Chapter 17 Multinational Financial Management 547- Agree today to exchange the 104,474.40 yen 90 days from now at the 90-day
forward exchange rate of 102.95 yen per dollar, for a total of $1,014.81.
This investment, therefore, has an expected 90-day return of $14.81/$1,000 "
1.481%, which translates into a nominal return of 4(1.481%) " 5.92%. In this case,
4% of the expected 5.92% return is coming from the bond itself and 1.92% arises
because the market believes the yen will strengthen relative to the dollar. Note that
by locking in the forward rate today, the investor has eliminated any exchange rate
risk. And because the Japanese bond is assumed to be default-free, the investor is
assured of earning a 5.92% dollar return.
Interest rate parity implies that an investment in the United States with the
same risk as a Japanese bond should have an annual return of 5.92%. Solving for rh
in the parity equation, we indeed! nd that the predicted annual interest rate in the
United States is 5.92%.
Interest rate parity shows why a particular currency might be at a forward
premium or discount. Note that a currency is at a forward premium whenever do-
mestic interest rates are higher than foreign interest rates. Discounts will prevail if
domestic interest rates are lower than foreign interest rates. If these conditions do
not hold, arbitrage will soon force interest rates back to parity.
17-7 PURCHASING POWER PARIT Y
We have discussed exchange rates in some detail, and we have considered the
relationship between spot and forward exchange rates. However, we have not yet
addressed this fundamental question: What determines the spot level of exchange
rates in each country? While exchange rates are in" uenced by a multitude of fac-
tors that are dif! cult to predict, particularly on a day-to-day basis, over the long
run, market forces work to ensure that similar goods sell for similar prices in dif-
ferent countries after exchange rates are taken into account. This relationship is
known as “purchasing power parity.”
Purchasing power parity (PPP), sometimes referred to as the law of one price,
implies that the level of exchange rates adjusts so as to cause identical goods to
cost the same amount in different countries. For example, if a pair of tennis
shoes costs $100 in the United States and 50 pounds in Britain, PPP implies that
the exchange rate will be $2 per pound. Consumers can purchase the shoes in
Britain for 50 pounds, or they can exchange their 50 pounds for $100 and pur-
chase the same shoes in the United States at the same effective cost, assumingPurchasing Power
Parity (PPP)
The relationship in which
the same products cost
roughly the same amount
in different countries after
the exchange rate is taken
into account.Purchasing Power
Parity (PPP)
The relationship in which
the same products cost
roughly the same amount
in different countries after
the exchange rate is taken
into account.What is interest rate parity?
Assume that interest rate parity holds. When a currency trades at a forward
premium, what does that imply about domestic rates relative to foreign in-
terest rates? when a currency trades at a forward discount?
Assume that 90-day U.S. securities have a 3.5% annualized interest rate,
whereas 90-day Canadian securities have a 4% annualized interest rate. In
the spot market, 1 U.S. dollar can be exchanged for 1.4 Canadian dollars. If
interest rate parity holds, what is the 90-day forward exchange rate between
U.S. and Canadian dollars? ($0.7134/C$ or C$1.40173/$)
On the basis of your answer to the previous question, is the Canadian dollar
selling at a premium or discount on the forward rate? (Discount)SELF^ TEST (^)