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IFM – Management Report
INTERNATIONAL FINANCIAL MANAGEMENT -MANAGEMENT REPORT-
“The test of a good theory is how well it stands up in the real world. Using empirical evidence, critically examine the main theories of International Financial Management and assess the extent to which each stands up in the real world.”
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Summary: INTRODUCTION .......................................................................................................................... 3 SECTION 1 ................................................................................................................................... 4 DISCUSSION ABOUT THE MAIN THEORIES ................................................................................. 4 The Purchasing Power Parity Theory (PPP):........................................................................................ 4 The Interest Rate Parity Theory (IRPT):............................................................................................... 5
SECTION 2 ................................................................................................................................... 6 Test on the Absolute Purchasing Power Parity .......................................................................... 6 The case of Australia ........................................................................................................................... 6 The case of Brazil ................................................................................................................................ 7 The case of Canada ............................................................................................................................. 8 The case of China ................................................................................................................................ 8 The case of Japan ................................................................................................................................ 9
SECTION 3 ................................................................................................................................. 10 Test on the Relative Purchasing Power Parity .......................................................................... 10 The case of Australia… ...................................................................................................................... 10 …Is also the case of many other currencies: ..................................................................................... 10 The case that is the exception to the rule. ....................................................................................... 11
SECTION 4 ................................................................................................................................. 12 Test on the Interest Rate Parity Theory .................................................................................... 12 SECTION 5 ................................................................................................................................. 14 Analysis and conclusion ............................................................................................................ 14 BIBLIOGRAPHY .......................................................................................................................... 15
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Brice BOUVIER – 07155935
IFM – Management Report
INTRODUCTION “In theory, theory and practice are the same. In practice, they are not.” This quote from Albert Einstein is really interesting. It would imply that there is a kind of lens between theory and practice which would deform one when we translate it in the other. However, it is stated that we could evaluate the degree of validity of a theory by studying its ability of being confirmed in practice, that is to say by studying empirical evidences. In this management report, we will first take a closer look to the discussions about two main theories of International Finance: • •
The Purchasing Power Parity Theory (PPP) The Interest Rate Parity Theory (IRPT)
Then, we will look for empirical evidences related to these theories. They will be of different nature and sources. The preferred source will be Primary Evidence but we will sometimes be forced to use secondary and even tertiary evidences to form our opinion.
Finally, we will conclude by analyzing all the evidences found and try to assess the extent to which each stands up in practice.
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SECTION 1 DISCUSSION ABOUT THE MAIN THEORIES The whole theories are really discussed by many different persons. Indeed, every theory has its own strengths and weaknesses. Moreover, the best way to assess a theory is to submit it to the real world.
The Purchasing Power Parity Theory (PPP): This theory is about the concept of evolution of the currencies. It assumes that the price for a same good should be the same all over the world. If we assume that, comparing the prices of a same good or basket worldwide (that is to say in different currencies), is supposed to give us a clue on a currency’s future fluctuation. But this theory has been elaborated assuming that the market was perfect, that there were no transportation costs and no official barriers to trade. In other words and to be valid, the prices of a same good/basket of good should be the same in every country, and the only difference should be due to the fluctuations of the currency. The relevance of this theory is really discussed but today, we can say that the common finding of all the studies carried is that the PPP theory stands up in practice only on the long term. However, the position of the International Finance’s specialists changed over the years. As an example, before the mid-70’s the PPP theory was widely believed as long as studies using statistics showed that PPP and currencies fluctuations was very related. But in a second time, after the mid-70’s, many studies proved the imperfection of such a theory and harmed the Purchasing Power Parity Theory’s credibility. Indeed, statistics are sometimes useless with explaining specific phenomenon. Thus, Kravis and Lipsey (1978) proved that there was a difference of PPP according to the kind of good studied (tradable or non-tradable). Nowadays, it is possible to say that there is two schools of thought because some of the recent studies failed to prove the inefficiency of that theory. •
•
Some people believe in the PPP theory. Indeed, many studies from Everett, George and Blumberg (1980), Rush and Husted (1985), Manzur (1990) or Taylor and Peel (2000) tends to prove its validity. Some people tend to believe that the fluctuations of any currency follows no pattern or at least not on the basis of a PPP Theory. This makes reference at the random walk hypothesis (Louis Bachelier 1900). Many studies failed to reject the random walk hypothesis: Mark (1990)
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The Interest Rate Parity Theory (IRPT): The interest rate parity is a theory which tries to predict future differences between spot rate and forward rate. To do so, it assumes that there are no arbitrage possible. In other words, if we consider that: • •
Investment A: 100€ are invested in France at a risk free rate and a forward contract for USD is made for this amount, at the end of the investment duration. Investment B: 100€ are exchanged in dollars at the spot rate and then invested in the United States at the risk free rate.
Then, with the Interest Rate Parity theory, A and B should not have a different future value.
