NBAE 554, Fall 2008
NBAE 5540 : International Finance
Lecture 3 : Exchange Rates Basics
and the Real Exchange Rate
Professor Gordon Bodnar
© Gordon Bodnar, 2008
Exchange Rate Basics

Bilateral exchange rate:
z
a relative price of two currencies, A and B

f
z
exchange rate denotes units one currency to equal the other
A is numeraire currency and B is base currency
quotation notation
f
market (oral) quote notation: exchange rate is B – A (or B : A)

one unit of the base currency (currency B) converts into the given
number of units of the numeraire currency (currency A)
GBP – USD = 2.01; 1 GBP trades for 2.01 USD
» this is the notation of the quote you will see from trader and on
trading sites on the web
f
mathematical ratio method: exchange rate is A / B

number of units of numeraire currency (currency A) per unit of
base currency (currency B)
XR(USD/GBP) = 2.01; it takes 2.01 USD to trade for 1 GBP
» this is the notation of the quotes used in text books and most
financial formulas
NBAE 5540: Lecture 3, Slide # 2
1
NBAE 554, Fall 2008
Exchange Rate Movements

XR terminology

z
in the notes I will use the mathematical quotation method
USD price of GBP = XR(USD/GBP)
key issue is to always know what is the base currency

the base currency is the currency for which the XR is a price

so in words: XR(USD/GBP) (or oral quote GBP-USD) is
» the exchange rate is always in units of the numerator currency
» USD price of GBP, price of GBP in terms of USD, GBP against (or
versus) USD, etc
z
exchange rate movements
f
terminology for decrease in USD/GBP rate:

this is a depreciation of the GBP
==> price of GBP in terms of USD falls (USD price of GBP falls),
==> fewer USD to buy a GBP
==> more GBP to buy a USD
==> price of the USD in terms of GBP rises (GBP price of USD rises)

this is also necessarily an appreciation of the USD
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 3
Daily Exchange Rate XR(USD/GBP)
1995:1 - 2008:6
2.25
This series is the price of the pound in terms of dollars
depreciation
of GBP
(appreciation
of USD)
1.75
appreciation
of GBP
(depreciation
of USD)
1.5
1/2/08
1/2/07
1/2/06
1/2/05
1/2/04
1/2/03
1/2/02
1/2/01
1/2/00
1/2/99
1/2/98
1/2/97
1/2/96
1.25
1/2/95
USD/GBP
2
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 4
2
NBAE 554, Fall 2008
Daily Exchange Rate XR(JPY/USD)
1995:1 - 2008:6
150
depreciation
of JPY
((appreciation
pp
of USD)
140
appreciation
of JPY
(d
(depreciation
i ti
of USD)
120
110
100
This series is the price of the dollar in terms of yen
90
1/2/08
1/2/07
1/2/06
1/2/05
1/2/04
1/2/03
1/2/02
1/2/01
1/2/00
1/2/99
1/2/98
1/2/97
1/2/96
80
1/2/95
JPY/USD
130
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 5
Measuring Exchange Rate Changes

Calculating percentage changes in currencies
f
By definition the % appreciation of currency A against
currency B will not equal the % depreciation of currency B
against currency A
Example: XR(CAD/USD)0 = 1.00 XR(CAD/USD)1 = 1.50
f
USD has appreciated and the CAD has depreciated
the USD changed by :
(1.50 - 1.00) / 1.00 = 50% against the CAD

