Business, CFA, Economics, Finance, General ramblings

Foreign Exchange Parity Relations

I have read a number of posts on various blogs that discuss different factors that contribute to the appreciate or depreciation of a currency. Most of the times, the discussion is either on the appreciation of the Indian Rupee or the current depreciation of the US Dollar. These posts leave me unsatisfied because they fail to cover all the points, which are very important if you talk about ForEx relations. It might be possible that the blog author himself is unaware of all the forces involved. With this educational objective in mind, I’ll try to cover some important issues that need to be considered when we hold a discussion on Foreign Exchange Parity Relations. This post is for educational purposes only and all information provided is almost correct to my knowledge even though it might not be substantive, because it has been derived from the CFA Level-I Curriculum of the CFA Institute. I have tried to be comprehensive here, though it’s highly possible that I’ve failed; in case you don’t understand something, then let me know. I’ll try my best to explain.

Balance-of-payments (BOP) accounting is a method used to keep track of transactions between a country and its international trading partners.

The BOP equation is:

current account + financial account + official reserve account = 0

The current account measures the exchange of merchandise goods, the exchange of services, the exchange of investment income, and unilateral transfers (gifts to and from other nations).

The financial (capital) account measures the flow of funds for debt and equity investment into and out of the country.

Official reserve account transactions are funds held at the International Monetary Fund (IMF) in the form of gold, other foreign currencies, and special drawing rights at the IMF.

A nation’s current account balance does not measure its economic health. Running a deficit in the current account balance simply means a country imports more than it exports, and a country can do this for a long time. Countries that run current account deficits tend to run financial account surpluses so that they offset each other.

Factors affecting a nation’s currency:

Differences in income growth among nations will cause nations with the highest income growth to demand more imported goods. Heightened demand for imports will increase demand for foreign currencies, and foreign currencies will appreciate relative to the domestic currency.

Differences in inflation rates will cause the residents of the country with the highest inflation rate to demand more imported (cheaper) goods. If a country’s inflation rate is higher than its trading partner’s, the demand for the country’s currency will be low, and the currency will depreciate.

Differences in real interest rates will cause a flow of capital into those countries with the highest available real rates of interest. Therefore, there will be an increased demand for those currencies, and they will appreciate relative to countries whose available real rate of return is low.

Exchange Rate Effects

* An unanticipated shift to an expansionary monetary policy will lead to a depreciating currency.
* An unanticipated shift to a more restrictive fiscal policy will result in budget surpluses.

BOP Component Effects

* An unanticipated shift to an expansionary monetary policy will decrease interest rates leading to a deficit in the financial account and a depreciation of the domestic currency leads to a surplus in the current account.
* A change in fiscal policy to a larger budget deficit will cause the current account to move towards deficit and the financial account to move toward a surplus.

Different Kinds of Exchange Rate Systems-

A fixed exchange rate system has a set rate of exchange and is supported by giving up discretion in monetary policy. Some countries fix their exchange rates to other currencies, such as the U.S. dollar, and sacrifice independent monetary policy.

A pegged exchange rate system involves a commitment of a country to use fiscal and monetary policy to maintain the country’s exchange rate within a narrow band relative to another (stronger) currency or to a bundle of currencies. This type of system requires a country to use its monetary policy to maintain the desired exchange rate.

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36 thoughts on “Foreign Exchange Parity Relations

  1. @Ankur,

    Can you tell me where did you get the 5% number from? Hey I didn’t include the GDP here because I was only talking about Forex parity relations. GDP is such a big topic that it needs another post.

