International Finance Management

In the previous sessions, Sessions 17 and 18 (Exchange Rate Theories: Purchasing Power Parity & Exchange Rate Pass Through), we discussed rate parity conditions like Purchasing Power Parity and Law of One Price, REER (Real Effective Exchange Rate) and NEER (Nominal Effective Exchange Rate System) aspects. Besides these parity conditions, macroeconomic factors like inflation rate, exchange rate and interest rates of countries are intertwined to create equilibrium. These equilibrium conditions can popularly to known as Interest Rate Parity, Fischer Effect, International Fischer Effect. Understanding the basis of these parity conditions forms the basis of exchange rate movement. When macroeconomic factors governing these parity conditions deviate, arbitrage opportunity is possible. Hence in the remaining part of this session as well as next session (Session 20), these parity conditions are discussed in detail. The parity conditions are Fischer effect, Int...

18.1: Exchange Rate Indices: NEER and REER As country’s currency can be compared with any other currency and a given country’s currency can be expected to appreciate compared some currencies while expected to depreciate against some other currency. But can we generalize, whether a given country currency is expected to appreciate or depreciate? This can be done so by comparing the currency value of any country with the currency value of its major trading partners. Since countries trade with many other countries, to determine the relative purchasing power of a given currency, it needs to be evaluated against all other currency values so that the currency’s true value can be identified. In other words, whether a currency is “over valued” or “under valued” compared to its major trading partners needs to be determined. This is done by calculating exchange rate indices. These indices are calculated by trade weighing bilateral exchange rates between the currency and its tradi...