50% appreciation
» %Δ formula = (New – Old)/Old or New/Old - 1
the CAD has changed by:
[(1/1.50) - (1/1.00)]/(1/1.00) = -33.3% against the USD

z
33% depreciation
problem is more serious for bigger changes
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 6
3
NBAE 554, Fall 2008
Korean Won in 1997 and 1998
2500
1960
1500
1210
1000
846
500
12/1/1998
11/1/1998
9/1/1998
10/1/1998
8/1/1998
7/1/1998
6/1/1998
5/1/1998
4/1/1998
3/1/1998
2/1/1998
1/1/1998
12/1/1997
11/1/1997
9/1/1997
10/1/1997
8/1/1997
7/1/1997
(1960/846) – 1 = 132% appreciation of USD
this is NOT a 132% depreciation, but a 57% depreciation of the KRW

f
6/1/1997
i 1997 th
in
the USD appreciated
i t d against
i t th
the KRW b
by 132%
f
5/1/1997
f

4/1/1997
2/1/1997
3/1/1997
0
1/1/1997
W/USD
KRW
2000
(846/1960) – 1 = 57% depreciation of KRW
in 1998 the KRW appreciated by 62% against the USD

this is not a 62% USD depreciation against KRW, just a 38% decline
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 7
Other Measures of Exchange Rates

Looking at bilateral rates is problematic
z
it does not assess the overall strength or weakness
of a currency
f
f
overall strength or weakness of a currency is better
measured by an Effective Exchange Rate (EXR)
most common form is a trade-weighted exchange rate index

trade-weighted foreign currency value of the dollar at time t would
be calculated as:
λ
N
⎛ XR(FCk /USD) t ⎞
⎟⎟
EXR(FC/USD )t = ∏ ⎜⎜
k =1 ⎝ XR(FCk /USD) 0 ⎠
k
» λ, are weights based upon relative trade flows (Σλ = 1)
» N is number of countries in the index
f
example: for N = 2 (with weights = 1/2 for each FC)
EXRt = [(XR(FC1/USD)t /XR(FC1/USD)0]1/2 x [(XR(FC2/USD)t / XR(FC2/USD)0]1/2

weights λ can be based upon any breakdown as long as Σλ = 1
» for example: a company might use relative foreign sales as weights
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 8
4
NBAE 554, Fall 2008
Effective USD Index XR(FC/USD)
95:1 - 08:6
Effectiv
ve Value of USD (2000 = 100)
120
110
appreciation
of the USD
depreciation
of the USD
100
90
80
This is a trade-weighted average
USD XR against the major other
developed country currencies
70
1/2/08
1/2/07
1/2/06
1/2/05
1/2/04
1/2/03
1/2/02
1/2/01
1/2/00
1/2/99
1/2/98
1/2/97
1/2/96
1/2/95
60
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 9
Trade Weighted Value of USD
1973 - 2008
160
Major Currencies
(Developed Markets)
120
100
80
60
Other Important Trading Partners
(Emerging Markets )
40
20
Jan-07
Jan-05
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
Jan-89
Jan-87
Jan-85
Jan-83
Jan-81
Jan-79
Jan-77
Jan-75
0
Jan-73
Index value of USD XR(FC/US
SD)
(avg 2000 = 100)
140
NBAE 5540: Lecture 3, Slide # 10
5
NBAE 554, Fall 2008
Spot Exchange Rates

Spot rate
z
the exchange rate quoted by market makers for
current transactions
f
reflects the current market price for exchange of
currencies

z
my notation = S(∗/∗)t
value date
f
actual delivery is not immediate

currencies are generally exchanged two days after
transaction is agreed
» value date is one day later for Western hemisphere
currencies and USD

this is to allow for trade clearing and record keeping
special rules for holidays and weekends
» value dates generally move forward in time
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 11
Exchange Rate Quotations

As relative prices exchange rates can be quoted
in different ways
z
"European
p
terms"
f
units of foreign currency per dollar
» S(CHF/USD) = 1.0565
z
S(JPY/USD) = 102.33
"American terms"
f
units of dollars per foreign currency
» S(USD/GBP) = 1.9509 S(USD/EUR) = 1.4614
z
in the interbank market all currencies are officially
quoted in European terms expect for

