Lecture Multinational financial management - Topic 7: Interest rate parity. In this chapter, tudents can forecast exchange rates and expected appreciations using interest rate parity and unbiased forward rate. | Topic #7: Interest rate paritY L. Gattis The Pennsylvania State University 1 Finance 407: Multinational Financial Management Review: No Calculator Estimate 2 Annual inflation in the . and Japan is 5% and 1%. The spot price of the Yen is ¥$. What is the expected spot price in 3 months? 104 103 101 99 96 Review: No Calculator Estimate 3 The euro is expected to devalue by 2% against the British pound in one year. British inflation is forecasted to be 5%. What is euro area inflation according to PPP? 7% 5% 3% 1% Review: No Calculator 4 An Ipad costs $699 in the . and ¥6,999 in China. The spot price of the yuan is ¥$. Is the yuan undervalued or overvalued according to PPP? Undervalued Overvalued Learning Objectives 5 Learning Objectives Students can forecast exchange rates and expected appreciations using interest rate parity and unbiased forward rate. Relative PPP and Interest Rate Parity 6 Relative PPP allows for differences in absolute prices, but changes in prices . | Topic #7: Interest rate paritY L. Gattis The Pennsylvania State University 1 Finance 407: Multinational Financial Management Review: No Calculator Estimate 2 Annual inflation in the . and Japan is 5% and 1%. The spot price of the Yen is ¥$. What is the expected spot price in 3 months? 104 103 101 99 96 Review: No Calculator Estimate 3 The euro is expected to devalue by 2% against the British pound in one year. British inflation is forecasted to be 5%. What is euro area inflation according to PPP? 7% 5% 3% 1% Review: No Calculator 4 An Ipad costs $699 in the . and ¥6,999 in China. The spot price of the yuan is ¥$. Is the yuan undervalued or overvalued according to PPP? Undervalued Overvalued Learning Objectives 5 Learning Objectives Students can forecast exchange rates and expected appreciations using interest rate parity and unbiased forward rate. Relative PPP and Interest Rate Parity 6 Relative PPP allows for differences in absolute prices, but changes in prices will affect future exchange rates If you assume differences in international interest rates reflect only differences in inflation, then changes in interest rates will also affect exchange rates. Assumes real interest rates and risk premiums are the same in both countries You could also flip all the h’s and f’s to get indirect quote IRP Caveats 7 Nominal Rate ≈ Real Rate + Inflation+ Default Risk Premium + Liquidity Risk Premium Differences in nominal rates may reflect differences in Inflation Liquidity Risk Credit Risk It is most appropriate to apply IRP to two currencies with similar credit risk and liquidity. Euro IRP for the EURUSD generally use yields on German bonds because of similar credit and liquidity risk of . bonds. Forecasting Using PPP or IRP for more or less than one year 8 For forecasting Interest Rates for t years For forecasting exchange rates exchange rates for less than one year – n months, where r or i is still annualized Poll The spot price of the euro is $. .
