When finance crosses international borders, free markets do an adequate job of keeping everything in check.  The price of a good, service, or investment opportunity is generally the same regardless of where the transaction occurs.  More formally, the law of one price states that in an efficient market, all goods must have only one price.

This means that if an American firm and a European firm produce the same product, it should ultimately sell for the same price after accounting for currency differences.  Moreover, a bond in Japan and a bond in Brazil should pay the same yield after accounting for inflation expectations.

Three relationships tie together international finance…

Purchasing Power Parity (PPP) dictates that inflation expectations between two countries directly affects the foreign exchange rate between those two countries (and vice versa).  So, if inflation in Brazil is expected to be 3% higher than in Japan, the Japanese Yen should appreciate by roughly 3% more than the Brazilian Real.

Spot Rate Expected/Spot Rate Current = (1+ Inflation Foreign Country)/(1 + Inflation Domestic Country)

 

Interest Rate Parity (IRP) provides the relationship between interest rates and foreign exchange rates.  So, if the UK’s Bank of England raises interest rates relative to the US Federal Reserve’s interest rates, the British Pound Sterling would appreciate relative to the US Dollar.  This relationship, like PPP, works in reverse too; a change in the foreign exchange rates may provide market expectations of a change in interest rate policy.

Spot Rate Expected/Spot Rate Current = (1+ Interest Rate Foreign Country) /(1 + Interest Rate Domestic Currency)

 

The International Fisher Effect relates interest rates and inflation expectations.  For example, the difference between South African interest rates and Australian interest rates should be in line with the difference between South African inflation expectations and Australian inflation expectations.

Interest Rate Foreign – Interest Rate Domestic = Inflation Foreign – Inflation Domestic

(1 + Nominal Interest Rate) = (1 + Real Interest Rate) (1 + Expected Inflation)

  

Now this doesn’t work perfectly and in all situations.  For example, it’s somewhat difficult to export certain goods and services; as in, I can’t export a haircut overseas–some items may just not feasible.  Furthermore, a government may choose to restrict certain products by way of quota or tariffs (to the detriment of their countries consumers).  Finally, information costs may cause a market to appear inefficient.  These variances are exceptions to the rules above, overall, foreign exchange parity relationships generally hold.

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