British pound, Australian dollar, New Zealand dollar, and Euro
» they are quoted in American terms

quotes in the brokers market and all futures contracts are in
American terms
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 12
6
NBAE 554, Fall 2008
Official US XRs as Posted by FED
MONETARY
UNIT
Apr. 14
COUNTRY
*AUSTRALIA
DOLLAR
REAL
BRAZIL
CANADA
DOLLAR
YUAN
CHINA, P.R.
*EMU MEMBERS
EURO
DOLLAR
HONG KONG
INDIA
RUPEE
YEN
JAPAN
MEXICO
PESO
DOLLAR
*NEW ZEALAND
SOUTH KOREA
WON
SWEDEN
KRONA
FRANC
SWITZERLAND
TAIWAN
DOLLAR
POUND
*UNITED KINGDOM
VENEZUELA
BOLIVAR
* U.S. dollars per currency unit.
0.9229
1 6795
1.6795
1.0207
6.999
1.5827
7.7912
39.86
100.87
10.4788
0.7876
979.3
5.94
0.9975
30.31
1.9816
2.1446
Apr. 15
Apr. 16
0.9245
1 6845
1.6845
1.0181
6.9945
1.5801
7.7931
39.83
101.33
10.484
0.7842
991.3
5.9512
1.0019
30.25
1.9627
2.1446
0.9396
1 672
1.672
1.0021
6.992
1.5978
7.7935
39.89
101.4
10.4616
0.7911
989.1
5.8751
0.9979
30.24
1.9756
2.1446
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 13
Source: Federal Reserve Board
Bid-Ask Quotations

Market makers always quote a bid and ask price

the bid and ask are spread around the “true value” of the XR

the spread is the remuneration received for making the market
» this is usually assumed to be the midpoint
GBP
CAD
EUR
JPY
Financial Times London closing prices
bid
offer
midpoint
1.9014
013
015
1.1012
010
013
1.4394
392
396
102.725
700
750
f
bid price
offer price
1.9013
1.1010
1.4392
102.700
1.9015
1.1013
1.4396
102.750
% b/a spread
0.0111%
0.0230%
0.0322%
0.0468%
the bid and ask (offer) prices are reported only as the last few
digits of the standard quote

dealers assume the “big numbers” are known
note each currency has a specified number of digits in its standard
quote
» GBP, CAD, and EUR are 4 digits after decimal, JPY is only 3

bid-ask spreads as % of midpoint are very small compared other
most financial markets
» round trip transaction costs (buy then sell) are 1 – 5 basis points
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 14
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NBAE 554, Fall 2008
Dealing with Bid / Ask Quotes

Market makers always give a bid and ask price
» the bid (ask) is the price at which they will buy (sell) the base currency
f
the quote for the XR(JPY/USD) rate are 102.700 – 102.750
» the bid-ask spread is the difference (50 points or “pips” for yen)
f
the base currency for these quotes are the USD, so …

z
you can buy USD from (sell JPY to) the market maker at 102.750
you can sell USD to (buy JPY from) the market maker at 102.700
3 steps for getting bid-ask spreads price right
1. which currency are the quotes a price for?
2. are you buying or selling that currency?
3 you get screwed! (pay the less desirable price => buy high - sell low)
3.
f
ex: USD/EUR is 1.4515 / 1.4525 and you want to buy USD100

these quotes are actually prices for EUR
in your transaction you will be selling EUR (buying USD)
you would like to sell EUR at high price (1.4525) but must sell to
dealer at low price 1.4515
» it will cost you EUR Z x USD1.4515/EUR = USD100; Z = EUR68.89
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 15
Forward Exchange Rates

Forward rates
z
a quoted price for the exchange of currencies at
some specified date in the future
f
f
this is a price offered today for a transaction at a
particular date in the future
standard forward rates are quoted for 7, 30, 60, 90, 180,
and 360 days but can be tailored to any date

my notation = F(∗/∗)t,k
» k period ahead forward rate available at at time t
z
value dates for forwards are similar to spot
f
delivery on a k-day forward transaction is typically k days
after the value date for the current spot transaction

there are special cases for holidays and month ends
» best to always ask for value date
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 16
8
NBAE 554, Fall 2008
Quotation of Forward Rates