  2. sorry.. that 5% data is old (probably taken from the textbooks written in 80s)….
    current figures are 3% .. sources http://us.rediff.com/money/2005/nov/17india2.htm
    and http://www.economist.com/finance/displaystory.cfm?story_id=8625681

    ya i agree GDP is a crap term…. a homemaker, or an aunt maintaining the house provide a valuable service… yet their contribution to the GDP is nill….

    then globalization and MNC have made a mockery of the term… read my post
    http://enagar.com/2006/11/20/profits-of-mnc/

  3. Ankur,

    Sorry, yours is the only comment that keeps getting stuck in moderation. 😦

    OK, so you’re talking about the Indian Economy. 🙂 I was wondering what you meant by 3% of remittances. I have read that post of yours earlier. Most of the MNCs take advantage of low taxation in some countries. So, I think the effect somehow gets negated. I don’t know how much the GDP gets affected by these actions of MNCs, but I don’t think it’s too much. Do you have any source that connects GDP with this issue?

  4. @Prax, I have seen you before at Ankur’s blog. Thanks for stopping by 🙂 Even though this post only stresses on the entire Forex theory, it would be interesting to read the above mentioned article. Can you provide me the link? I don’t know who ila is.

  5. @Patrick, Heh…I get a lot of those. I’ve been doing good. You seem to have been doing the disappearing act. I can totally understand though. Your work’s still crazy?

  6. ila patnaik is a columnist in Indian express…. you can find her webpage on my blogroll.

    remittances are a strong contribution to the economic health of the poor nations esp in africa and asia… interestingly, most remittances comes from the unskilled/semi skilled labor… rather than the white collar professionals…

    //Most of the MNCs take advantage of low taxation in some countries. So, I think the effect somehow gets negated. //
    you will have to explain me how the effects get negated… the only thing it does is that countries like Bermuda, Luxembourg make substantial profits when neither the capital nor the efforts were made in the country…

    //I don’t know how much the GDP gets affected by these actions of MNCs, but I don’t think it’s too much.//
    ya actually it is sector specific…. but a lot of shipping companies register their boats in countries they have never sailed to.
    then usually you find this practice more prevalent in financial and other knowledge based sectors where margins are higher. also there is tremendous overheads involved… so unless you save a million dollars a year by this, it is not worth it…

  7. My blog doesn’t like you 😛 just joking. I seriously don’ know why this happens to ONLY your comment and no one else’s. The comments on this blog are not even moderated until later. I will reply to your comment in a bit.

    I’ll take a look at ila patnaik’s column. Thanks!

  8. Ankur:

    Another country that has become a favorite with the developed nations is Brazil, or, I should say, Latin America in general. Take a look at this article. It talks about lots of stuff related to remittance. The biggest point made is that the country to which the remittance is made, also loses a lot of income in the form of fees.

    I can understand why semi-skilled labors remit more money- their family back home is probably quite poor. White collar workers have families that are generally more well-off.

    Also, remittances are more in dollar terms for larger countries like India and China. But their contribution to the GDP is higher in case of smaller African countries like Tonga, Haiti, Jordan etc. (Source: International Monetary Fund).

    you will have to explain me how the effects get negated… the only thing it does is that countries like Bermuda, Luxembourg make substantial profits when neither the capital nor the efforts were made in the country…

    I should have probably phrased that one better. What I meant is that we can’t compare the distribution of the profits of a company and its effect on GDP because GDP is an incorrect evaluation for measuring the economic health of two countries. In this case, we should use Purchasing Power Parity.

    Exxon Mobil, GE have lots of unrepatriated earnings in countries such as Ireland, Luxemborg etc. The pharma companies rank #1 in this regard and the industry sector that’s no # 1 is Manufacturing, for obvious reasons 🙂

    If you take a look at the 10-K filings and other SEC reports, you’ll see that most of the times there is no clear distinction between the profits earned from the domestic sectors and the international sectors. I’m telling you this because I have tried doing this a number of times while analyzing M&A. Very rarely will you come across such clear data. In such a case, it’s only a speculation and you can only guess.

    From this article, let me quote the following:

    “It is not the case that income shifting from one foreign jurisdiction to another has a direct effect on US revenue. ….

    ….In October 2004, the US Congress passed a Corporate Tax Bill, which was prompted by a US need to comply with a World Trade Organisation ruling to end a domestic tax subsidy for US exporters.

