AUD/EUR and forecast the
exchange rate, 5 years from now. Repeat for 10 years from now.
You should be using Excel for this exercise.
Year 1 2 3 4 5 6 7 8 9 10
AUS 2% 5% 3% 2% 3% 4% 5% 5% 3% 2%
EUR 2% 8% 4% 1% 2% 3% 1% 2% 2% 3%