Outright forward bid/ask quotation
f
2 prices similar to the spot price bid and ask

rates at which to buy from or sell to the market maker in the future,
in this case 90 days
F(CHF/USD) t, 90 = 1.1629 / 1.1647
» you buy (sell) Swiss francs against US$ in 90 days at 1.1629 (1.1647)

Swap forward quotation
f
provides the number of pips (points) to add/subtract from the spot
bid or ask quote to obtain the outright forward quotes

seeing the CHF quotes above in swap form would be:
S(CHF/USD)t = 1.1652 / 1.1660 and F(CHF/USD) t,90 = 23 / 13
in swap form, the swap points are either added (if in ascending
order relative to the slash) or deducted (if in descending order) from
the current bid and ask spot quotes
» these swap quotes give the same prices as the outright forwards above
because they are subtracted (descending relative to slash)

bid = 1.1652 – 0.0023 = 1.1629; ask = 1.1660 – 0.0013 = 1.1647
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 17
The Forward Premium

A common measure in the international money
markets is the forward premium on a currency
z
it is the % difference between forward and spot price
f
expressed in annualized percentage terms
⎡ F(A/B) t,k − S(A/B) t ⎤ ⎛ 360 ⎞
Annualized k-Day
⎟
⎥⎜
Forward Premium on B = ⎢
S(A/B)
⎝ k ⎠
⎣

⎦
t
using this measure, currency B is said to be at a premium when
this term is positive or at a discount if this term is negative
» the forward premium is a measure of how much more expensive a
currency is for transaction in the future
» a premium (discount) on B implies a discount (premium) on A
f
if forward rate is more than 1 year ahead, (N = years in future )
Annualized N-year Forward
Premium on B =
⎡ F(A/B)
⎢
⎣ S(A/B)
t, n
t
⎤
⎥
⎦
(1/N)
−1
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 18
9
NBAE 554, Fall 2008
Triangular Arbitrage and Cross Rates

There are many ways of moving between currencies
f
f
go directly from one currency to another
go through a third currency
these alternative imposes restrictions on prices that
limit “triangular arbitrage”
z
Example: S(USD/GBP) = 1.9550 and S(USD/EUR) = 1.4475
what is the cross rate: S(EUR/GBP)?
f
f
since USD1 => GBP0.5115 and USD1 => EUR0.6908,
we can set up triangle that imposes that EUR0.6908 = GBP0.5115
USD1
S(USD/GBP) = 1.9550
GBP 0.5115
f
S(USD/EUR ) = 1.4475
EUR 0.6908
S(EUR/GBP) = 1.3505
this can also be done with bid-ask spreads to define maximal bid –
ask spread for the cross rate
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 19
PPP and the Real Exchange Rate

Purchasing Power Parity (PPP)
f
z
a concept regarding the equilibrium value of a currency
based upon it purchasing power in different locations
economists
i
use three
h
concepts off PPP
1. for individual goods - The Law of One Price
2. for general price levels - Absolute PPP
3. in first difference form for relating exchange rate changes to
inflation rates - Relative PPP

