Page 83 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes

Notes The IFE suggests that if a company regularly makes foreign investments to take
advantage of higher foreign interest rates, it will achieve a yield that is sometimes below
and sometimes above the domestic yield.

Points above the IFE line like E and F reflect lower returns from foreign deposits than the
returns that are possible domestically. For example, point E represents a foreign interest rate
that is 3 per cent above the home interest rate. Yet, point E suggests that the exchange rate of the
foreign currency depreciated by 5 per cent to more than offset its interest rate disadvantage.
Points below the IFE line show that the firm earns higher returns from investing in foreign
deposits. For example, consider point Y in the Figure 5.2. The foreign interest rate exceeds the
home interest rate by 4 per cent. The foreign currency also appreciated by 2 per cent. The
combination of the higher foreign interest rate plus the appreciation of the foreign currency will
cause the foreign yield to be higher than what was possible domestically. If an investor were to
compile and plot the actual data and if a majority of the points were to fall below the IFE, this
would suggest that the investors of the home country could have consistently increased their
investment returns by investing in foreign bank deposits. Such results refute the IFE theory.

Task Examine the relationship between interest rate differential and exchange rate
changes for a few currencies over time to determine whether the International Fisher
Effect (IFE) appears to hold over time for the currencies examined.

Self Assessment

Fill in the blanks:
12. A country’s …………………… interest rate is usually defined as the risk free interest rate
paid on a virtually costless loan.

13. The IFE argues that a rise in a country’s nominal interest rate relative to the nominal
interest rates of other countries indicates that the …………………… value of the country’s
currency is expected to fall.
14. The IFE uses …………………… rates rather than inflation rate.
15. The IFE suggests that nominal interest rates are unbiased indicators of ……………………
exchange rates.

5.4 Comparison of Purchasing Power Parity, International Fisher
Effect and Interest Rate Parity Theories

Table 5.1 compares three related theories of international finance, namely (i) Interest Rate Parity
(IRP) (ii) Purchasing Power Parity (PPP) and (iii) the International Fisher Effect (IFE). All three
theories relate to the determination of exchange rates. Yet, they differ in their implications. The
theory of IRP focuses on why the forward rate differs from the spot rate and the degree of
difference that should exist. This relates to a specific point in time. The, PPP theory and IFE
theory focus on how a currency’s spot rate will change over time. While PPP theory suggests
that the spot rate will change in accordance with inflation differentials, IFE theory suggests that
it will change in accordance with interest rate differential.

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