Essentials of Financial Risk Management by Rick Nason & Brendan Chard

Author:Rick Nason & Brendan Chard
Language: eng
Format: epub
Publisher: Business Expert Press
Published: 2018-07-20T16:00:00+00:00

Case Study

The Big Mac Index

Perhaps the most well-known expression of Purchasing Power Parity is the Big Mac Index that was created by the Economist weekly newspaper. The Big Mac Index tracks the cost of a McDonald’s Big Mac burger in a variety of different currencies around the world. If Purchasing Power Parity holds, then the Big Mac hamburger, which is as close as one can get to a completely fungible global consumer good, should have the same cost after accounting for the exchange rate. Of course, the conversion is not perfect, in part because McDonald’s does not change the prices of its hamburgers on a daily basis to track currency moves. However, the Big Mac Index does give a relatively accurate, yet quirky, analysis of which currencies are over- or under-valued. It needs to be noted that Purchasing Power Parity is not perfect as taxes, transaction costs, and a variety of other factors will affect the exchange rate.

The second key currency relationship is Interest Rate Parity. Interest Rate Parity states that investing for a set period of time in one period at a fixed interest rate in one currency should provide the same investment outcome as investing in a different currency, and at that second currency’s associated fixed interest rate, for the same period of time. In other words, forward exchange rates can be completely explained by interest rate differentials.

Consider the following two-currency example:

1-year interest rate in currency A is 5 percent

1-year interest rate in currency B is 8 percent

Spot exchange rate is 1 unit of currency A = 2 units of currency B

If one has 100 units of currency A to invest, then at the end of 1 year they will have:

100A × (1+interest rate) = 100 × (1 + 0.05) = 105 units of A

Alternatively, the investor could exchange their 100 units of currency A at the spot exchange rate and receive 200 units of currency B to invest. Investing the 200 units of currency B for 1 year will provide investment proceeds at the end of the year of:

200B × (1 + 0.08) = 216 units of B

Thus, the forward exchange rate must be by Interest Rate Parity:

105 A = 216 B → 1A = 2.0571 B

In this case, currency B has depreciated (it now takes more units of currency B to buy 1 unit of currency A). Note that if the 1-year forward exchange rate quoted in the market is anything other than 1A equals 2.0571B, then there will be an arbitrage opportunity and speculators will trade in the currency markets (and the associated money markets) until the Interest Rate Parity relationship holds.1

Interest Rate Parity provides a direct connection between interest rates in two countries and the respective forward exchange rates in the two countries. Spot rates, forward rates, and even the respective interest rates will adjust to ensure that Interest Rate Parity holds within a tight band. Therefore, while Purchasing Power Parity holds approximately, Interest Rate Parity is a rule that is forced to hold true due to the actions of arbitrage traders.

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