The Law of One Price

in the absence of frictions, arbitrage should ensure that the
price of identical products measured in a single currency will
be the same in all countries
PABig Mac = S(A/B) x PBBig Mac
example: PUSDBig Mac = S(USD/GBP) x PGBPBig Mac
= S(USD/EUR) x PEURBig Mac
» in reality this holds only for homogenous commodities with low
transportation costs
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 20
10
NBAE 554, Fall 2008
Economist Big Mac Standard
The hamburger standard (6/05)
Big Mac Prices
in local
in USD
currency
United States USD 3.06
$
$3.06
Switzerland
CHF 6.33
$5.05
Euroland
EUR 2.93
$3.58
Britain
GBP 1.89
$3.44
Japan
JPY 252
$2.34
Canada
CAD 3.30
$2.63
Brazil
BRL 5.94
$2.39
South Korea KRW 2503
$2.49
Australia
AUD3.25
$2.50
China
CNY 10.51 $1.27
$
Russia
RUR 42
$1.48
z
z
Implied PPP Actual
Local Currency Local Currency
Rate
XR 6/9/05
under(-) or misalignment %
(FC/USD) (FC/USD) over(+) valuation
4/25/00
2.06
1.255
64%
39%
0.950
0.819
16%
-5%
0.613
0.549
12%
20%
81.7
107.5
-23%
11%
1.07
1.255
-14%
-23%
1.93
2.489
-22%
-34%
817
1005
-19%
8%
1.06
1.30
-2%
18%
3.43
8.27
-59%
-52%
13.7
28.5
-52%
-45%
in 2005, the USD is overvalued against most currencies other than
the European ones
while the CAD and BZR have strengthen since 2000, the most
undervalued currencies, China, and Russia, remain significantly so
f
for more on the Big Mac index see the Economist website
http://www.economist.com/markets/Bigmac/Index.cfm
NBAE 5540: Lecture 3, Slide # 21
Purchasing Power Parity

Absolute PPP (APPP)
f
identical baskets of consumer goods in two countries will have
exactly the same price (in a given currency)

generally
ll economists
i t consider
id the
th b
basket
k t off goods/services
d /
i
th
thatt
comprise the CPI or WPI (PPI) baskets in each country
Example: Let CPIA = PA and CPIB = PB
f
price of A basket changed into B should buy B basket
S(A/B) ⋅ PB = PA => S(A/B) ⋅ (PB/PA) = 1

f
the number of currency B it takes to buy the basket of goods in
country B can be traded to buy the basket of goods in country A
when this is true we say that both currencies have the same
purchasing power
this does not hold constantly in the data

problems
» baskets of goods looked at differ across countries
» location of consumption might matter for price
» ability to arbitrage goods/services is slow compared XR movements
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 22
11
NBAE 554, Fall 2008
Purchasing Power Parity

Relative PPP (RPPP)
f
this is absolute purchasing power parity in relative form

assumes that absolute purchasing power might not hold exactly
but if error changes slowly
» level of prices measured in a single currency may not be equal, but
relation holds when looked at in difference form

theory allows prices of goods in different countries to differ
» possibly due to taxes, transaction costs, and transportation costs, etc
z
so S(A/B) ⋅ (PB/PA) = K ≠ 1, but = K all periods
f
so applying a percentage change operator (taking logs):
%ΔS(A/B) + %ΔPB - %ΔPA ≈ 0
f
thus %ΔS(A/B) ≈ %ΔPA - %ΔPB = inflation differential

the change in XR will be equal to the difference in inflation rates
» where %ΔP is the country’s (CPI or WPI) inflation rate
f
implication of RPPP: the currency of the country with the higher
inflation rate depreciates by the relative inflation difference
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 23
The Real Exchange Rate

We examine PPP via the real exchange rate, R
f
this is the nominal exchange rate adjusted by the relative prices
R(A/B)t = S(A/B)t / [PtA/PtB] = S(A/B)t · [PtB/PtA]

f
the real exchange rate has units of price of B goods relative to the
price of A goods (though we can also think in terms of currency units)
since the price info we generally have is indexed (CPI, WPI), we
often see the real exchange rate expressed in index form

indexed with respect to itself at some base period (rationally chosen)
R(A/B)t
z
z
=
S(A/B)t [PB /P A ]t
S(A/B)
(
)0 [PB /P A ]0
R(A/B)Index = 1 at base period (time 0)
R(A/B)Index > 1 => real appreciation of B, real depreciation of A
f
B goods have become more expensive relative to A goods

z
INDEX
bad for producers of B goods, good for producers of A goods
R(A/B)Index < 1 => real depreciation of B, real appreciation of A
f
B goods have become less expensive relative to A goods

bad for producers of A goods, good for producers of B goods
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 24
12
NBAE 554, Fall 2008
Calculating Real Exchange Rates

