FREE online courses on Investment Decisions in Exchange Rates - Predicted Exchange Rates

 

If the real rate of interest is the same in all countries (due to the international mobility of capital) the International Fisher Effect implies that differences in nominal interest rates will signal differences in the expected rates of inflation across countries.  Given that RUS is 6 percent per year and that the German interest rate RDM is 11 percent per year, we would expect the expected rate of inflation in Germany to be roughly 5 percent greater than the expected rate of inflation in the U.S..

 

Relative Purchasing Power Parity implies that the expected changes in exchange rates should reflect differences the expected rates of inflation in the two countries in question,

 

                                      =    [ ]N

 

where E( S$/DM(t+n) ) denotes the exchange rate expected in n periods.  This formula implies that over the next two years we can expect the following exchange rates

 

                   E( S$/DM(t+1) )     =     $0.65/DM1 [ ],

 

                   =     $0.6207/DM1  ,

 

          and

 

                   E( S$/DM(t+2) )     =     $0.65/DM1 [ ],

 

                   =     $0.5928/DM1  .

 

 

The anticipated structure of exchange rates can be used to convert the anticipated WV denominated cash flows to dollars, which can then be discounted using the US cost of capital.

 

                             Cash Flows in 1000s of DM

                             0        1        2        3       

 

          Investment in DM

 

             a.  Plant and Equipment    <DM 25,000>

 

             b.  Working Capital <DM   5,000>           DM 5,000

 

          DM Cash Flows                   DM 20,000     DM 20,000              

 

          Total DM Cash Flows <DM 30,000>  DM 20,000     DM 25,000

 

          Projected Exchange Rate     $0.6500/DM1  $0.6207/DM1  $0.5928/DM  

 

          Projected Dollar Cash Flow   <$19,500>     $12,414         $14,820        

 

Assuming that the firm has a weighted average cost of capital of 12 percent, the net present value of the projected dollar stream of cash flows is $3,398 (1000s), which indicates that the project should be accepted.