ECONOMIC EXPOSURE, PURCHASING POWER PARITY AND THE INTERNATIONAL FISHER EFFECT

Exchange rates, interest rates and inflation rates are linked to one another through a classical set of relationships which have import for the nature of corporate foreign exchange risk. These relationships are: (1) the purchasing power parity theory, which describes the linkage between relative inflation rates and exchange rates; (2) the international Fisher effect, which ties interest rate differences to exchange rate expectations; and (3) the unbiased forward rate theory, which relates the forward exchange rate to exchange rate expectations. These relationships, along with two other key "parity" linkages, are illustrated in Figure 1.
The Purchasing Power Parity (PPP) theory can be stated in different ways, but the most common representation links the changes in exchange rates to those in relative price indices in two countries. Rate of change of exchange rate = Difference in inflation rates
The relationship is derived from the basic idea that, in the absence of trade restrictions changes in the exchange rate mirror changes in the relative price levels in the two countries. At the same time, under conditions of free trade, prices of similar commodities cannot differ between two countries, because arbitragers will take advantage of such situations until price differences are eliminated. This "Law of One Price" leads logically to the idea that what is true of one commodity should be true of the economy as a whole--the price level in two countries should be linked through the exchange rate--and hence to the notion that exchange rate changes are tied to inflation rate differences.
The International Fisher Effect (IFE) states that the interest rate differential will exist only if the exchange rate is expected to change in such a way that the advantage of the higher interest rate is offset by the loss on the foreign exchange transactions.
This International Fisher Effect can be written as follows: The expected rate of change of the exchange rate = The interest rate differential
In practical terms the IFE implies that while an investor in a low-interest country can convert his funds into the currency of the high-interest country and get paid a higher rate, his gain (the interest rate differential) will be offset by his expected loss because of foreign exchange rate changes.
The Unbiased Forward Rate Theory asserts that the forward exchange rate is the best, and an unbiased, estimate of the expected future spot exchange rate. The theory is grounded in the efficient markets theory, and is widely assumed and widely disputed as a precise explanation.
The "expected" rate is only an average but the theory of efficient markets tells us that it is an unbiased expectation--that there is an equal probability of the actual rate being above or below the expected value.
The unbiased forward rate theory can be stated simply: The expected exchange rate = The forward exchange rate
Now we can summarize the impact of unexpected exchange rate changes on the internationally involved firm by drawing on these parity conditions. Given sufficient time, competitive forces and arbitrage will neutralize the impact of exchange rate changes on the returns to assets; due to the relationship between rates of devaluation and inflation differentials, these factors will also neutralize the impact of the changes on the value of the firm This is simply the principle of Purchasing Power Parity and the Law of One Price operating at the level of the firm. On the liability side, the cost of debt tends to adjust as debt is repriced at the end of the contractual period, reflecting (revised) expected exchange rate changes. And returns on equity will also reflect required rates of return; in a competitive market these will be influenced by expected exchange rate changes. Finally the unbiased forward rate theory suggests that locking in the forward exchange rate offers the same expected return as remaining exposed to the ups and downs of the currency -- on average, it can be expected to err as much above as below the forward rate.
In the long run, it would seem that a firm operating in this setting will not experience net exchange losses or gains. However, because of contractual, or, more importantly, strategic commitments, these equilibrium conditions rarely hold in the short and medium term. Therefore the essence of foreign exchange exposure, and, significantly, its management, are made relevant by these "temporary deviations."