BUSF_A01.qxd

Chapter 15 • International aspects of business finance

If real interest rates are equal in all countries, then:

=

where rnhis the nominal (or money) interest rate in the home country, rnfis the nominal

(or money) interest rate in the foreign country, inhis the rate of inflation in the home

country and infis the rate of inflation in the foreign country.

Shapiro and Balbirer (2000) also show that, while this relationship seemed not to be

precisely as the model suggests, countries with high nominal interest rates tended to

have high levels of inflation.

International Fisher effect

The international Fisher effectcombines the underlying principles of the general

Fisher effect and PPP. Fisher implies that interest rates will move to take account of

inflation rates:

=

PPP implies that exchange rates move in response to differences in inflation rates (see

equation (15.1)):

=

Since the interest rates referred to in the PPP model are nominal rates, putting

Fisher and PPP together we have:

=

The international Fisher effect therefore implies that the exchange rate is, in theory,

directly linked to nominal interest rates.

Again Shapiro and Balbirer (2000) show that this relationship is a broadly correct

approximation to reality.

Interest rate parity

As we saw earlier in this section, there are two bases on which we can buy or sell for-

eign currencies. We can trade for immediate delivery of the currency, when we shall

be trading at a ‘spot’ rate of exchange. Alternatively, we can buy or sell the currency

under a forward contract. Here, delivery will take place on some specified date in the

future, but the exchange rate at which the transaction is effected is set now. Naturally,

the ‘forward’ rate will be linked closely to the spot rate. In theory, were the nominal

interest rates the same, in the countries of both currencies, the spot and forward rates

would be the same. Remember that nominal interest rates reflect both real interest

16.6 Risk and the discount rate

1 +rnh

1 +rnf

e 1

e 0

1 +ih

1 +if

e 1

e 0

1 +inh

1 +inf

1 +rnh

1 +rnf

1 +inh

1 +inf

1 +rnh

1 +rnf

‘