4500.13 - Interest Rates and Foreign Exchange: Futures...

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Unformatted text preview: Interest Rates and Foreign Exchange: Futures & Options Markets Purpose: Discuss the use of forward, futures, and option contracts in international commerce Forward Contracting For Money: Inflation And The Price Level Future Price Level = (Present Price Level) * (1+i) n Example: present price level index is 100, inflation 10% compounded annually ... the index next year would be 110 ... the following year it would be 121 ... then 133.1 ... and so on Inflation and the Price Level Purchasing Power = Future Amount * Present Price Level Future Price Level Inflation and the Price Level Example: Amount = $100, inflation =10% 1st year: With the price level index at 110% of what it was, $100 would buy only 100/110ths of what it used to buy So, in terms of purchasing power, it would shrink to $90.91 2nd year: It would shrink to $82.64 3rd year: It would shrink to $75.13, and so on Purchasing Power = Future Amount * Present Price Level Future Price Level Purchasing Power = Future Amount * 1 (1+i) n Deflation is like inflation, but with a negative i Example: Amount = $100; 10% deflation 1 year later: Price level would be 90% of what it was $100 would then buy 100/90ths of what it did before, so $100 would expand to the equivalent of $111.11 2 years later: Price level be 81% of what it was at the start $100 would then buy 100/81ths of what it did before, so $100 would expand to the equivalent of $123.46 And so it goes Theory of Interest Purchasing Power (1+r) n PV = = FV (1+i) n (1+r) n Therefore: PV = FV (1+i) n (1+r) n Theory of Interest Purchasing Power (1+r) n PV = = FV (1+i) n (1+r) n Therefore: PV = FV (1+i) n (1+r) n Therefore: 1+R = (1+i)(1+r) Theory of Interest Purchasing Power (1+r) n PV = = FV (1+i) n (1+r) n Therefore: PV = FV (1+i) n (1+r) n Therefore: 1+R = (1+i)(1+r) R = r + i + ri r = R - i 1+i This relationship is known as the Fisher Effect: Illustration of Fisher Effect (annual compounding) Today : Invest $100 Desired r is 3% real profit of $3 Expected i is 4% One year from now : Nominal return is 7.12% R = i + r (1+i) R = i + r + ri Collect $107.12 Spend $3 * 1.04 = $3.12 Reinvest $104 Keeps real principal intact Fisher Effect Examples r = 4% i = 3% R = 7.12% r = 3% i = 7% R = 10.21% R = r + i + ri Compute Purchasing Power in Future Future Purchasing Power = PV(1+R) n (1+i) n Therefore: 1+r = (1+R) (1+i) Therefore: r = R - i 1+i r = (1+R) (1+i) (1+i) (1+i) - = (1+R) - (1+i) (1+i) Illustration of Fisher Effect (annual compounding) Year zero: Invest $100 R is 15% i is 12% One year later: Collect $115 Reinvest $112 Keeps real principal intact Spend $3 PV of real profit is $3/1.12 = $2.68 Expected real return is 2.68% r = (R – i) / (1 + i) Fisher Effect in Another Form Examples R = 10% i = 7% r = 2.80% R = 13% i = 10% r = 2.73% r = R - i 1+i Questions for Discussion Why are people concerned about inflation?...
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This note was uploaded on 04/15/2011 for the course FINA 4500 taught by Professor Staff during the Spring '08 term at North Texas.

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4500.13 - Interest Rates and Foreign Exchange: Futures...

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