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IBUS 302: International Finance
Topic 9–Fisher Effects
Lawrence Schrenk, Instructor
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Learning Objectives
1. Distinguish real versus nominal values. ▪
2. Calculate the real exchange rate and discuss its implications for international competition.
3. Describe the evidence for PPP and the reasons there may be deviations from it.
4. Explain the international Fischer effect and the forward expectations parity.▪
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Real versus Nominal Values
Nominal Values Values before an adjustment for inflation The price stated in a contract The actual price you will pay either now or later
Real Values Values after an adjustment for inflation ‘Constant’ dollars Incorporates only productivity changes
The Fisher Effect (FE)
Variables Nominal return (i) Real Return (r) Inflation (p)
Relationship
NOTE: Do not use the approximation: i ≈ + rp
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1 1 1 i E
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If PPP Holds
If PPP holds There is inflation (i.e., price levels change) FX rates change cancelling the effects of inflation
So the changes have been only nominal Real exchange rate (q) = 1. International competitiveness does not
change The amount you can buy in dollar terms has not
changed.
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If PPP Does Not Hold
If PPP does not hold There is inflation (i.e., price levels change) FX rates may change, but do not completely
cancel the effects of inflation So some part of the changes are real
Real exchange rate (q) ≠ 1. International competitiveness does change
The amount you can buy in dollar terms has changed.
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q is the deviation from PPP q is the real exchange rate
e is the (empirical) percentage change in F based on current data. (Do not confuse it with ePPP which is the (theoretical) percentage change in F consistent with relative PPP.)
Real Exchange Rate
$1
1 1 x
qe
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Formula:
Notation (not in the textbook)
ePPP is the percentage change in F predicted by PPP.e is the (empirical) percentage change in F based on
current data. If e = ePPP, then
PPP holds, i.e., no deviation and q = 1 International competitiveness does not change.
ePPP versus e
F Se
S
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q and competitiveness < 1 domestic more competitive = 1 no change > 1 domestic less competitive
Real Exchange Rate and Competitiveness
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Real Exchange Rate Example
p$ = 5%
p€ = 4% S($/€) = 1.4300 F($/€) = 1.4500 What is q?
Solution
Actual Change in Forward Rate
Real Exchange Rate
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1.4500 1.4300
1.43000.0140 1.40%
F Se
S
$1 1.05
1.02121 1 1.0140 1.014x
qe
Analysis
If PPP held, then the forward rate should be:
The actual forward rate, F, is 1.4500, so PPP does not hold, and q > 1, so domestic trade is less competitive
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$ 0.05 0.040.0096
1 1.04
1.4300 1.0096 1.4438
xPPP
x
PPP
e
F
Practice: Absolute PPP
Data US Big Mac $3.54 UK Big Mac £2.29 S($/£) = 1.4689
Questions What is SPPP($/£)? Does absolute PPP hold?
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Practice: Relative PPP
S($/£) = 1.4689, F12($/£) = 1.4722, p$ = 7.4%, p£ = 6.1%
Question: Does relative PPP hold? What is ePPP?
What is FPPP?
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$
1x
PPPx
e
PPPF ($/x) S($/x) 1 e
Practice: Relative PPP
S($/£) = 1.4689, F12($/£) = 1.4722, p$ = 7.4%, p£ = 6.1%
Question: If not what is the real exchange rate? What is e ? (Remember this is different from ePPP)
What is q?
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F Se
S
$1
1 1 x
qe
Practice: Relative PPP
S($/£) = 1.4689, F12($/£) = 1.4722, p$ = 7.4%, p£ = 6.1%
Question: What are the implications for international competition?
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PPP Deviations
Transportation Costs Shipping costs can remove arbitrage
opportunity; imports become relatively more expensive.
Trade Restrictions Example: Pharmaceutical Industry
Cost of Non-Tradable Inputs Taxes Productivity
‘Big Mac’ Index
Index Analysis
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International Fischer Effect and the Forward
Expectations Parity
Overview
Interest Rate Parityinterest rates (i) → forward rate
Purchasing Power Parityinflation (p) → forward rate
Fisher Effect
interest rates (i) ↔ inflation (p)
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Implications
IRP connects FX and interest rates PPP connects FX and inflation Fisher Effect connects interest rates and
inflation
PPP IRP
Fisher Effect
FX
Inflation Interest Rates
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Fisher Effect (FE)
Inflation increases causes interest rate increase. Recall time value of money (TVM) motivations
Opportunity Costs Inflation Risk
Interest rates must compensate the investor for expected inflation:
1 1 1i E
Fisher Effect
Fisher Effect applies to all currencies individually:
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$ $ $1 1 1i E
£ £ £1 1 1i E
International Fisher Effect (IFE)
Combine PPP and FE to get IFE The real rate should be equal r$ = r£
Rewrite FE as:
Recall PPP:
Substitute FE into PPP:
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1x x
xx
iE
$
1x
PPPx
E e
$
1x
IFEx
i iE e
i
Forward Expectations Parity (FEP)
Combine IFE and IRP to get FEP
Recall IFE:
Recall IRP (in a different form):
Combine IFE and IRP for FEP:
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$
x1xIRP
IFE
i iF SE e
S i
$
1x
IFEx
i iE e
i
$
x1xIRP
i iF S
S i
Forward Expectations Parity (FEP): Implications I
Percentage Change Analysis
The percentage change in the exchange rate, i.e., the forward premium or discount, is equal to the expected change in the exchange rate.
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$
x1xFEP
IFE
i iF SE e
S i
Forward Expectations Parity (FEP): Implications II
Forward Rate Analysis
The expected forward rate is equal to the spot rate increased by the expected change in the exchange rate.
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$
x
1
where 1
FEP IFE
xIFE
E F S E e
i iE e
i
FEP Example
S($/A$) = 0.6495, i$ = 4.2%, iA$ = 3.3%
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$ $
$
11
0.042 0.0330.6495 1 0.6552
1.033
AFEP
A
i iE F S
i
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Implications
IRP connects FX and interest rates PPP connects FX and inflation Fisher Effect connects interest rates and
inflation ▪
PPP IRP
Fisher Effect
FX
Inflation Interest Rates
IFE
FEP ▪
Fisher Required Formulae
Fisher Effect (FE)
International Fisher Effect (IFE)
Forward Expectations Parity (FEP)
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1 1 1i E
$
1x
IFEx
i iE e
i
$
x1xFEP
IFE
i iF SE e
S i
