When Purchasing Power Parity (PPP) Theory applies to product markets, Interest Rate Parity (IRP) condition applies to financial markets. Interest Rate Parity (IRP) theory postulates that the forward rate differential in the exchange rate of two currencies would equal the interest rate differential between the two countries. Thus it holds that the forward premium or discount for one currency relative to another should be equal to the ratio of nominal interest rate on securities of equal risk (and duration) denominated in two currencies. For example, where the interest rate in India and US are respectively 10% and 6% and the dollar-rupees spot exchange rate is Rs.42.50/US $. The 90 day forward exchange rate would be calculated as per IRP as follows: = 42.50 (1+0.10/4)/(1+0.06/4) = Rs.42.9250 And hence, the forward rate differential [forward premium (p)] will be; (42.9250 — 42.50)/42.50 = 1% And the interest rate differential will be; Continue reading
International Finance
International finance is the branch of economics that studies the dynamics of foreign exchange,foreign direct investment and how these affect international trade. Also studies the international projects, international investment and the international capital flow .International Finance can be broadly defined, as the study of the financial decisions taken by a multinational corporation in the area of international business i.e. global corporate finance. International finance draws much of its background from the preliminary studies in the topics of corporate finance such as capital budgeting, portfolio theory and cost of capital but now viewed in the international dimension.
Global Financial Markets
The financial markets of the world consist of sources of finance, and uses for finance, in a number of different countries. Each of these is a capital market on its own. On the other hand, national capital markets are partially linked and partially segmented. National capital markets are of very different stages of development and size and depth, they have very different prices and availability of capital. Hence, the international financier has great opportunities for arbitrage — finding the cheapest source of funds, and the highest return, without adding to risk. It is because markets are imperfectly linked, the means and channels by which foreigners enter domestic capital markets and domestic sources or users of funds go abroad, are the essence of this aspect of international financial management. The other aspect is the fact that domestic claims and liabilities are denominated in national currencies. These must be exchanged for another Continue reading