This theory is really different than the Purchasing Power Parity Theory as long as it is supposed to work on the short term basis whereas PPP works exclusively on long term.
Concerning the empirical evidences and here again, two different kinds of conclusion appeared. As a consequence, there are two different kinds of reaction: •
•
Those who believe in the evidences brought by Roll and Solnik (1975), Giddy and Dufey (1975) or Popper (1993). They showed that there were no significant interest differential in covered IRP (covered because of the insurance of having a predetermined rate of exchange with the forward rate). Other people tend to be convinced by the arguments highlighted by Stein (1965), Hilley, Breidleman and Greenleaf (1981) or Fletcher and Taylor (1994). Their researches tended to prove that there are significant deviation from IRP.
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SECTION 2 Test on the Absolute Purchasing Power Parity As explained in section one, the Purchasing Power Parity is an economical theory which implies that the fluctuation of a currency can be forecasted by studying the price of a same basket of good in different countries. As a result, a spot rate evolution should follow a global trend leading to the price of a same basket in two different currencies. For this reason, I have decided to study the historical data evolutions of 12 different currencies against the US dollar and see if it goes to an equilibrium between PPP and current spot rate. The problem has been to find the data. The different calculations of this research are shown in the relative appendix. In this table, the PPP value comes from the World Bank group, a family of five international organizations responsible for providing finance and advice to countries for the purposes of economic development and eliminating poverty. Concerning the historical spot rates, they come from the Federal Reserve Bank of New York, the USA’s central bank. The next graphs are showing the relation between the PPP Index symbolized by the red line and the historical data of the spot rate between USD and the national currency (Australian Dollars, Brazilian Real, Japanese Yen, We are going to try to analyze the relations found.
The case of Australia
Here, the PPP for 2005 indicates 1.39 and is symbolized by the red line. At the beginning of January, the spot rate was 1.2837 AUD for 1 USD. Thus, we can confirm that in a first time, the PPP Theory
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seems to be validated by this empirical evidence. Indeed, the spot rate even equals the PPP index in February 2006, that is to say 13 months after. However, in a second time, the trend collapses and loses 26.33% in only two years time.
The case of Brazil
Concerning the Brazilian evolution of historical data, we must say that at the first sight, it is striking that at the beginning of 2005, the value of the spot rate was far greater than the PPP index. However, the curve seems to follow a decreasing trend. In 3 years time (between January 2005 and January 2008), the decrease of difference between the PPP index and the historical spot rate is more than 70%. That tends to validate the PPP theory as long as it stands up in practice. Nevertheless, we should notice here that the mechanisms works only on a long term basis. Indeed, that theory is not relevant with explaining the jerk increase observed between May and June 2006.
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The case of Canada
Here, we can clearly see that the PPP theory does not stand up in practice. Indeed, the first year the spot rate are staying around the PPP. But in 2006, the spot rates are going under the PPP and they will not meet up with it anymore. Despite a kind of regular increase between September 2006 and February 2007, the curve suddenly collapses to reach a low point at 0,95 in November 2007.
The case of China
Another interesting graph is the Chinese case. This graph is surprisingly smooth and the movement towards an equilibrium between PPP and spot rate seems to be without important fluctuation. However, even if the general trend tends to validate the PPP, it must be said that the point of equilibrium is longer than usual to be reached. However, the last months of 2007 and the first months of 2008 seemed to indicate a quickening of the phenomenon.
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The case of Japan
Finally, we should study the Japanese evolution. On this graph, we can see that the historical spot rates move towards the PPP index until June 2007. During that period of time, (January 2005 to July 2007), the Spot rate increased of 18,95%. But from July 2007, the situation is really different as the spot rate data collapse: -16,80% in only 9 months time. That is probably due to the subprime crisis. So, a question arises: Why not every countries are as affected as Japan? The answer lies in the structure of the Japanese economy: It is really dependant of its exportation to the USA. So, if the American economy is touched, the Japanese economy is also touched. And of course, this has an influence on the spot rates of USD/JPY.
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SECTION 3 Test on the Relative Purchasing Power Parity The Relative form of the Purchasing Power Parity theory describes the difference in the inflation rate between two countries by studying the fluctuation of a same basket of goods in different countries.
In order to find empirical evidences on this relative theory, I have decided to compare the Annual Percent Change in the inflation rate (in %) and the Annual Percent Change of the spot rate during a long period of time (12 years). Here, a clear relation is often remarkable.
The case of Australia…
Here, we can see that the annual Percent Change in Inflation rate seems to influence the changes in spot rate. Indeed, the inflation rate decreases between 1995 and 1997. For sure, the relation is not perfect but between 1999 and 2002 the 2 curves show the same trends but at a different extent.