    …The Bill provides for a tax holiday that allows companies to bring home those deferred overseas earnings at a tax rate of just 5.25 per cent, a move that is expected to bring more than $100bn back into the US. The holiday has been termed as a “temporary stimulus” and that there is “no intent to…enact it again in the future”.”

    Also, Swiss cantons are offering tax rates of about 6% (the absolute lowest) compared to Ireland’s lowest of 12.5%.

    It would be interesting to do a follow up post on this issue I guess.

  9. 1) the underlined link in “Take a look at this article.” does not work… can you retype it.

    2) PPP: its a nice term, but its too cumbersome.. plus it inflates the data of the developing countries primarily because labor/services r cheep there. i can afford a maid if she costs me 500/- INR a month (about 13D) , and that is the worth of the benefit i get from her services… but the statisticians will make it look like she is doing work worth 500USD

  10. //If you take a look at the 10-K filings and other SEC reports, you’ll see that most of the times there is no clear distinction between the profits earned from the domestic sectors and the international sectors. //

    i perfectly agree to it.. and in the real case which i had illustrated in my blog.. making this distinction is next to impossible…… but give me one reason why would a company do that?

    but I am sure every company would have a detailed record of the revenue streams… where they are selling, what are they selling and at what price are they selling…. and this is all that matters….
    you would always do the manufacturing/processing wherever its the cheapest/most convenient and accrue the profits to the office where the taxes r the least….
    and a investor, i can say that… one should never worry too much on the profits….. just have a eye on them… while you do extensive research on the revenue.

  11. @Ankur Aggarwal:

    Sorry about the broken link; I’ve fixed it now.

    I totally agree with you about PPP. Same problem with relative PPP also. It became famous because of the Big Mac Index 🙂

    but give me one reason why would a company do that?

    Why they would do? I don’t know. But they should do it to provide various stakeholders and analysts with good quality financial and accounting data for proper valuation. It all ends up in the Corporate Governance of the firm. Historically, firms that have had good Corp. Governance have earned MUCH more compared to other firms that don’t follow such Rules. It’s all to do with building trust with your stakeholders. This becomes even more imp. in light of the recent accounting scandals.

    I’m totally in agreement with you on the profits part. It’s just an accounting number and I’ve never attached any importance to it. There are so many things that can be manipulated. For instance, the LIFO FIFO inventory system, revenue recognition process etc.

    while you do extensive research on the revenue.

    Bang on! You are Buffet’s child. Haha.

    @Nova, Glad that you liked it.

  12. //Big Mac Index//
    i know if you look at the theory, it looks stupid… but if you look at the data and the results.. you would be amazed by the accuracy. so no comments from my side.
    btw can you recheck my calculations and data for india…..
    in india a MacD burger costs 20/- how much is our currency over/under valued?
    http://www.economist.com/finance/displaystory.cfm?story_id=9448015

    //. But they should do it to provide various stakeholders and analysts with good quality financial and accounting data for proper valuation. //
    my point is that lets look at Dell….
    1) it has a successful marketing team which sells huge volumes of computer at a low price.
    2) because of huge volumes its plants are able to assemble computers at a very low cost.
    success of the company is because of low cost and huge volumes… so tell me what part of the profit should go to the assembly line and what part should go to marketing team.

    don’t say 50-50 because then a problem in the assembly will imply a problem in marketing and vice versa. then you can add complications like different tax rate… benefits because of outsourcing, logistics and other departments.

    the point is that the statements should never LIE…. its better to under-report then the deceive. and in situations like this when there is no clear cut answer… better be silent.

  13. @Ankur Aggarwal:

    i know if you look at the theory, it looks stupid… but if you look at the data and the results.. you would be amazed by the accuracy. so no comments from my side.

