Unit 2: Parity conditions and financing
International Finance and Financial Derivatives notes · PTU syllabus (MBA 915-18)
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Unit summary
Exchange rates, interest rates and inflation are linked by parity conditions, and firms raise money in global markets. This unit covers purchasing power parity, the Fisher effect, the international Fisher effect, interest rate parity, the forward–spot relationship, international capital markets — ADRs and GDRs — foreign bond markets, and short-term financing through banker's acceptances, factoring and forfaiting.
After this unit you can
- Apply PPP, the Fisher effect and the international Fisher effect
- Apply interest rate parity and the forward–spot relationship
- Explain ADRs, GDRs and foreign bond markets
- Explain banker's acceptances, factoring and forfaiting
PTU syllabus topics
- Purchasing Power Parity
- Fisher effect
- International Fisher Effect
- Interest Rate Parity
- forward-spot rate relationship
- international capital markets (ADRs, GDRs)
- foreign bond markets
- short-term financing (banker's acceptance, factoring, forfaiting)
Relative PPP
Change in spot ≈ inflation home − inflation foreign
Fisher effect
Nominal rate ≈ real rate + expected inflation
Interest rate parity
F = S × (1 + i home) / (1 + i foreign)
International Fisher
Change in spot ≈ interest home − interest foreign
Topic 1
Determination of exchange rates
- Demand and supply: demand for foreign currency from imports, outward investment and debt repayments; supply from exports, inward FDI/FPI, remittances.
- Factors: relative inflation, interest rate differentials, income growth, current account balance, capital flows, government intervention, expectations and speculation, political stability.
- Exchange rate regimes: fixed (gold standard, Bretton Woods 1944–1971), floating, managed float, currency board, pegs.
Topic 2
Parity conditions: PPP, Fisher effect, IFE and IRP
Purchasing power parity (relative)
S1 ÷ S0 = (1 + Ih) ÷ (1 + If)
Interest rate parity
F ÷ S = (1 + ih) ÷ (1 + if)
Fisher effect
(1 + i) = (1 + r)(1 + inflation)
International Fisher effect
Expected change in spot rate ≈ ih − if
Unbiased forward rate
Forward rate = expected future spot rate
Example
Spot ₹83/$; Indian interest 7%, US 4% for one year. IRP forward = 83 × 1.07 ÷ 1.04 = ₹85.39/$. If the actual forward is ₹84, covered interest arbitrage: borrow $, convert to ₹, invest at 7%, sell ₹ forward — earning a riskless profit until rates realign.
- Absolute PPP: the same basket costs the same everywhere (Big Mac index); deviations persist due to transport costs, tariffs, non-traded goods.
Topic 3
The forward–spot rate relationship
- Forward premium or discount: a currency is at a forward premium when the forward rate exceeds the spot rate (in direct quotes).
Annualised premium or discount
(F − S) ÷ S × 12 ÷ months × 100
Unbiased forward rate hypothesis
Forward rate = expected future spot rate
Example
Spot ₹84.00/$, 3-month forward ₹84.63/$. Annualised premium on the dollar = 0.63 ÷ 84 × 4 × 100 = 3%.
- Empirically the forward rate is a noisy predictor of the future spot rate (forward premium puzzle).
Topic 4
International capital markets and foreign bond markets
Meaning
Issued in a foreign country in that country's currency
Issued outside the country of the currency
Example
Yankee bond (US$ in USA by a non-US issuer), Samurai (yen in Japan)
US$ bond issued in London
Regulation
Host country's regulations
Lightly regulated
Masala bond
—
Rupee-denominated bond issued abroad by an Indian entity
- International equity: cross-listing; ADRs (US), GDRs (Europe/Luxembourg); direct listing of Indian companies on GIFT City IFSC exchanges (from 2024).
- International portfolio investment: gains from diversification because markets are less than perfectly correlated; home bias — investors hold too much domestic equity; risks — currency, political, information.
Topic 5
ADRs and GDRs
Market
Listed and traded in the US (NYSE, NASDAQ)
Listed in Europe (London, Luxembourg) and other markets
Currency
US dollars
Usually US dollars or euros
Regulation
SEC rules; costly disclosure
Lighter regulation
Investors
US investors, including retail
Institutional investors mainly
Indian examples
Infosys, Wipro, HDFC Bank, ICICI Bank
Several Indian companies in the 1990s–2000s
- Mechanism: shares are deposited with a domestic custodian; an overseas depository bank issues receipts representing them.
- Indian framework: Depository Receipts Scheme, 2014; companies may also list directly on international exchanges at GIFT City IFSC.
Topic 6
Foreign bond markets
- Foreign bonds: issued by a borrower in another country's market and currency — Yankee (US), Samurai (Japan), Bulldog (UK).
- Eurobonds: issued outside the country of the currency — a dollar bond sold in London.
- Masala bonds: rupee-denominated bonds issued abroad — currency risk borne by investors.
- Other: FCCBs, green bonds, ECBs under RBI rules.
Topic 7
Short-term international financing
- Banker's acceptance: a time draft drawn on and accepted by a bank — the bank guarantees payment, making the bill marketable; the exporter can discount it.
- Factoring (international): the exporter sells receivables to a factor, who provides finance, collection and credit protection (two-factor system with an import factor).
- Forfaiting: the exporter sells medium-term receivables (usually avalised bills or promissory notes) to a forfaiter without recourse, eliminating credit, currency and political risk.
Tenor
Short term (up to 180 days)
Medium term (6 months to several years)
Recourse
With or without recourse
Always without recourse
Goods
Consumer and recurring trade
Capital goods, large projects
Instruments
Invoices and receivables
Bills of exchange or promissory notes, often bank-guaranteed
- Others: pre-shipment and post-shipment export credit, letters of credit, export credit insurance (ECGC), supplier's and buyer's credit.
Key terms
- Purchasing power parity
- Exchange rates adjust to inflation differentials
- Interest rate parity
- Forward premium equals the interest differential
- Forward premium
- Forward rate above the spot rate
- ADR
- Receipt traded in the US representing foreign shares
- Forfaiting
- Non-recourse purchase of medium-term export receivables
Quick revision
- Exchange rate determinants; PPP (absolute, relative); Fisher; IFE; IRP; covered interest arbitrage.
- Forward premium formula; unbiased forward rate.
- Euro and foreign bonds; masala bonds; ECBs.
- ADR vs GDR; Depository Receipts Scheme 2014.
- Banker's acceptance, factoring and forfaiting.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.State relative PPP.
- Q2.What is the international Fisher effect?
- Q3.State the interest rate parity condition.
- Q4.Compute the forward premium if spot is ₹80 and the 6-month forward ₹81.20.
- Q5.Distinguish ADR and GDR.
- Q6.Distinguish factoring and forfaiting.
Long-answer questions
- Q1.Explain the parity conditions linking inflation, interest rates and exchange rates.
- Q2.Explain interest rate parity and covered interest arbitrage with an example.
- Q3.Discuss international capital markets — ADRs, GDRs and foreign bonds.
- Q4.Explain short-term international financing instruments.
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