Business finance : theory and practice

Chapter 15 • International aspects of business finance
If real interest rates are equal in all countries, then:
‘
1 + r nh 1 + i
= nh
1 + r nf 1 + i nf
where r nh is the nominal (or money) interest rate in the home country, r nf is the nominal
(or money) interest rate in the foreign country, i nh is the rate of inflation in the home
country and i nf is the rate of inflation in the foreign country.
Shapiro and Balbirer (2000) also show that, while this relationship seemed not to be
precisely as the model suggests, countries with high nominal interest rates tended to
have high levels of inflation.
International Fisher effect
The international Fisher effect combines the underlying principles of the general
Fisher effect and PPP. Fisher implies that interest rates will move to take account of
inflation rates:
1 + r nh 1 + i
= nh
1 + r nf 1 + i nf
PPP implies that exchange rates move in response to differences in inflation rates (see
equation (15.1)):
e 1
e 0
1 + i
= h
1 + i f
Since the interest rates referred to in the PPP model are nominal rates, putting
Fisher and PPP together we have:
e 1
e 0
1 + r
= nh
1 + r nf
The international Fisher effect therefore implies that the exchange rate is, in theory,
directly linked to nominal interest rates.
Again Shapiro and Balbirer (2000) show that this relationship is a broadly correct
approximation to reality.
Interest rate parity
As we saw earlier in this section, there are two bases on which we can buy or sell foreign
currencies. We can trade for immediate delivery of the currency, when we shall
be trading at a ‘spot’ rate of exchange. Alternatively, we can buy or sell the currency
under a forward contract. Here, delivery will take place on some specified date in the
future, but the exchange rate at which the transaction is effected is set now. Naturally,
the ‘forward’ rate will be linked closely to the spot rate. In theory, were the nominal
interest rates the same, in the countries of both currencies, the spot and forward rates
would be the same. Remember that nominal interest rates reflect both real interest
rates and the rate of inflation.
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