UNSW Sydney FINS3616
International Business Finance T3,2024 Lecture 3 Mohamad Mourad – Lecturer in Charge
([email protected]) Lecture 3 –
Schedule • The Fisher Effect (FE) • International Fisher Effect (IFE) • Uncovered Interest Rate Parity
(UIRP) • Covered Interest Rate Parity
(CIRP) • Unbiasedness Hypothesis • Week 3 BONUS Exercise
Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these
notes (Mohamad Mourad) 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 for commercial purposes. Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. Reproduction,
distribution and re-use of these notes outside the scope of the cour e, i
any way, shape or form
st ic ly prohibited. The author of these notes
(Mohamad Mourad) 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 for commercial purposes. Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for commercial purposes. General Announcement: iLab Sessions - iLab sessions are on in Week 3 and 4.
- Students must only attend the iLab Session in which they are officially enrolled.
- 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for commercial purposes. The Key Theoretical Relationships in International
Macroeconomics Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for commercial purposes. Recapping
International Parity Condition 1: APPP International Parity Condition 2: RPPP Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for commercial purposes. Recap from Week 2 APPP
= /
- Tells us:
- Used for: RPPP:
- Tells us: - Used for: (1 + ℎ ) 1 +
ℎ/ = (ℎ/) ς=1
1 + ℎ,
ς=1
1 + ,
ℎ/ =
ℎ/, Year 1 2 3 Spot Rate
3% 7% 5% USD0.70/AUD
4% 8% 6% Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for commercial purposes. International Parity Condition 3:
The Fisher Effect (FE) Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for commercial purposes. International Parity Condition 4:
The International Fisher Effect (FE) Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for commercial purposes. International Parity Condition 5:
Uncovered Interest Rate Parity (UIRP) Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for commercial purposes. International Parity Condition 6:
Covered Interest Rate Parity (CIRP) Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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/,
- 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. - Thus, in equilibrium it does not matter where you invest since the returns are equalized. Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for commercial purposes. Covered Interest Rate Parity (CIRP) – For You - Is there an arbitrage opportunity given these money market prices? Particulars Bid Rate Ask Rate / 1.18/ 1.22/ / 1.24/ 1.30/
4.75% 4.90%
6.50% 6.80% Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for commercial purposes. The Unbiasedness Hypothesis Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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 for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for commercial purposes. Exercise for You - What basic lesson about PPP Theory can you draw from this quote? “The fundamental things apply As time goes by”. Herman Hupfeld, songwriter (1931; from the film Casablanca,
1942) Source: Taylor, A.M and Taylor, M.P, 2004, ‘The Purchasing Power Parity Debate”,
Journal of Economic Perspectives, Vol. 18, No. 4, pp. 135-158. Note: These notes are for the exclusive use of students enrolled in FINS3616 International Business Finance for Term 3,2024. 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 of these notes
(Mohamad Mourad) 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 for 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% 51作业君版权所有
