INTERNATIONAL PARITY RELATIONS & EXCHANGE RATE

FORECASTING

3.1 PARITY CONDITIONS

An understanding of the forces that drive exchanges rate changes and hence the effect
on investment and financial opportunities is crucial. The law of one price that must
hold in arbitrage equilibrium prevails when the same or equivalent things are trading
at the same price across locations or markets.
Figure 3.1 below shows the Parity conditions

Fig 3.1: Parity Conditions

Inflation
PPP FE

Change in Change in
Exchange Rate IFE Interest Rate

UFR Change in IRP

Forward

Five parity conditions linked by the adjustment of rates and prices to inflation to
explain arbitrage and the law of one price. Inflation and home currency depreciation
are jointly determined by the growth of domestic money supply relative to the growth
of domestic money demand, i.e. 𝑴𝑺 > 𝑴𝑫 = 𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏. Nominal interest rate is
the sum of Real Interest Rate and expected Inflation.
3.2 PURCHASING POWER PARITY (PPP)
This theory states that spot exchange rates between currencies will change due to the
differential in inflation between currencies. That is, the exchange rate between
currencies of two countries should be equal to the ratio of the countries’ price levels.
Simplified it means, when country A’s inflation rate rises relative to that of country
B, the demand for country A’s currency relative to that of country B declines as its
exports also decline due to high prices. Consumers and firms in country A will
increase their demand for imports. These changes will place a downward pressure on
the currency of the high inflation country leading to its depreciation.

Taking the US and the UK for instance, the PPP states that the exchange rate between
the dollar and the pounds should be:
𝑷$
𝑺=
𝑷£
Where:
S = Price per one pound

If the standard commodity basket costs $225 in the US and £150 in the UK, then the
exchange rate between the two currencies should be $1.50/£.

3.2.1 Conditions for PPP

i. All goods and services are tradable internationally.
ii. Transportation and other trading costs are nil.
iii. Consumers in all countries consume the same proportions of goods and
services.
iv. The law of one price prevails, i.e. identical goods and services sell at the same
price worldwide.

The absolute PPP states that prices of similar products in different countries should
be equal when measured in common currency or converted to one currency. However
because of market friction resulting from transportation costs, tariffs, quotas, etc, the
law of one price does not always hold. This led to the development of the Relative
PPP.
3.3 DERIVATION OF THE PPP
Assume the home currency experiences inflation 𝑰𝒉 while the foreign country
experiences inflation of 𝑰𝒇 .
Due to inflation the price index of goods in the home country becomes:
𝑷𝒉 (𝟏 + 𝑰𝒉 )(𝟏)

That for the foreign country becomes:

𝑷𝒇 (𝟏 + 𝑰𝒇 )(𝟐)

For floating exchange rate regimes the foreign exchange will have to move to
accommodate these changes. The theory of PPP suggests that the exchange rate will
adjust to maintain a Parity Purchasing Power.

If inflation occurs and the exchange rate of the foreign currency changed the foreign
country’s price index from the consumer’s perspective becomes:

𝑷𝒇 (𝟏 + 𝑰𝒇 )(𝟏 + 𝒆𝒇 )(𝟑)
Where:
𝑷𝒇 = Foreign price
𝑰𝒇 = Foreign inflation
𝒆𝒇 = Exchange rate

According to the PPP the percentage change in the foreign currency (𝒆𝒇 ) should
change to maintain parity in the new price indices of the two countries, which follows
that:
𝑷𝒇 (𝟏 + 𝑰𝒇 )(𝟏 + 𝒆𝒇 ) = 𝑷𝒉 (𝟏 + 𝑰𝒉 ) (𝟒)

𝑷𝒉 (𝟏 + 𝑰𝒉 )
⇒ 𝒆𝒇 = −𝟏 (𝟒𝒂)
𝑷𝒇 (𝟏 + 𝑰𝒇 )
However these countries started at the same point because price indices where
initially assumed to be equal in both countries, implying that 𝑷𝒉 = 𝑷𝒇 .

