Inflation, Exchange Rates, and Required Returns

15 Pages Posted: 21 Oct 2008

See all articles by Robert S. Harris

Robert S. Harris

University of Virginia - Darden School of Business

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Abstract

This note describes the links between inflation, exchange rates, and interest rates in an international setting. Students are introduced to the basic ideas, which are illustrated with data from four countries. The note emphasizes the managerial implications of these links and their relevance to forecasting exchange rates. It is useful as both background reading to supplement cases and as part of preparation for a lecture on the topic.

Excerpt

UVA-F-1158

INFLATION, EXCHANGE RATES, AND REQUIRED RETURNS

As businesses cross national boundaries, some issues take on new importance: differences in cultures and languages, new sets of institutions and customs, fluctuations in exchange rates, and governmental policies on cross-border flows of goods and capital. Success requires understanding these and other issues and then incorporating them into business strategies and tactics. This note focuses on three key financial market issues that emerge in international business: differences in inflation, patterns in exchange rates, and differences in required returns (for example: interest rates). Exhibit 1 provides data on those three issues. Why do interest rates differ across countries? What explains the patterns in forward exchange rates? What are the links between inflation, interest rates, and exchange rates? Answers to those questions provide valuable insights for managers.

Domestic Financial Markets

As a starting point, consider how investors view the future in a purely domestic setting. Investor requirements can be thought of as required returns. Such a return requirement is the minimum expected return that will convince an investor to put money into a particular investment, and is the rate by which investors will judge value creation. A required return is often decomposed as the sum of a least risk nominal rate and a risk premium as shown in Equation 1.

Nominal required = Least risk nominal + Risk premium (1)

. . .

Keywords: exchange rates, forecasting, inflation, interest rates, international finance, international, Alternative Business Issue or Setting

Suggested Citation

Harris, Robert S., Inflation, Exchange Rates, and Required Returns. Darden Case No. UVA-F-1158, Available at SSRN: https://ssrn.com/abstract=909387

Robert S. Harris (Contact Author)

University of Virginia - Darden School of Business ( email )

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Charlottesville, VA 22906-6550
United States
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434-924-4859 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/harris.htm

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