Basic International Finance Equations to Remember

Part of the International Finance For Dummies Cheat Sheet

International finance is a subject based on numbers. And, with that comes calculations. Calculating the fundamentals of international finance puts the subject in perspective and gives it a visual component to help understand how things work. Here are some of the widely-used equations in international finance:

  • Inverting exchange rates. If you have the Chine Yuan (CNY)-dollar exchange rate, but need the dollar-Chinese Yuan exchange rate, just invert the former. Suppose you have the exchange rate as CNY6.22 per dollar. The dollar-Chinese Yuan exchange rate is:

    image0.png
  • Calculating cross rates. Suppose the dollar-British pound (GBP) and the dollar-Canadian Dollar (CAD) exchange rate is $1.51 and $0.97, respectively. Even if the Canadian dollar-British pound exchange rate is not listed, you can easily calculate the Canadian dollar-British pound exchange rate as CAD1.57:

    image1.png
  • Therefore,

    image2.png

    Of course, if you need the British pound-Canadian dollar rate, take the inverse of CAD1.57:

    image3.png
  • Calculating real exchange rate (RER). The nominal exchange rate indicates the relative price of two currencies. The real exchange rate expresses the relative price of two countries’ consumption baskets in the same currency. If the price of the consumption basket in the U.S. and the Euro-zone is PUS and PE, respectively, and you have the dollar-euro exchange rate, the RER becomes:

    image4.png
  • By multiplying the exchange rate with the price of the European consumption basket, you convert the latter into dollar. Therefore, the dollar price of the European basket divided by the price of the U.S. basket (expressed in dollars) gives you the real exchange rate.

  • If the dollar-Euro exchange, the euro price of the European basket, and the dollar price of the U.S. basket are $1.31, €135, and $121, the RER is:

    image5.png
  • Calculating the percent change in exchange rates. The percent change formula is a handy tool to calculate the change in exchange rates (or other variables). If a year ago the dollar-euro exchange rate was $1.32 and is now $1.31, then the change in the exchange dollar-euro exchange rate (ER) is 0.76 percent appreciation in the dollar:

    image6.png
  • Applying the interest rate parity (IRP). This concept relates the nominal interest rates in home (RH) and foreign country (RF) to the change in the exchange (ρ), which is referred to as forward premium or discount:

    image7.png
  • For smaller differences between two countries’ interest rates, you can use the following approximation:

    image8.png
  • After calculating ρ, you apply it to the spot rate (St) to calculate the IRP-suggested forward rate (FIRP):

    image9.png
  • If, for example, RH, RF, and St are 1 percent, 1.12 percent, and $1.32 per euro, the forward discount on euro is 0.12 percent:

    image10.png
  • In this case, the IRP-suggested forward rate is $1.318 per euro:

    image11.png
  • Using the purchasing power parity (PPP). The PPP relates home country’s inflation rate (πH) to that of foreign country (πF) to predict the change in the exchange rate (e):

 

image12.png

  • For smaller differences between two countries’ inflation rates, you can use the following approximation:

    image13.png image14.png
  • After calculating e, you apply it to the spot rate (St) to calculate the PPP-suggested expected exchange rate :

    image15.png
  • If, for example, πH, πF, and St are 3 percent, 2 percent, and $1.31 per euro, the dollar is expected to depreciate by 0.98 percent against the euro:

    image16.png
  • Given the spot rate of $1.31 per euro, the PPP-suggested expected exchange rate is $1.323 per euro:

    image17.png
  • Add a Comment
  • Print
  • Share
blog comments powered by Disqus
Advertisement

Inside Dummies.com