Thus equation 4a becomes:

(𝟏 + 𝑰𝒉 )
𝒆𝒇 = −𝟏 (𝟓)
(𝟏 + 𝑰𝒇 )

This formula relates the relationship between the relative inflation rate and exchange
rate according to the PPP theory. If PPP is expected to hold then the best prediction
for one period spot rate should be the price quoted by international foreign currency
dealers over 24 hours, i.e.:

(𝟏 + 𝑰𝒉 )𝒕
𝒆𝒕 = 𝒆𝟎 𝒕 (𝟔)
(𝟏 + 𝑰𝒇 )
Where:
t = Period, in years

The above equation assumes that the future spot rate (𝒆𝒕 ) bears constant relationship
to the spot exchange rate (𝒆𝟎 ).

Example
Projected inflation rates for South Africa (SA) and Zimbabwe for the next 12 months
are 10% and 20% respectively. If the exchange rate is $0.34/ZAR, what should the
future spot rate be at the end of the next 12 months?

Solution
(𝟏 + 𝑰𝒉 )𝒕 (𝟏. 𝟐)𝟏
𝒆𝒕 = 𝒆𝟎 𝒕 = 𝟎. 𝟑𝟒 = $𝟎. 𝟑𝟕𝟏/𝒁𝑨𝑹
(𝟏 + 𝑰𝒇 ) (𝟏. 𝟏)𝟏

The test of the PPP theory is to choose two countries and compare their inflation rate
differentials to the percentage change in the foreign currency value during several
time periods, then plot a graph of points representing the inflation differentials and
 the exchange rate percentage change for each specific time period and then determine
whether these points closely resemble the PPP line as predicted by the theory.
If the points deviate significantly from the PPP line then the percentage change in the
foreign exchange rate is not being influenced by the inflation differentials in the
manner PPP theory suggests.

3.4 FISHER EFFECT (FE)

The FE states that the nominal interest rates are a function of the real rate and
premium for inflation expectations, i.e.:
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝒓𝒂𝒕𝒆 = 𝑹𝒆𝒂𝒍 𝒓𝒂𝒕𝒆 + 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒊𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏

The real rates of interest tend towards equality everywhere through arbitrage. With
no government intervention, nominal rates vary by inflation differentials.

3.5 INTERNATIONAL FISHER EFFECT (IFE)

According to IFE countries with higher expected inflation rates have higher interest
rates. In a perfect financial market investors of all countries require the same real rate
of return; therefore the differences observed in the interest rates of different countries
arise mainly due to differentials in expected inflation. The actual return to investors
investing in money market securities in their home countries is simply the interest
rate offered on those securities only. However for those investing in foreign money
markets they earn an actual return as above which depends on the foreign inflation
rate (𝑰𝒇 ) and also the percentage change in the value of the foreign currency
representing a security in terms of the home currency.

3.6 INTERNATIONAL ARBITRAGE AND INTEREST RATE PARITY

Arbitrage can be defined as taking advantage of a discrepancy in quoted prices of a
product or service. If there are discrepancies in the foreign exchange market, meaning
the quoted prices of the currencies vary from what the market prices would be or it is
in other locations certain market forces will come to realign the rates to their expected
values. This mechanism of market realignment takes place as a result of international
arbitrage.
The international arbitrage can be analysed in there in three components namely:
  Locational Arbitrage (Cross Market Arbitrage)
 Triangular Arbitrage (Cross Currency Arbitrage), and
 Covered Interest Arbitrage.

Once market forces cause interest rates and exchange rates to be such that covered
interest arbitrage is no longer feasible we reach an equilibrium state referred to as
interest rate parity/equilibrium.
3.7 INTEREST RATE PARITY (IRP)
It is an arbitrage condition that must hold when international financial markets are in
equilibrium. In other words, ignoring risk considerations, an arbitrage opportunity
will exist whenever the domestic interest rate exceeds the foreign interest rate by more
or less than the forward discount on the domestic currency. If interest rate differential
is greater than the forward discount it pays to shift funds from foreign securities to
domestic securities and cover oneself by purchasing foreign currency forward to
guarantee return on the funds at the exchange rate indicated by the forward discount.
If interest rate differential is less than the forward discount it pays to shift funds from
in the other direction covering oneself by selling foreign currency forward. Such
attempts to take advantage of interest rate differentials and forward discounts will
eliminate them.