    Well, even though I didn’t talk about the accuracy of the Big Mac Index in the last statement, I would like to make a comment now. Since it is based on PPP, it’s not really accurate because it doesn’t consider ignores the effects of taxes, profit margins and the price of raw materials in different countries. The contents of the burger should be the same too. But the contents of the burger will cost much more in India. Why? Because there is no concept of a veggie burger here in the US. There are 10 different kinds of Burger and all of them contain at least beef, if nothing else. Beef is not sold in McDs in India. So, I don’t see the point of comparing Rs. and USD this way. The only thing I’ve eaten at McD over here is salad and may be one horrible ice-cream. 😛

    Anyway, Big Mac Index is just a light hearted way of comparing two currencies. It’s not accurate.

    my point is that lets look at Dell….

    Well, you seem to have misunderstood me here. I was not talking along these lines at all. My comment was only in regard to Corporate Governance, which is defined as, the system of principles, policies procedures, and clearly defined responsibilities and accountabilities used by the stakeholders to overcome the conflict of interest inherent in the corporate form.

    don’t say 50-50 because then a problem in the assembly will imply a problem in marketing and vice versa. then you can add complications like different tax rate… benefits because of outsourcing, logistics and other departments.

    Again…I wasn’t talking about all this 🙂 Btw, if you do talk about the profit sharing of Dell, then I don’t think we are in a position to evaluate it in this manner. I don’t know the company policy for profit distribution. We need to read the financial statements, various 10-K reports, other SEC filings etc. to determine this.

    the point is that the statements should never LIE….

    Agree 100%

    its better to under-report then the deceive. and in situations like this when there is no clear cut answer… better be silent.

    Not at all. Under-reporting is as big as lying by the way. That’s the reason Sarbanes-Oxley Act had been introduced in the US a couple of years back. I don’t know if you’re aware, but there were big Accounting scandals such as Enron, WorldCom etc. over here. Why did it happen? You will be surprised to know that it was because of under-reporting. Enron had huge number of insider transactions, which it didn’t reveal in its report. Huge amount of off balance sheet debt which the analysts couldn’t catch because of the under-reporting. So, the creditors lent them lots of money on credit without realizing that their bonds are actually junk and that their stocks are heavily over valued. The company officials piled on all the debt, sold off their stock while the prices were still high and bailed out. And this was a company that was the biggest energy company in the US. And all of it happened because of under-reporting.

    The accounting system worldwide, esp. US, has evolved a lot in the wake of such accounting scandals to make sure that there is no deceiving by under-reporting. Needless to say, there are 1000s of companies that can still cheat and deceive. Hopefully, something as big as Enron won’t happen because such scandals put the tax payers money into bad use and reduce the trust of the investors in the company and the financial markets.

  14. actually i was supporting the Big Mac theory…. somehow inspite of all inaccuracies it somehow shows a very good trend.

    about dell… what i am saying is that modern business consists of a lot of processes and the company performance is the sum of all of them…. but its hard to put a value to the profit made in each and every one.

    about enron… i think i will need a course in modern accounting practices….

    btw you guys in USA know atleast 10 times more about the company finances and business than you can find for any of the indian company listed in BSE.

  15. Ankur,

    Yes, I agree. Big Mac does show some very good trends. It’s fun to play with such indexes. There is another one made by Iowa University that’s based on the 2008 US Presidential Elections. You can also buy fake “stocks”. 🙂

    Agree about Dell too. It’s highly difficult to say how much of profit was because of marketing etc.

    Yes, I don’t think that the company filings in India are as good. Mom says the same thing to me about Indian companies too. Probably I’ll sit with the company statements of Reliance Industries one of these days, esp. after Mukesh Ambani is the richest man in the world now. 😉

  16. why don’t you start a fund…
    ask 10 friends to pool in 1k USD each… and have the sole objective to invest in 4 companies (irrespective of the nationalities)…
    if you beat the market for 2-3 years consistently… then this could become a really big thing.

  17. Ankur:

    Yes, I will; though not in collaboration with anyone. I want to have complete control over my money 🙂 I’m graduating soon and once I get a real job, I’ll invest some money and keep it. Right now, I have no money. Heh.

    Btw, I’m a little curious- Why did you say four companies? Is that a magical number for you?

