Page 81 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes due to sample periods over which the models are estimated. Theoretical difficulties arise
from the existence of trade restrictions, transport and transaction costs, as also from rate
consumption and interest rate smoothing behaviour. In practice, persistent swings in real
exchange rate are observed. For India, Pattanaik (1999) finds that PPP over the long run
defines the presence of a cointegrated relationship between exchange rate and relative
prices and the misalignment at any point of time is corrected by 7.7 per cent per quarter
through nominal exchange rate adjustments. Bhoi and Dhal (1998) tested for the relevance
of UIP and CIP and concluded that neither holds true.
Other Countries

Much research has been conducted to test whether PPP exists. Various studies in US have
found evidence of significant deviations from PPP, persistently for lengthy periods.
Whether the IFE holds true in reality depends on the particular time period examined.
In 1978-79, the US interest rates were generally higher than foreign interest rates and the
foreign currency values strengthened during this period, supporting IFE theory to an
extent. However, during the 1980-84 period, the foreign currencies consistently weakened
far beyond what would have been anticipated according to IFE theory. Also, during the
1985-87 period, foreign currencies strengthened to a much greater degree than suggested
by the interest differential. Thus, IFE may hold for sometime, but there is evidence that it
does not consistently hold true.
Source: International Financial Management, Madhu Vij, Excel Books.

5.3 International Fisher Effect (IFE)

The IFE uses interest rates rather than inflation rate differential to explain the changes in exchange
rates over time. IFE is closely related to the PPP because interest rates are significantly correlated
with inflation rates. The relationship between the percentage change in the spot exchange rate
over time and the differential between comparable interest rates in different national capital
markets is known as the ‘International Fisher Effect.’
The IFE suggests that given two countries, the currency in the country with the higher interest
rate will depreciate by the amount of the interest rate differential. That is, within a country, the
nominal interest rate tends to approximately equal the real interest rate plus the expected
inflation rate. Both, theoretical considerations and empirical research, had convinced Irving
Fisher that changes in price level expectations cause a compensatory adjustment in the nominal
interest rate and that the rapidity of the adjustment depends on the completeness of the information
possessed by the participants in financial markets. The proportion that the nominal interest rate
varies directly with the expected inflation rate, known as the ‘Fisher effect, has subsequently
been incorporated into the theory of exchange rate determination. Applied internationally, the
IFE suggests that nominal interest rates are unbiased indicators of future exchange rates.

Did u know? A country’s nominal interest rate is usually defined as the risk free interest
rate paid on a virtually costless loan. Risk free in this context refers to risks other than
inflation.
In an expectational sense, a country’s real interest rate is its nominal interest rate adjusted for the
expected annual inflation rate. It can be viewed as the real amount by which a lender expects the
value of the funds lent to increase on an annual basis. For a firm using its own funds, it can be
viewed as the expected real cost of doing so. The nominal interest rate consists of a real rate of

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