Example
You have $1 to invest over 1 year period. Consider 2 points:
i. Invest in the domestic country at the US interest rate, or
ii. Invest in the foreign country, the UK at the foreign interest rate and hedge the
exchange rate value of the foreign investment forward.
Assume a default-free investment.

i. Domestic investment
𝑭𝑽 = $𝟏(𝟏 + 𝒊$ )
Where: 𝒊$ =US dollar interest rate

ii. Foreign investment

 a. Change $1 to pounds at the prevailing spot exchange rate (S), i.e.
𝟏
£ (𝑺).

b. Invest the pound amount at UK interest rate (𝒊£ )for 1 year, i.e.
𝟏
£ (𝑺) (𝟏 + 𝒊£ ).

c. Sell the maturity value of the UK investment forward in exchange for

𝟏
predetermined dollar amount, i.e. $ [( ) (𝟏 + 𝒊£ )] 𝑭.
𝑺

Where: F = Forward Exchange Rate.

Because one has hedged the exchange rate risk by a forward contract, one has
effectively redenominated the UK investment in dollar terms. The effective dollar
interest rate from such alternative UK investment is given by:
𝑭
(𝟏 + 𝒊£ ) − 𝟏
𝑺

Because of arbitrage position the future dollar proceeds from investing in the two
equivalent investments must be the same, i.e.:
𝑭
(𝟏 + 𝒊$ ) = (𝟏 + 𝒊£ )
𝑺
When simplified for F gives:
𝟏 + 𝒊$
𝑭 = 𝑺[ ]
𝟏 + 𝒊£
This is the formal statement for IRP.

3.8 TRIANGULAR ARBITRAGE (CROSS CURRENCY ARBITRAGE)

Figure 3.2 below illustrates Triangular Arbitrage.

Fig. 3.2: Triangular Arbitrage

USD

Cross rate
 BWP ZAR

Foreign exchange quotations can be expressed through a third currency as a vehicle

currency. The cross exchange rate concept is used to determine the relationship
between two currencies. Triangular arbitration is riskless because it does not tie up
funds, there is certainty about the prices at which the currencies have been bought or
sold.
NB: The point of this discussion is that because of triangular arbitration cross
exchange rates are usually aligned to the sport exchange rate correctly.

3.9 COVERED INTEREST ARBITRAGE

It is a process which involves investing in a foreign country and covering against
foreign exchange risk exposure by selling the expected proceeds immediately in the
forward foreign exchange market.

Example
Given that:
𝒊$ = 5% S = $1.50/£
𝒊£ = 8% F = $1.48/£

The arbitrager can borrow $1 million. Is there an arbitrage opportunity? How can an
investor arrange a covered interest arbitrage? Calculate arbitrage profit.

Solution
Proof of arbitrage opportunity existence
𝑭 𝟏. 𝟒𝟖
(𝟏 + 𝒊 £ ) − 𝟏 = (𝟏 + 𝟎. 𝟎𝟖) − 𝟏 = 𝟔. 𝟓𝟔%
𝑺 𝟏. 𝟓𝟎

Given that this is not equal to 𝒊$ which is equal to 5% it follows that an arbitrage
opportunity exists, i.e.:
𝑭
(𝟏 + 𝒊$ ) < (𝟏 + 𝒊£ )
𝑺
Covered interest arbitrage arrangement
 Since interest rate is lower in the US one can borrow dollar terms and lend pound
terms, i.e.:
✓ Borrow $1 million in the US over 1 year, i.e.: $1 million x 1.05 = $1.050
million
✓ Buy £666,667 spot using the borrowed $1 million, i.e.:$1 million/1.50
✓ Invest £666,667 in UK over 1 year, i.e.:£666,667 x 1.08 = £720,000
✓ Sell £720,000 forward, i.e.: £720,000 x $1.48/£ = $1,065,600
✓ At maturity the arbitrager closes the arbitrage position and stands to gain
$15,600 out of no risk or cost, i.e.: $1,065,600 - $1,050,000

3.10 EXCHANGE RATE FORECASTING

Exchange rate forecasting is vital for currency traders that are actively involved in
speculating, hedging and arbitrage in the foreign exchange markets. It is equally vital
for INTERNATIONAL BUSINESSs that are formulating international sourcing,
production, financing and marketing strategies.
Exchange rate forecasting techniques can generally be classified into three distinct
categories namely:
 Efficient market approach,
 Fundamental approach, and
 Technical approach.

