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Fundamental Equilibrium
Relationships
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Interest Rate Parity Determinants of international interest rates
Domestic and foreign credit conditions
Forward-exchange rates and exchange rateexpectations
Arbitrage
Factors that inhibit arbitrage
Capital controls
Risk factors
Transaction costs
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Term structure of interest rate
Relationship between interest rates and time to
maturity Expectation of future short term rates is vital
determining the level of longer term rates
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Covered interest arbitrage equalizes the return
(adjusted for cost of eliminating exchange risk
by means of a forward contract) in differentcurrencies
Ex: interest rate on a dollar deposit must equal the
interest rate on Swiss Franc deposit covered in
the forward market
Results from arbitrage between the spot and
forward markets
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Covered interest arbitrage
Movement of funds
Between securities denominated in differentcurrencies
To profit from effective rates of interest in
different curremcies.
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Deviations from interest rate parity May not always hold true
Capital controls can divide credit markets
Financial instruments are not always alike
Tax treatments
Liquidity
Day count
Pricing conventions
Institutional arrangements
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Fisher Open Theorem Irving Fischer
Identifies relationship between changes in
interest rates and changes in price levels.
Compensation for lending present funds
Increase in purchasing power
Increase in price levels
Risk of default
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Components of interest rate Nominal Rate
Real rate of return
Inflation premium
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Fisher Effect :
1+ Nominal Rate =
(1+ real rate)*(1+Increase in Inflation rate)
r = a + i + ai
r = nominal rate
a= real rate of interest
i = inflation premium
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Ex-post, the price change will not equal the
expected value
But if the market utilizes all the informationavailable r should include the best possible
estimate of inflation rate.
Then the change in interest rate will be equalto change in the expected price levels
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1+Rh = 1+Ih
1+Rf =1+If
Rh, Rf : rate of interest in home and foreign
country respectively
Ih, If : rate of inflation in home and foreign
country.
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Generalized version of Fisher effect says:
Currencies with higher inflation rates should
bear higher interest rate and viceversa
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Example The real interest rate is 5%
Inflation rate premium 1%
Calculate nominal interest rate
r = a + i + ai
= .05+.01+.05*.01
= .0605
=6.05%
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International Fisher Effect Describes relationship between the interest
rate and the expected exchange rate changes.
Expected rate of change in exc.rate = interestrate differential
IFE = E(S1) S0 = Ih-If
S0
E(S1) = Expected spot rate
S0 = spot rate
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Difference between IRP and IFE IRP substitutes a know forward rate but IFE
takes into account the expected rate of change
in the exchange rate.
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Foreign Exchange Exposure Foreign exchange risk
Foreign exchange exposure
ARE THEY SAME ?
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Foreign exchange exposure is the extent to
which transactions, assets and liabilities of an
enterprise are denominated in currencies otherthan reporting currency of the enterprise.
Foreign exchange risk is the net potential
gains or losses which can arise from exchangerate changes.
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Types of exposures Transaction Exposure
Translation Exposure
Economic Exposure
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Transaction Exposure/Conversion
Exposure Arises due to:
time difference between the date of the
conclusion of the contract and the dischargeof the obligations.
The transaction is required to be denominated
in foreign currency for the transactionexposure to occur.
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Transactions resulting in
Transaction Exposure Accounts payable in foreign currencies
Accounts receivable in foreign currency
Debt payments to be made in foreign currency
Commitments to accept loan repayments in
foreign currency
Anticipated payments from foreign
subsidiaries
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Entities which face transaction
exposure1. Traders (importers and exporters)
2. Multinational corporations
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Instruments of Hedging Forward Contracts
Money Market Hedge
Future Contracts Option Contracts
Currency Invoicing
Exposure Netting
Foreign Currency Accounts Leading and Lagging
Hedging with proxy currencies (when the forwardmarket for the currency does not exist)
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Translation Exposure/Accounting
Exposure Translation exposure of a corporation is
simply the difference between the exposed
assets and liabilities. The gains and losses due to translation
exposure are accounting in nature, there is no
cash implication.
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Methods of Translation Current and Non-current Method
Monetary and Non-monetary Method
Temporal Method
Current Rate Method
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Current/Non-Current Method Current Assets and Liabilities current rate
Non-current assets and liabilities historical
rates
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Monetary/Non-monetary method
Monetary assets and liabilities Current rates
Non-Monetary assets and liabilities
Historical rates
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Difference between the two methods In Monetary and non-monetary method
inventory is valued at historic rates unlike in
current and non current method it is valued atcurrent rate.
Term Liabilities are valued at current rate in
monetary and non-monetary method unlike incurrent and non-current method they are
valued at historic rates
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Temporal Method:
Inventories and Investments translated at
current rate (if they are valued at market pricein the B/S)
Current Rate Method:
All the assets and liabilities are valued atcurrent rate
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Managing Translation Exposure Fund Adjustments
Forward Contract Hedge
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Economic ExposureAlso Called as
Operating Exposure
Competitive Exposure
Strategic Exposure
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Economic Exposure Effect of unexpected exchange rates on the
future operating cash flows of the company.
Change in economic net worth of a companydue to change in exchange rates.
Ambiguous but has wider ramification with
far reaching effects. Involves not only the action of the company
but also of competitors and consumers.
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Impact of economic exposure Cash inflows
Cash outflows
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Impact on cash outflows Factors :
Sources of inputs - domestic and foreign
Supplier reaction
Government reaction
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Managing Economic Exposure Marketing Strategies
Market Selection
Pricing (to retain market share or profit margin,frequency of price change)
Product Decisions
Production Strategies Financial Strategies (Cheap Borrowing)