International corporate finance

Pitable arbitrage opportunities

The width of this band will depend on the size of transaction costs. Another major reason for deviations from IRP is capital controls imposed by governments. For various macroeconomic reasons, governments sometimes restrict capital flows, inbound and/or outbound. Governments achieve this objective by means of jawboning, imposing taxes, or even

outright bans on cross-border capital movements.£one pound in terms of dollars should be: These control measures imposed by governments can effectively impair the arbitrage<=>7$,.$48%$9:?:+$48%.$48%$)#,0%$"-".%$)"/.2$,.$4%#(3$"-2"**'#!"##$%&'()&'%#$('&*+),-.&'/,(&'0%'12345'6'723883'9:'()&'0-:;,(0$-'/,(&process, and, as a result, deviations from IRP may persist.<3!3'0%'&*#&+(&='($'>&'?@'0-'()&'-&*('A&,/',-='5@'0-'()&'&"/$'B$-&CPAn interesting historical example is provided by Japan, where capital controls were$30038"/*2$@%A &*#&+(&='&*+),-.&'/,(&'0-'$-&'A&,/'%)$";='>&'12345DE238?F'6'72388$S($/£) = = = $2/£imposed on

and off until December 1980, when the Japanese government liberalized international capital flows. Otani and Tiwari (1981) investigated the effect of capital controls on IRP deviations during the period 1978−1981. They computed deviations from interest rate parity (DIRP) as follows:

Suppose the spot exchange rate is $1.25 = €1.00. If the inflation rate in the U.S. is expected to be 3% in the next year and 5% in the euro zone, then the expected exchange rate in one year should be:

(1 + i )S________¥ (6.11)

<3!3'0%'&*#&+(&='($'>&'?@'0-'()&'-&*('A&,/',-='5@'0-'()&'&"/$'B$-&C'()&-'()DIRP = − 1(1 + i

)F$1.25×(1.03) = €1.00×(1.05). • The euro will trade at a 1.90% discount in the forward$&*#&+(&='&*+),-.&'/,(&'0-'$-&'A&,/'%)$";='>&'12345DE238?F'6'72388DE2385where::The euro will trade at 1.90% discount in the market $1.25×(1.03)i = interest rate on three-month Gensaki bonds.14¥forward market i = interest rate on three-month Euro-dollar deposits. πF($/€) €1.00×(1.05) 1.03 1 +$ = yen/dollar spot exchange rate in Tokyo.S $= ==F = yen/dollar three-month forward exchange rate in Tokyo. πS($/€) 1.05 1 +$1.25 €€1.00Capital controls were often imposed by governments in an effort to improve the balance-of-payments12Relative PPP states that the rate of change in PPP and IRPsituations and to keep the exchange rate at a desirable level.the exchange rate is equal to differences in the Readers can convince themselves that DIRP in

Equation 6.11 will be zero if IRP holds exactly.13!"#$%&'"()))(*%$%"*(%+$%(%+"(,$%"(-.(/+$01"(&0(%+"("2/+$01"(Gensaki bonds, issued in the Tokyo money market, are sold with a repurchase agreement. While interest rates14rates of inflation—roughly 2%. on Gensaki bonds are determined by market forces, they can still be affected by various market imperfections.,$%"(&*("34$#(%-(5&..","0/"*(&0(%+"(,$%"*(-.(&0.#$%&-06,-41+#7(89:

• Notice that our two big equations equal eachother:PPP IRPπF($/€) 1 + + i1 F($/€)$ = $= =πS($/€) 1 + + i1 S($/€)eun1778X_ch06_140-172.indd 148 09/01/17 10:3€ €

We could also reformulate our equations as inflation or interest rate differentials:

• We could also reformulate our equations as inflation orπinterest rate differentials: 1

+F($/€) $= π1 +S($/€) €π π πF($/€) – S($/€) 1 + 1 + 1 +$ $ €== –1 –π π πS($/€) 1 + 1 + 1 +€ € €π πF($/€) – S($/€) – π π≈$ €E(e) = –= $ €πS($/€) 1 + €Expected Rate of Change in ExchangeRate as Interest Rate DifferentialF($/€) – S($/€) i i– ≈$ € i i= –E(e) = $ €S($/€) i1 + €! !"#$%&'($&)"**"+,-'.&"%&/$01,2"%3&$45$+'$) "%*-0'"6%7&CHAPTER 6 INTERNATIONAL PARITY RELATIONSHIPS AND F/0%03$21&6*'$%&,1$&0&89,"+:&0%)&)"2'.;&1(62'+,'<π π ≈ i i– –$ €$ € PPP Deviations and Whether PPP holds or not has importanholds and thus the differential inflationthe Real Exchange exchange rate changes, countries’

Deviations from PPP (Purchasing Power Parity) rate may or may not be systematically affected by exchange rate changes. The implications of whether PPP holds or not are significant for international trade.

If PPP holds, it means that changes in nominal exchange rates are exactly offset by the differential inflation rates between countries. In this case, the international competitive positions of countries in world export markets will not be systematically affected by exchange rate changes. Furthermore, the trade balances of countries would not be affected by these changes.

However, if there are deviations from PPP, changes in nominal exchange rates cause changes in the real exchange rate, which in turn affects the international competitive positions of countries. Consequently, these changes would impact the trade balances of countries.

The real exchange rate, denoted as q, measures deviations from PPP. It can be defined as follows:

q = (1 + e) (1 + π)

Here, e represents the nominal exchange rate and π represents the inflation rate.

It is important to note that if PPP holds, the value of q will be unity.

q = 1. When PPP is violated, the real exchange rate will deviate from unity. Suppose, for example, the annual inflation rate is 5 percent in the United States and 3.5 percent in the U.K., and the pound appreciated against the dollar by 4.5 percent. Then the real exchange rate is .97:

q = (1.05)/(1.045)(1.035) = .97

In the above example, the dollar depreciated by more than is warranted by PPP, strengthening the competitiveness of U.S. industries in the world market. If the dollar depreciates by less than the inflation rate differential, the real exchange rate will be greater.

than unity, weakening the competitiveness of U.S. industries. To summarize,

q = 1: Competitiveness of the domestic country unaltered.

q < 1: Competitiveness of the domestic country improves.

q > 1: Competitiveness of the domestic country deteriorates.

PPP probably doesn’t hold precisely in the real world for a variety of reasons. Haircuts cost 10 times as much in the developed world as in the developing world. Film, on the other hand, is a highly standardized commodity that is actively traded across borders. Shipping costs, as well as rates plotted in Exhibit 6.7 are, however, tariffs and quotas, can lead to deviations from PPP. PPP-determined exchange rates still provide a valuable benchmark. rate

is a weighted average of bilateral real effective exchange rate determined by the country's Fisher effect. Another parity condition we often encounter in the literature is the Fisher effect. The real effective exchange rate Fisher effect holds that an increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country. Formally, the Fisher effect can be written for the United States as follows: E(π= ρ + ) + ρ ) ≈ ρ + ) where ρ denotes the equilibrium expected "real" interest rate in the United States. The exchange rate of the Chinese yuan fell sharply and remained at a low level until 2006 when it began to rise. On the other hand, the nominal exchange rate for Germany generally fell until 2000 and then started to steadily decline. In the mid-1990s until 2007, hurting the country's competitiveness.