  18. rather interesting comments
    now that ankur has directed u to ilas page which i also link to
    u should look at her latest ie column
    first i wondered what u were intending to say due to the rather educational post but i figured out from ur blog name that more than a blog it is ur mini cache
    dell was an interesting example it along with gateway changed the way the markets worked with just in time inventory management, but funnily u didnt talk abt after sales service which is also a vital component in decision mkg
    ankur can the big mac be a real indicator or jst a play thing or rough indicator for understanding currency mkt valuation?

  19. @Prax, Mini cache as in? 🙂

    The first company that comes to my mind when I think about JIT system is Wal-mart. There’s no beating their state of the art logistics.

    but funnily u didnt talk abt after sales service which is also a vital component in decision mkg

    This post was actually meant to discuss only forex relations and not even GDP. But Ankur drove the discussion in some other direction and I couldn’t resist. 🙂 About Dell’s sales service- I think the phone customer service is one of the worst. I had previously blogged about Indian Call Centers. This post is about HP, but Dell is even worse. Recently, they have improved a bit, taking some cue from competitors like HP, Gateway etc. Also, they have expanded their marketing to traditional stores such as Best Buy, Walmart etc. Earlier, they used to rely heavily on selling only through their website.

    Big Mac is not a “real” indicator. It’s a rough indicator. The Economist link that Ankur provided explains it to some extent. You can also read about it in Wikipedia.

    Btw, I saw Ila’s writings at Indian Express. They are quite interesting.

  20. @Ankur Aggarwal:

    That’s what I thought. Research has shown that the market risk decreases as you hold a diversified portfolio. The optimal number of stocks in a portfolio is 20+. All the unsystematic risk gets eliminated and what is left is the systematic risk.

  21. //The optimal number of stocks in a portfolio is 20+. //

    honey won’t that amount to create a personal index….. plus you would need a whopping 100k USD or 6Lakhs INR to buy a minuscule no of shares of each of your target company.

    then add to it that I won’t recommend anybody to invest outside the blue chips or the exceptional emerging players…. so where can you find 20 such companies with are both attractively priced and have a bright future.

  22. Ankur:

    Let me ask you a question- what kind of index can you possibly construct with only 20 stocks? A value weighted, a price weight or an average weighted one?

    I only wish it were that easy to construct a personal index. 🙂

    Yes, you will definitely need a lot of money to invest in 20+ stocks. No doubt about that. Probably you can start with 5 and keep increasing if you have more capital and the time and energy.

    [ won’t recommend anybody to invest outside the blue chips or the exceptional emerging players…. ]

    Why? Shouldn’t you diversify your holdings instead of putting all your eggs in one basket?

    @Arvind:

    Thank you 🙂 I’ll take a look at your blog.

    @Ankur, Haha 🙂

  23. most of the respected index of the world have 30 shares… so I am sure with 20 shares you can cover 4-5 attractive sectors.

    //Why? Shouldn’t you diversify your holdings instead of putting all your eggs in one basket?//
    blue chip is a very big segment… the top 30 shares constitute about 70% of the entire market turnover. (same should be for S&P shares) plus you have access to very detailed analysis and liquidity.

    my target is to have about 25% p.a. returns with as low risk as possible. (and i have been consistently overshooting it by atleast 4 times.)

  24. [most of the respected index of the world have 30 shares… so I am sure with 20 shares you can cover 4-5 attractive sectors.]

    So, you meant an index fund.

    [blue chip is a very big segment… the top 30 shares constitute about 70% of the entire market turnover.]

    Sure. Agree totally!

    [my target is to have about 25% p.a. returns with as low risk as possible. (and i have been consistently overshooting it by atleast 4 times.)]

    That’s an awesome return I would say. You need to teach me some stuff then.

  25. //That’s an awesome return I would say. You need to teach me some stuff then.//
    i have been just lucky… i usually buy the stocks when the market looks gloomy and just wait till it is optimistic….

    plus for the past 2 years I have been updating my blog with all the strategies i undertake 🙂

    Yes, I noticed that. 🙂 You invest a lot in IPOs, which pay off well, if done wisely.

    Ruhi

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