…Is also the case of many other currencies: On the following graphs, you can remark that the Inflation Rates are often following the same patent than Spot Rates. Of course the Inflation rates changes are smaller than the spot rates’ changes, but the general trend is similar: If the Inflation rate increases, the Spot rate increases also and vice-versa. However, these graphs can only give us a general idea of the future fluctuation because the data are not accurate enough to give an exact value. Finally, it must also be noticed that this theory stands up only on long term basis because at short term, the fluctuation are not always explainable.
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The case that is the exception to the rule. The case of the United kingdom shows almost no relation between Inflation rate and Spot rate. Indeed, when the spot rates tends to increase, the inflation decreases and conversely. (Period between and 2004).
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SECTION 4 Test on the Interest Rate Parity Theory As stated in E. Kerr Lectures of International Financial Management, “this theory attempts to Predict Change in Differences between Spot Rates and Forward Rates by comparing EXPECTED Short-Term Interest Rates in Two Countries” As a result I have tried to find the figures of short term interest rates in two countries. Because much more sources are available for US and UK data, I have decided to test the relation between these two countries.
Thus, after hours of data researches and manipulations, I finally made the table available for you in the relative appendix. From this table, I have created this graph:
Here, we can see that the fluctuation of the US and UK interest rates (Red and Green Lines) can obviously give us an idea of the difference between spot rate and forward rate (blue curve). Indeed, all the general trends described by the interests are reflected into the blue line. As an example, during the whole 36 months between January 1999 and January 2002, the movements of the Interests rates are really similar to those of the difference between Spot and Forward rates. But if here we find a clear relation between Interest rates. We should try to carry out the same study of empirical evidences on long term interest rate. Because the Internet does not abound with information of this kind, the following graph has been made from annual average.
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On that graph, we should notice that the link between the difference in spot/forward rate is not as clear as in the previous graph. Indeed, from 1995 to 1999 the green line follow an opposite relationship with the blue and red lines. When the interest rates decrease, the difference increase and when they decrease, the difference increases. Nevertheless, in a second time, the green line faintly follows the pattern observed in the Interests rates curves. In any ways, the relation is NOT as clear as for short term interest rates.
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IFM – Management Report
SECTION 5 Analysis and conclusion Finding an accurate and exact way to forecast the values of spot rate is at the centre of the attention in International Finance. Finding it would result in really strong competitive advantage and abnormal profits may be made. But all the empirical evidences found in this management report (sections 2, 3 and 4) tend to validate some relationship but do not allow us to think that these theories are unerring to predict future fluctuations.
The section 2 showed that the absolute PPP theory could stand up for a specific economy but making itself completely not credible for another. The empirical evidence found are really controversial: • • •
Sometimes the spot rate moves more or less rapidly to the PPP index (Brazil and China). Sometimes the movement toward PPP is initiated but differs on the long run (Australia and Japan). Finally, sometimes the movement could happen but something seems preventing the correct fluctuation (Canada)
However, concerning the relative PPP Theory tested in section 3, it must be said that our empirical evidences seem to validate that theory on the long term. Indeed, the inflation rate movement year after year have a fairly similar with the evolution of the spot rates. But on the short term, this theory is purely rejected by the findings. To finish, our fourth section highlights a clear relationship between the short term interest rate (UK and US) and the difference between spot rate and forward rate. The relation between the trends are really strong and interest rate could therefore give an idea of the future arbitrage opportunities available. But to catch these opportunities, the investor must be very prompt to react since once executed, operations such as arbitrage smooth the differences on the market and thus absorb these opportunities. Indeed, selling dollars would make the first rate going down (create offer) and buying the foreign currency would create demand and increase the rate: the market is auto-regulated. For that matter, we can say that the same relation with long term interest rates is not so dependant because the long term of the interest rate reduce the possibility of arbitrage. To conclude, the sections 2, 3 and 4 proved that not all theories stand up in practice and no theory gives an exact forecast with certainty. Moreover, most of the time a distinction between short and long term has to be establish because it influences the validity of these theories.
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BIBLIOGRAPHY
http://www.economyprofessor.com/economictheories/wicksells-theory-of-capital.php New York Federal Reserve - http://www.newyorkfed.org/markets/fxrates/historical/fx.cfm World Bank Group http://web.worldbank.org/WBSITE/EXTERNAL/DATASTATISTICS/ICPEXT/0,,pagePK:62002243~theSite PK:270065,00.html International Monetary Fund - http://www.imf.org/external/index.htm Bank of England - http://www.bankofengland.co.uk/ Organisation for Economic Co-operation and Development http://www.oecd.org/home/0,2987,en_2649_201185_1_1_1_1_1,00.html Multinational Finance – Adrian Buckley – Fifth Edition – Prentice Hall International Financial Management Module – 3BUS0050 – Edward KERR – University of Hertfordshire, academic year 2007/2008. Appendixes downloadable at: http://bricebouvier.free.fr/Dissertation%20-%20Reports/Appendixes%20to%20IFM%20report.zip
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