International Financial Management: Lecture-6

Md. Bayazid Sarker

CERTIFIED DIGITAL FINANCE PRACTITIONER (CDFP),
The Fletcher School of Law and Diplomacy, Tufts University, USA
| Master of Economic Policy, GRIPS, Tokyo | Master of Economics, DU | MBA, DU |
| Director, FEOD, Bangladesh Bank | Adjunct Assistant Professor, NSU |

Class Lecture
for
BBA Program
NOTH SOUTH UNIVERSITY

Email: bayazidsarker@gmail.com

November, 2024

* All rights are reserved by the teacher. Content and views expressed in this class lecture are presenter’s own and do not necessarily reflect that of Bangladesh Bank or any other authority.
 International Financial Management: Lecture-6

Foreign Exchange Market and Exchange Rate Determination

Interest rate parity [IRP], Purchasing power parity [PPP]
and International Fisher effect [IFE]:
International Arbitrage:
Simultaneous buying and selling of foreign currency for making profit, is called arbitrage. It
may occur in two ways:
1. Because of exchange rate difference between two financial centers.[Currency arbitrage]
2. Because of Interest rate difference between two financial centers. [Interest arbitrage]

There are three common forms of arbitrage:

1. Locational arbitrage: When quoted ER vary between two locations
2. Triangular arbitrage: When quoted cross rates and calculated cross rate are different
from one’s base currency.
3. Covered interest arbitrage: “Interest arbitrage” refers to the process of capitalizing on
the difference between interest rates between two economies and ‘covered’ refers to
hedging exchange position against exchange rate risk. Mostly used by the banks.

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 International Financial Management: Lecture-6

Foreign Exchange Market and Exchange Rate Determination

Interest rate parity [IRP]:
Once market forces cause interest rates and exchange rates adjust such that covered
interest arbitrage [CIA] is no longer feasible, the equilibrium position is called IRP. It may
exist, when ROR achieved form CIA = ROR in home country.
Let, local investment ( ) at prevailing rate (S)
Investment amount = /S [in foreign]
After 1 year it will get
Reconverted into forward rate F, and the received amount in local currency

Now the rate of return (R) from this investment

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 International Financial Management: Lecture-6

Foreign Exchange Market and Exchange Rate Determination

Interest rate parity [IRP]:
Now, IRP exists, if ROR in home country = ROR achieved form CIA.
Therefore,

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 International Financial Management: Lecture-6

Foreign Exchange Market and Exchange Rate Determination

Purchasing power parity [PPP]:
Price of the same basket of products in two different economies should be equal when
measured in a common currency [exchange rate] is called PPP. It may hold, when same
basket of products can be purchased by the same price in 2nd economy [foreign]
Price index
Price index Inflation
[after inflation]
Home

Foreign

If ER changes, then foreign price index from the home economy’s consumers will be
Now, PPP may hold if new price index of home = new price index of foreign.

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 International Financial Management: Lecture-6

Foreign Exchange Market and Exchange Rate Determination

Purchasing power parity [PPP]:
Therefore,

Implications:

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 International Financial Management: Lecture-6

Foreign Exchange Market and Exchange Rate Determination

International Fisher effect [IFE]:
IFE uses interest rate rather than inflation rate differentials to explain why exchange rate
change over time. IFE holds: if
effective return on foreign investment= interest rate on a local money market investment.
Let, return of foreign bank deposit
and effective return on foreign deposit = Therefore,

Implications:

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 International Financial Management: Lecture-6

Foreign Exchange Market and Exchange Rate Determination

International Arbitrage and Interest Rate Parity (IRP):

International Arbitrage:
1. Local Arbitrage
2. Triangular Arbitrage
3. Covered Interest Arbitrage (CIA)

IRP exists, if ROR in home country = ROR achieved form CIA.

Chapter-7: International Corporate Finance, 10e, Jeff Madura

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 International Financial Management: Lecture-6

Foreign Exchange Market and Exchange Rate Determination

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 International Financial Management: Lecture-6

Foreign Exchange Market and Exchange Rate Determination

Poblem-12, P-226, Jeff Madura Calculation:

Given Information: Arbitrage Process: USD CAD USD

Spot CAD 1 = USD 0.80 IRP exists, if ROR in home country = ROR achieved form CIA.

90-day forward CAD 1 = USD 0.79 Initial Investment = USD 100

90 days Canadian Int. Rate = 4% =0.04 1. ROR in home country (USA) =USD 100 ✕[1+.025 ✕ !" ]
#$"
90 days US Int. Rate = 2.5% =0.025
= USD 100 ✕ 1.00625=100.625
US Investor Invests = USD 1.00 million
!
2. USD 100✕ ".$" = CAD 125
!"
3. CAD 125 ✕[1+ 0.04 ✕ #$"
]= CAD 125 ✕1.01= CAD 126.25

4. CAD 126.25 ✕ 0.79 = USD 99.7375

Profit/Loss=USD (99.7375-100)= USD -0.2625

%".'$'(∗*""
Rate of Return= = -0.2625%
*""

ROR in USA (0.625%) > ROR from CIA (-0.2625%)

Therefore, CIA is not feasible.
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 International Financial Management: Lecture-6

Foreign Exchange Market and Exchange Rate Determination

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 International Financial Management: Lecture-6

Foreign Exchange Market and Exchange Rate Determination

Poblem-10, P-226, Jeff Madura Calculation:

Given Information: Arbitrage Process: MXN USD MXN

Spot MXN 1 = USD 0.100 IRP exists, if ROR in home country = ROR achieved form CIA.

180-day forward MXN 1 = USD 0.098 Let, Initial Investment = MXN 100.00

180 days Mexican Int. Rate = 6% =0.06 1. ROR in home country (Mexico) = 6%

180 days US Int. Rate = 5% =0.05 MXN 100.00 ✕ 1.06 = MXN 106.00
2. MXN 100.00 ✕ 0.100 = USD 10.00
3. USD 10.00 ✕ 1.05 = USD 10.50
*
4. USD 10.50 ✕ = MXN 107.14
"."!+

Profit/Loss=MXN (107.14-100.00)= MXN 7.14

ROR in Mexico (6%) < ROR from CIA (7.14)
Therefore, CIA is feasible.

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