International Financial Management: PPP, IFE and Derivatives

This article discusses the relationship between International Fisher Effect (IFE), Purchasing Power Parity (PPP) and derivatives in International Financial Management. It explains how PPP and IFE in theory make derivatives unnecessary and evaluates the differing ways in which derivatives can protect against the failing of IFE and PPP. The article also discusses the use of forward, future, option and swaps contracts as derivative instruments to minimize the negative impact of currency volatility. The subject is relevant to courses in finance, economics and international business.

Running head: INTERNATIONAL FINANCIAL MANAGEMENT
International Financial management
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Table of Contents
Explain why PPP and IFE in theory make derivatives unnecessary and evaluate the differing
ways in which derivatives can protect against the failing of IFE and PPP:...............................2
Reference and Bibliography:......................................................................................................7

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Explain why PPP and IFE in theory make derivatives unnecessary and evaluate the
differing ways in which derivatives can protect against the failing of IFE and PPP:
Economist and Analyst relatively use international fisher effect and purchasing power
parity on deriving the adequate price for a particular financial instrument. However, the
determination of price is actually derived from the theoretical analogy, where an equilibrium
condition is evaluated to determine actual value for particular financial product. The
theoretical derivation of identifying the actual value is relatively flawed, due to the
continuous change in demand and supply of a particular financial product. therefore, when
International fishes effect and purchasing power parity is not effective than adequate
derivative instruments are used by investors to curb the actual prices in accordance with the
theoretical price. In this context, Titman, Keown and Martin (2017) stated that derivative
instruments are used by investors to detect and hedge the current statistics of a particular
financial product, which is relevantly traded in the capital and currency market.
Moreover, derivative instruments are relatively used by traders to determine the
accurate pricing of a particular financial product. In addition, the presence of international
fisher effect and purchasing power parity nullifies the requirement of derivative instruments,
as it determines the fair value of a particular product. Therefore, investors are not needed to
use the derivative instrument for getting the accurate price of a particular Product. Hence, it
could be assumed that International fisher effect and purchasing power parity reduces the
usage of derivatives by traders to determine relevant prices in the financial market. On the
other hand, Titman and Martin (2014) argued that International fisher effect and purchasing
power parity is only a technical term used to drive prices in theoretical world, which does not
stop the traders from using derivatives in the real-world practice. From the discussion in the
journal Purchasing power parity is relatively a puzzle, which has to Reconcile extremely due

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to high short term volatility of real exchange rate. The use of multivariate for model has
relatively helped in detecting the very slow conversion of PPP derivations in medium and
long term (Rogoff 1996). However, the article indicated that during short term conditions the
impact of purchasing power parity is a relatively not adequate to determine the actual
currency valuation for exchange rates. The short term volatility is relatively high and the
derivations from purchasing power parity fail to portray the actual exchange rate. Article
relevantly indicates that there is no satisfactory alternative explanation for the purchasing
power puzzle, as the prices in the international market before significantly during short
durations and medium duration. The article also indicated that due to the adjustment cost
such as transportation, actual tariff, and labour mobility the overall exchange value no
particular currency is drastically changed. Therefore, the currency exchange rate is relatively
different in real case scenario and in theoretical purchasing power parity (Rogoff 1996).
The article focuses on deriving the currency carry trades by providing the relationship
between carry trade excess Returns, interest rates spreads, risk taking and exchange rate
volatility. The article relevantly identifies the changes in Currency exchange rate which is
conducted to determine the actual carry trade Returns in the currency market. The currency
carry trade is relatively conductor due to the fear of Financial Market distress and funding
constant which might hamper operational feasibility of organisation. Moreover, from the
article it could also be identified that the Sharpe ratio of fixed exchange rate is relatively
higher in comparison to flexible exchange rate. This relatively indicates that with the
interaction of fixed exchange rate the overall impact of purchasing power parity can be
improved over the period of time (Hoffmann 2012).
There are different ways in which derivatives can allow and help investors against the
feeling of international fisher effect and purchasing power parity. Derivatives provide
adequate instruments to the traders for reducing the negative impact of the failed theoretical

