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Abstract
Keywords: purchasing power parity, inflation, exchange rate, foreign investment, domestic investment
International Monetary Relations
The paper aims to understand international monetary relations with respect to currency exchange rates, varying interest rates, inflation rates and purchasing power parity between nations. The calculations are made on the assumption that I have won the Irish Lottery. I bought a ticket while I was on vacation in Ireland and my winnings amount to 1 million (euros) after all taxes were taken out.
Question 1
If the current exchange rate is US$1 equals €0.70, how much did you win in US dollars?
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Answer:
It is given in the question that, US$1 = €0.70
Reversing current exchange rate, €1 = US$1.428571
Thus, 1 million (euros) in USD = US$1.428571* 1 million = US$ 1,428,571.43
Question 2
Suppose that the interest rate in Irish banks is 2% for a one year CD. In the USA, the rate is 4% for a one year CD. If you left your winnings in Ireland, how many euros would you have in a year? If you had taken your winnings back to the USA, how many dollars would you have?
Answer
If the winning is left in Ireland, interest earned in one year = €20,000 (calculating 2% of €1,000,000). Adding this interest to the principal amount of €1 million, the total euros I would have in one year is €1,020,000.
If the winning is taken back to the USA, interest earned in one year = US$57, 142.86 (calculating 4% of US$ 1,428,571.43). Adding this interest to the principal amount of US$ 1,428,571.43, the total US dollars I would have in one year is US$1,485,714.29.
Question 3
Suppose when you cashed in your CD in Ireland a year from now, the exchange rate had changed from US$1 to €0.70 to US$1 to €0.65. How much would your Irish bank account be worth in US dollars at that point? Would you have been better off leaving your winnings in Ireland or bringing them home to the USA?
Deriving from the given exchange rate, €1 = US$ 1.538462 (reversing the given US$:€ exchange rate)
Thus, value of Irish bank account in terms of US dollars in a year = US$ 1,569,230.77 (derived by multiplying 1.538462, the exchange rate and 1,020,000, total euros)
The current situation clearly indicates that euros have appreciated as compared to the US dollars. The value of winnings in a year if invested in the USA would have been US$1.49 million (from question 2). However, when left in Ireland and with changed exchange rate, the value of the winning in US dollars in one year is US$ 1.57 million. Thus, I would have been better off leaving the winnings in Ireland.
Question 4
Explain how banks and individuals can use covered interest arbitrage to protect themselves when they make international financial investments.
Answer
Interest rate on deposits usually differs across nations. In addition to this, exchange rate between two nations also varies from time to time. Banks and individuals can use covered interest rate arbitrage to protect their international financial investments. According to Kim and Woo (1999), if the restrictions on cross-border international capital movement do not exist, the risks are limited to exchange rates fluctuations alone. This risk of exchange rate fluctuation can be eliminated by exploiting the interest rate differential such that returns on both domestic and international financial assets are identical. This is known as covered interest arbitrage, which involves getting into a forward contract to eliminate exchange rate risk.
Taking an example, an investor is contemplating investing US$ 1 million either domestically of in international assets. Assuming that spot exchange rate is US$1 equals €0.70 and one year forward exchange rate is US$1 equals €0.65. One year CD rate in the USA is 4 % and in Ireland is 2%. If the amount is invested in the USA, the total dollars in one year will be US$1,040,000. However, if the dollars are converted into euros today (US$1 million = €700,000), invested in Ireland CD (interest earned = €700,000* 2%) and a forward contract (at US$1 equals to €0.65) is taken for the future value of the proceeds (€714,000), the total number of dollars will be US$1,098,462. Thus, the option of covered interest arbitrage is better for an investor.
Question 5
Using the theory of purchasing power parity, explain how inflation impacts exchange rates. Based on the theory of purchasing power parity, what can we infer about the difference in inflation between Ireland and the USA during the year your lottery winnings were invested?
Answer
Purchasing power parity (PPP) are the rates of currency conversion that eliminate the differences in price level between countries (Oecd.org, n.d.). In other words, PPP defines the exchange rate (or the PPP rate) at which the same amount of money is needed to purchase similar basked of goods and services in two countries.
As inflation increases, it erodes the domestic purchasing power reducing the basket of goods and services that can be bought with a given amount of money (Damodaran, 2011). This requires readjustment of the exchange rate or the PPP rate, causing a decline in the value of the domestic currency. Thus, PPP theory infers that value of domestic currency declines with increase in domestic inflation, which reduces the exchange rate between the domestic and the foreign country.
The theory can be applied to the case of winning lottery in Ireland. The exchange rate of the US dollar to euros decreases from 0.70 to 0.65 in a year. This infers that inflation in the USA has increased with respect to Ireland and the difference in inflation between the two countries has increased during this period of one year.
Conclusion
Covered interest arbitrage and purchasing power parity are two essential concepts in international financial investments. Covered interest arbitrage eliminates exchange rate risk by exploiting the interest rate differential between two countries. If no restrictions exist in capital movement, it renders returns on domestic and international investment identical. Purchasing power parity defines the exchange rate which the same amount of money is needed to purchase similar basked of goods and services in two countries. It helps in determining exchange rates between countries due to the effect of inflation.
References
Damodaran, Harish (2011). Inflation, exchange rates and PPP. Retrieved from http://www.thehindubusinessline.com/opinion/columns/harish-damodaran/article1540678.ece
Kim, In-June and Woo, Junk Seok (1999). Covered Interest Arbitrage and the Currency Crisis in Korea. Retrieved from http://147.46.167.195/~ecores/korean/no21.pdf
OECD (n.d.). Prices and Purchasing Power Parities (PPP). Retrieved http://www.oecd.org/department/0,3355,en_2649_34347_1_1_1_1_1,00.html
