Principles of Corporate Finance_ 12th Edition

712 Part Eight Risk Management

bre44380_ch27_707-731.indd 712 10/08/15 10:08 AM

This is often called purchasing power parity.^7 Just as the price of goods in Walmart stores

must be roughly the same as the price of goods in Target, so the price of goods in Ruritania

when converted into dollars must be roughly the same as the price in the United States:

Dollar price of goods in the U.S. =

peso price of goods in Ruritania

__________________________

number of pesos per dollar

Purchasing power parity implies that any differences in the rates of inflation will be offset

by a change in the exchange rate. For example, if prices are rising by 1.0% in the United

States and by 11.1% in Ruritania, the number of pesos that you can buy for $1 must rise by

1.111/1.01 − 1, or 10%. Therefore purchasing power parity says that to estimate changes in

the spot rate of exchange, you need to estimate differences in inflation rates:^8

equals

1 + expected Ruritanian

inflation rate

1 + expected U.S.

inflation rate

Expected peso

spot rate

Current peso

spot rate

Expected difference

in inflation rates

Expected change

in spot rate

In our example,

Current spot rate × expected difference in inflation rates = expected spot rate

50 × 1.111_____^

1.010

= 55

Interest Rates and Inflation Rates

Now for the fourth leg! Just as water always flows downhill, so capital tends to flow where

returns are greatest. But investors are not interested in nominal returns; they care about what

their money will buy. So, if investors notice that real interest rates are higher in Ruritania than

in the United States, they will shift their savings into Ruritania until the expected real returns

are the same in the two countries. If the expected real interest rates are equal, then the differ-

ence in nominal interest rates must be equal to the difference in the expected inflation rates:^9

equals

1 + Ruritanian

interest rate

1 + U.S.

interest rate

1 + expected Ruritanian

inflation rate

1 + expected U.S.

inflation rate

Difference in

interest rates

Expected difference

in inflation rates

In Ruritania the real one-year interest rate is 4%:

Ruritanian expected real interest rate = ___1 + Ruritanian nominal interest rate

1 + Ruritanian expected inflation rate

− 1

= ______ 1.155^

1.111

− 1 = .040

(^9) In Section 3-5 we discussed Irving Fisher’s theory that over time money interest rates change to reflect changes in anticipated infla-
tion. Here we argue that international differences in money interest rates also reflect differences in anticipated inflation. This theory
is sometimes known as the international Fisher effect.
(^8) In other words, the expected difference in inflation rates equals the expected change in the exchange rate. Strictly interpreted, pur-
chasing power parity also implies that the actual difference in the inflation rates always equals the actual change in the exchange rate.
(^7) Economists use the term purchasing power parity to refer to the notion that the level of prices of goods in general must be the same in
the two countries. They tend to use the phrase law of one price when they are talking about the price of a single good.