Example
Time 0 Time 1
S(A/B)
1.50
1.25
R(A/B)t = S(A/B)t ⋅ [PB /P A ] t
PA
103
119 (15.5%)
R(A/B) t
INDEX
R(A/B) t
=
PB
118
156 (32.2%)
R(A/B)
(
)0
Calc: R(A/B)0 = 1.50 · (118/103) = 1.72
R(A/B)1 = 1.25 · (156/119) = 1.64
R0INDEX = 1.72/1.72 = 1.00 R1INDEX = 1.64/1.72 = 0.95
f
f
in nominal terms currency B changed against A by -16.6% over
the period (1.25/1.50 – 1)
in real terms currency B change against A by -5% over the period
(1.64/1.72 - 1)
» some of the nominal depreciation of B was offset by higher inflation
f
determine the APPP level for S(A/B) at time 1
find hypothetical value of S(A/B)1 such that R(A/B)1 = R(A/B)0
S(A/B) 1 · (P1B/P1A) = S(A/B)0 · (P0B/P0A) = 1.72
= 1.50 · (118/103) / (156/119) = 1.31

to maintain the same real rate exchange rate at time 1 the spot rate at time 1
would need to have been S(A/B) = 1.31
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 25
USD/EUR Real Exchange Rate Index
(using WPI) 1973:6 - 2008:4
1.4
EUR overvalued
against USD
(Euro goods dear)
With Rindex at 1.24 at
4/08, the EUR is
over-valued against
USD relative to 6/73
using WPI
1
In 2001, the EUR is undervalued against the USD by
20% but it appreciates in
real terms by over 50% by
2008
0.8
EUR undervalued
against USD
(Euro goods cheap)
Jun-07
Jun-05
Jun-03
Jun-01
Jun-99
Jun-97
Jun-95
Jun-93
Jun-91
Jun-89
Jun-87
Jun-85
Jun-83
Jun-81
Jun-79
Jun-77
Jun-75
0.6
Jun-73
USD/EUR RXR Index
(June 1973 - 1.00)
1.2
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 26
13
NBAE 554, Fall 2008
Relation between RXR and PPP

Law of one price and the RXR
f
using the prices of any specific goods, the real exchange rate
should always be equal to 1

R(A/B)t = S(A/B)t ⋅ PtB/PtA = 1 for prices of any good
Absolute PPP and the RXR
f
using prices for a basket of goods, the real exchange rate
should be equal to 1

R(A/B)t = S(A/B)t ⋅ PtB/PtA = 1 for prices of the baskets of goods
» need not hold true for each good independently
» not necessarily true if using price index data (then Rt = R0 = k, but
RINDEX = 1 )

Relative PPP and the RXR
f
the real exchange rate need not be equal to one, but its
changes must be equal to zero

R(A/B)t = S(A/B)t ⋅ PtB/PtA ≠ 1, but ΔR(A/B) = 0
NBAE 5540: Lecture 3, Slide # 27
Inflation Adjusted Exchange Rates

