ch04 - INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL...

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INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT , 9TH ED. CHAPTER 4 PARITY CONDITIONS IN INTERNATIONAL FINANCE AND CURRENCY FORECASTING This chapter emphasizes that currency prices are determined in the same way that other asset prices are, by the interaction of supply and demand curves. The key concept here is the relationship between inflation and exchange rate changes--the internal devaluation of a currency (inflation) eventually leads to its external devaluation. K EY P OINTS 1. Inflation is the logical outcome of an expansion of the money supply in excess of real output growth. As the supply of one commodity increases relative to supplies of all other commodities, the price of the first commodity must decline relative to the prices of other commodities. In other words, its value in exchange or exchange rate must decline. Similarly, as the supply of money increases relative to the supply of goods and services, the price of money in terms of goods and services must decline, i.e., the exchange rate between money and goods declines. 2. The international parallel to inflation is domestic currency depreciation relative to foreign currencies. In order to maintain the same exchange rate between money and goods both domestically and abroad, the foreign exchange rate must decline by (approximately) the difference between the domestic and foreign rates of inflation. This is purchasing power parity, which is itself based on the law of one price. 3. Although the nominal or actual money exchange rate may fluctuate all over the place, we would normally expect the real or inflation-adjusted exchange rate to remain relatively constant over time. The same is true for nominal versus real rates of interest. However, although the prediction that real interest and exchange rates will remain constant over time is a reasonable one ex ante, ex post we find that these real rates wander all over the place. As we will see in Chapter 11, a changing real exchange rate is the most important source of exchange risk for companies. 4. Four additional equilibrium economic relationships tend to hold in international financial markets: purchasing power parity, the Fisher effect, international Fisher effect, interest rate parity, and the forward rate as an unbiased estimate of the future spot rate. 5. These equilibrium relationships are at the heart of a working knowledge of international financial management. I point out to the students that they will be seeing them in many different guises--from the analysis of a firm's foreign exchange exposure to currency forecasting to the decision as to which currency to borrow or lend in. The final section makes six key points about exchange rate forecasting: 1. The foreign exchange market is no different from any other financial market in its susceptibility to being profitably predicted. 2.
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ch04 - INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL...

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