W6: international corporate finance

• exchange rate - price of one country's currency expressed in terms of another currency
• cross-rate - implicit exchange rate between two currencies when both are quoted in a third currency
• in arbitrage: buy low and sell high
• for investors it is difficult to gain from triangular arbitrage. usually investment banks can profit from the arbitrage.
• absolute purchasing power parity: a commodity costs the same regardless of what currency is used to purchase it or where it's selling
• under absolute purchasing parity, the exchange rate and change in exchange rate is determined and adjusted to keep purchasing power constant among currencies
• conditions for absolute PPP to hold:

  • no transaction costs
  • no barriers to trading → tariffs
  • assets must be identical in both locations
• in the real world absolute PPP may hold for:

  • very uniform traded goods
  • easily transportable items
• relative purchasing power parity tells us that inflation determines the change in exchange rates over time, but doesn't tell use what determines the absolute level of the exchange rate
• relative PPP states that the expected percentage change in the exchange rate over the next year should equal the difference in inflation rates between two countries
• interest rate parity (IRP) - explains difference between forward and spot rates
• interest rate parity:

  if an investor places money in a high interest rate currency, they will be no better off after conversion back into their domestic currency using a forward contract than if they left the money in the domestic currency
• forward rate:

  • premium - subtract from spot rate
  • discount - add to spot rate