Another way to see the same thing is to compare
actual XRs S(A/B) to inflation adjusted XRs, Z(A/B)

create inflation adjusted rates by adjusting a benchmark spot XR
for realized relative inflation since the benchmark time period
1. assume a base period (i.e., time zero), and set S(A/B)0 = Z(A/B)0

this is often a rate at which we believe APPP holds
2. create Zt, for t = 1,…,T by adjusting Z0 for relative inflation of
currency A to currency B over the period 0 to t
Z(A/B)t = Z(A/B)0· (P0B/ P0A)/(PtB/ PtA) = Z(A/B)0· (PtA/ P0A)/(PtB/P0B)
» can use either CPI inflation or WPI (PPI) inflation

f
this series of Z(A/B)t rates are the exchange rates that maintain the same
real exchange rate as existed at time zero
we can then plot these inflation-adjusted XRs (the series of
Z(A/B)) against the realized spot rates to measure misalignment

this tells us the same thing about under/over-valuation as the real
index but in units of S(A/B) rather than index units
» allows identification of what APPP XR is at any point in time
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 28
14
NBAE 554, Fall 2008
USD/EUR Inflation-Adjusted and
Nominal Exchange Rates
1.60
Inflation Adjusted XR
(IAXR) suggests
equilibrium value for
EUR is around
USD1 25
USD1.25
both WPI and CPI adjusted 73:6 – 08:04
1.50
Nominal
XR
1 40
1.40
USD/EUR
1.30
IAXR(CPI)
1.20
1.10
IAXR(WPI)
1.00
Assumed initial
equilibrium for June
1973
0.90
(results in average
deviation of only 1.5%
for WPI, -3% for CPI)
0.80
Jun-07
Jun-05
Jun-03
Jun-01
Jun-99
Jun-97
Jun-95
Jun-93
Jun-91
Jun-89
Jun-87
Jun-85
Jun-83
Jun-81
Jun-79
Jun-77
Jun-75
Jun-73
0.70
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 29
USD/BRL Inflation-Adjusted and
Nominal Exchange Rates
94:6 – 08:4
1.2
1
BRL followed WPI
rates until 2003
Since then has seen
significant real
appreciation
0.8
0.6
date of Real Plan 6/94
BRL 1 = USD 1
starting point of
baseline real valuation
0.4
IAXR(CPI)
(
)
IAXR(WPI)
Jun-07
Jun-06
Jun-05
Jun-04
Jun-03
Jun-02
Jun-01
Jun-00
Jun-99
Jun-98
Jun-97
Jun-96
Jun-95
0.2
Jun-94
USD/BRL
NXR
Jan 1999 devaluation.
slight overshooting
b t adjustment
but
dj t
t to
t
restore “Real Plan” PPP
level
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 30
15
NBAE 554, Fall 2008
Brazilian Inflation-Adjusted versus
Nominal Exchange Rates
1973 - 2008
1.0E+12
1.0E+11
RXR(CPI)
1 0E+10
1.0E+10
RXR(WPI)
NXR
1.0E+8
1.0E+7
Here despite more than
100 billion times more
inflation than the USD,
the USD/BRL rate is at a
level that produces the
basically same real value
today as in June 1973.
1.0E+6
1.0E+5
PPP works especially well in
highly inflationary
environments. Note because
of high inflation for BRL, one
currency unit today in June
1973 would be worth 1.4 x
1012 reals today
1.0E+4
1 0E+3
1.0E+3
1.0E+2
1.0E+1
1.0E+0
Jun-07
Jun-05
Jun-03
Jun-01
Jun-99
Jun-97
Jun-95
Jun-93
Jun-91
Jun-89
Jun-87
Jun-85
Jun-83
Jun-81
Jun-79
Jun-77
Jun-75
1.0E-1
Jun-73
USD/BRL
(logarithmic scale)
1.0E+9
NBAE
FNCE5540:
731: Lecture 3,
2, Slide # 31
Implications of PPP for Managers

Short run analysis
z
most short run changes in XRs not related to PPP
deviations
f

unless deviations from PPP are large
Long run analysis
z
z
PPP a reasonable method for forming long run XR
expectations
current deviation from PPP should be taken into
account for long run analysis of foreign activities
f
form profit expectations under assumption of return to
PPP level over next few years

current profitability may be due to current PPP deviation
» this will not last for ever
» think of it as a temporary situation
NBAE 5540: Lecture 3, Slide # 32
16