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instruments used to derive prices (Deresky 2017). The following measures are used by the
investors when International fisher effect and purchasing power parity fails to comply with
the demands of investors.
Forward Contract:
Forward contract is considered one of the derivative instrument which is used by
investors to regulate the prices of a particular financial product that is affected by interest
rates. With the help of forward contract investors are able to fix the overall exchange prices
in future which tends to change due to the demand and supply of a particular currency. The
use of Forward contracts eventually helps to fix the prices of a particular product in future
time according to the prices portrayed by international fisher effect and purchasing power
effect to minimize the flaws in the theoretical analogy. According to Brooke (2016), forward
contract is relatively a measure, where investors are reluctant to use the exchange rate due to
its volatility and preferred forward rates to conduct exchanges.
Future Contract:
One of the biggest derivative instrument that is used by investors all around the world
are future contracts, as it helps in minimizing the risk involved in trading currencies. the
futures contract relatively determines the actual value of a particular currency in future at a
certain date due to its demand and supply. The actual currency value is a relatively volatile
due to the demand and supply, while it never Matches the future value of a particular
currency. However, with the help of the derivative instrument the actual and the theoretical
value are relatively made closer to determine the fair value of a particular currency.
Therefore, when purchasing power parity and international fisher Effect Theory the
derivative instruments provides leverage and accurate value of a particular currency, which
would be traded in the capital and currency market. Future contracts are sold and bought on

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the currency and capital market, which relatively allows the investors to accurately determine
the actual value of a particular currency when purchasing power parity and international
fisher effect fail (Finkler et al. 2016).
Option Contract:
Option is the third derivative instruments that is currently being used by multinational
companies and speculators to minimize the negative impact from currency volatility. This
instrument relatively helps in minimizing the overall capital blockage that is needed in future
contracts and forward contracts. The option contract relatively allows the multinational
companies and speculators to conduct trades by determine the accurate pricing of a particular
currency. The attractiveness of the option contract relatively allows organizations to conduct
the trade adequately for determining the accurate position of a currency. Moreover, the option
contract is relatively used as a hedging process by maximum of the multinational companies
to regulate or determine the accurate currency value in which the transaction will take place
(Wild, Wild and Han 2014). The option contracts play a vital role in minimizing the negative
impact of not determining the accurate pricing of a currency by purchasing power parity and
international fisher effect. the contract eventually helps traders and multinational companies
to minimizes the negative volatility in the currency market and conduct the transaction with
accurate pricing of a particular currency.
Swaps Contract:
The evolution of trading has relatively brought us the swap contracts, which is used to
identify the actual level of demand and supply in a particular market, while determining the
accurate price of the currency. The contract relatively reduces the problems that might be
faced by organization during the currency conversion. Swaps are conducted on different
levels such as interest swaps, currency swaps, etc. For example, the Government of

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Switzerland took a drastic step in 2011 to purchase Euro currency for evaluating their Swiss
Franc. This led to the accumulation of high Euro currency in the treasury of Switzerland
National Bank. The manipulation conducted by the country relatively portrayed a negative
impact on its progress while nullified the rules of international fisher effect and purchasing
power parity (Cremers et al. 2016).

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Reference and Bibliography:
Brooke, M.Z., 2016. Handbook of international financial management. Springer.
Cavusgil, S.T., Knight, G., Riesenberger, J.R., Rammal, H.G. and Rose, E.L.,
2014. International business. Pearson Australia.
Cremers, M., Ferreira, M.A., Matos, P. and Starks, L., 2016. Indexing and active fund
management: International evidence. Journal of Financial Economics, 120(3), pp.539-560.
Deresky, H., 2017. International management: Managing across borders and cultures.
Pearson Education India.
Finkler, S.A., Smith, D.L., Calabrese, T.D. and Purtell, R.M., 2016. Financial management
for public, health, and not-for-profit organizations. CQ Press.
Hoffmann, A., 2012. Determinants of carry trades in Central and Eastern Europe. Applied
Financial Economics, 22(18), pp.1479-1490.
Rogoff, K., 1996. The purchasing power parity puzzle. Journal of Economic literature, 34(2),
pp.647-668.
Titman, S. and Martin, J.D., 2014. Valuation. Pearson Higher Ed.
Titman, S., Keown, A.J. and Martin, J.D., 2017. Financial management: Principles and
applications. Pearson.
Wild, J.J., Wild, K.L. and Han, J.C., 2014. International business. Pearson Education
Limited.