3.13.1 Efficient Market Approach

Financial markets are said to be efficient if the current asset prices fully reflect all the
available and relevant information. The Efficient market Hypothesis (EMH) by
Professor Eugene Fama can be split into three forms namely, weak form, semi-strong
form, and strong form.

In an efficient market the current exchange rate is said to have already taken into
account all relevant information, such as money supply, inflation rates, trade balances
and output growth. Thus the exchange rate will only change when the market receives
new information. Thus one cannot determine exchange rate from past trends since
information is unpredictable.
 In such a case the exchange rate is said to follow a random walk which suggests that
today’s exchange rate is the best predictor of tomorrow’s exchange rate, i.e.:

𝑺𝒕 = 𝑬(𝑺𝒕+𝟏 ) 𝒐𝒓 𝑺𝒕 = 𝑬(𝑺𝒕+𝟏 |𝑰𝒕 )

Where:
𝑺𝒕+𝟏 = Future spot rate
𝑰𝒕 = Set of information currently available

Predicting the exchange rates using the efficient market approach has two advantages:
a. It is costless to generate the forecasts since it is based on market determined
prices.
b. Given the efficiency of foreign exchange markets, it is difficult to outperform
the market-based forecast unless the forecaster has access to private
information that is not yet in the current exchange rate.

3.13.2 Fundamental Approach

This approach uses various models or fundamental factors and relationships that
affect exchange rate fluctuations which include interest rates, inflation, money supply
and other economic variables. Such analysis may employ linear regression and other
statistical methods, but based on an economic theoretical framework which assumes
key economic factors affecting exchange rates.

The monetary approach, for example, suggests that the exchange rate is determined
by three independent variables namely, 1) relative money supply, 2) relative velocity
of moneys, and 3) relative national output. One can then formulate the following
equation:
𝑺 = 𝜶 + 𝜷𝟏 (𝒎 − 𝒎∗ ) + 𝜷𝟐 (𝒗 − 𝒗∗ ) + 𝜷𝟑 (𝒚∗ − 𝒚) + 𝒖
Where:
S = Natural logarithm of the spot exchange rate
𝒎 − 𝒎∗ = Natural logarithm of the domestic/foreign money supply
𝒗 − 𝒗∗ = Natural logarithm of the domestic/foreign velocity of money
𝒚∗ − 𝒚 = Natural logarithm of the foreign/domestic output
𝒖 = random error term, with mean zero
 𝜶&𝛽 = Model parameters

The three main difficulties with the fundamental approach are:

(1) One has to forecast a set of independent variables to forecast exchange rates.
 The model parameters that are estimated using historical data may change
overtime because of changes in government policies and/or the underlying
structure of the economy.
 The model itself can be wrong.

3.13.3 Technical Approach

This approach first analyses the past behavior of exchange rate for the purpose of
identifying “patterns” (time series) and then projecting them into the future to
generate forecasts. It is based on the premise that history repeats itself. Thus this
approach is at odds with the efficient market approach and it differs from the
fundamental approach in that it does not use key economic variables such as money
supply or trade balances for the purpose of forecasting. Technical analysts at times
use various transaction data like trading volumes, outstanding interests, and bid-ask
spreads to aid their analysis.

Many technical analysts or chartists compute moving averages as a way of separating

short- and long-term trends from vicissitudes of daily exchange rates. The diagram
below illustrates the long-term and short-term moving averages.

Fig. 3.3 Short- and Long-term Moving Averages

$/£ LMA

A
SMA
 tA tB
Time
The cross-over at A indicates that the pound is appreciating whilst at B signals that
the pound is depreciating against the dollar.

Many traders, despite their discredit on the validity of the approach, use technical
analysis. If enough traders use technical analysis, the predictions based on it can
become self-fulfilling to some extent, at least in the short-run.

COUNTRY RISK ANALYSIS

8.1 Definition of Country Risk
Country risk refers to the potential adverse impact of a country’s environment on an MNC’s
cash flows and ultimately its market value.

Country risk analysis encompasses the assessment of potential risks and rewards associated
with making investments and doing business in a country. Ideally, we are interested in whether
reasonable economic policies are likely to be pursued as this creates a business environment in
which firms may flourish. However, political considerations may cause countries to pursue
economic policies that are adverse to business. Because of this, the focus of country risk
analysis cannot be purely economic in its approach: it must also cover political factors that give
rise to economic policies.

8.2 Importance of Country Risk Analysis

It is a screening device to avoid countries with excessive risk

Helps in monitoring the risk levels associated with countries in which MNCs operate

Assists in the assessment of certain types of risks for proposed capital budgeting projects in
foreign countries.

8.3 Political Risk Factors

There are a number of country characteristics that relate to the political environment that
influence an MNC’s operations, which include;
Attitude of host government
A host government that is hostile to foreign owned enterprises poses high risks to the operations
of MNCs. Turnover in governments or philosophy can be used as a proxy for a country’s
political risk. New policy enactments can affect the cash flows of an MNC.
Blockage of fund transfers
Host governments may block funds transfers, causing subsidiaries to venture into sub-optimal
projects just to make use of the funds

Currency inconvertibility
Some governments may not allow their home currency to be exchanged into other currencies.

Wars
Where a country constantly engages in war with neighbouring countries or experiences internal
strife, the safety of employees and machinery becomes a major challenge.

Bureaucracy Government bureaucracy may complicate the MNC’s business e.g. in

facilitating certain documentation.

Financial Risk Factors

Besides political risk factors, financial risk factors also need to be considered in country risk
analysis:
State of the economy
Since there is a strong correlation between a country’s state of the economy and several
financial factors, the following macroeconomic factors must be analysed:
Interest rates
Inflation
Exchange rates
Budget deficit
Unemployment levels
Country Risk Assessment Techniques
Checklist Technique
This involves a judgement on all the political and financial factors that are pertinent to a firm’s
assessment of country risk. These factors should be converted to some numerical form in which
they can be assessed e.g. a scale of 1 to 5 i.e. very bad to very good. This is a consensus method
in which certain pre-determined risk factors are decided in advance.
Delphi Technique
It involves the collection of independent opinions on country risk without group discussion by
the experts who provide these opinions, thereby providing independent opinions. Evaluations
are collected, aggregated and returned to the experts, who then have the chance to change their
minds having seen their peers’ assessments. Problems with this method include questionnaire
design and choice of variables, availability and selection of experts, and interpretation of
results.
Quantitative Analysis
Once the financial and political variables have been measured for a period of time, models for
quantitative analysis can be used so as to identify the characteristics that influence the level of
a country’s risk;
Discriminant analysis

Regression analysis

The Grand Tour/ Inspection Visits

This involves travelling to a foreign country and meeting with government officials, executives
and/or consumers.
Old Hands
This technique involves seeking the opinion and advice of experts who have many years of
experience in that country in various capacities. However, the value of such knowledge
depends on how it can be directly applied to the investment under consideration.
Combination of Techniques
It may be most appropriate to implement two or more techniques to take care of the strengths
and weaknesses associated with each particular technique.

8.10 Managing Political Risk

Political risk can be managed at two levels, i.e. pre-investment and post-investment.
8.10.1 Pre-investment Planning
a) Avoidance:- screen out investments in politically uncertain countries.

b) Insurance:- insure assets in politically risky areas

c) Concessions/ negotiating the environment:- negotiate with host government and come to an
understanding that specifies precisely the rules under which the firm will operate.

d) Structuring the investment:- increase the host government’s cost of interfering with the
company’s operations by adjusting the operating policies (in the areas of production, logistics,
exporting and technology transfers) and financial policies so as to link the value of the foreign
project to the MNC’s continued control e.g. keep the local affiliate dependent on sister
companies for supplies or markets.

8.10.2 Post-investment/ Operating Policies

a) Planned divestment:- phase out ownership over a fixed time period by selling all or a
majority of equity interest to local investors.

b) Maximise short term profit:- defer maintenance expenditure, cut investment, curtail
marketing expenditure, produce lower quality merchandise, set higher prices, and eliminate
training programs

c) Change benefit/cost ratio:- if the government’s objectives for expropriation are based on the
belief that economic benefits will more than compensate the costs of expropriation, the MNC
can initiate programs to reduce the perceived advantages of local ownership and thereby
diminish the incentive to expel foreigners e.g. train local workers and managers, expand
production facilities, establish local R&D facilities.
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d) Develop local stakeholders:- cultivate local individuals and groups who have a stake in the
affiliate’s continued existence as a unit of the parent MNC e.g. workers.

e) Adaptation:- enter into licensing and management agreements