Exchange rate 4 Flashcards
The critical issue for the analyst is to construct a projection of nominal prices that are consistent with X through time and the projection of changes in real prices.
assumed pattern of inflation rates
The projection of the future path of real prices is of particular importance if the price of one
or more input or output is
significantly above or below its normal level or trend.
Historical data for nominal prices are relatively X, but forecasting nominal prices in a consistent manner is a Y
Easy to obtain,
notoriously difficult task
The nominal price of an item is the outcome of two sets of economic forces:
macroeconomic forces that determine the general price level or inflation, and the forces of demand and supply for the item which causes its price to move relative to other goods and services in the marketplace
In order to construct a cash flow forecasts in nominal prices, we must take into
both real prices and the general price level consideration the movement of
The weights established at
that time will rarely change
Instead of calculating the price level for the entire economy, a price level may be created for a certain subset of prices such as
construction materials or consumer goods.
The price index simply
normalizes the price level so that in the base period the index is equal to one
Inflation is much more difficult to
forecast than the changes in real prices,
The supply of money, in turn, is often determined by the
size of the public sector deficit and how it is financed
inflation is inevitably the end result.
If governments finance their deficit by
borrowing heavily from the Central Bank,
A common mistake of project evaluators is to assume that many of the prices of inputs and outputs for a project are
rising relative to the rate of inflation. This is
highly unlikely
To forecast the movement of the real price of a good or service, we need to consider such items as the anticipated change
in the demand for the item over time, the likely supply response, and the forces which are going to affect its cost of production.
The use of constant prices simplifies the construction of a cash flow profile of a project, but it also eliminates
from the analysis
a large part of the financial and economic information that can affect the future performance of the project
It should be noted that real prices are sometimes referred to
constant prices
two specific prices are discussed below due to the important role they play in the financial analysis of projects.
These are the interest rate and the price of foreign exchange.
As the inflation rate increases, the nominal interest rate will be
increased to ensure that the present value of the interest and principal payments will not fall below the initial value of the loan.
Inflation reduces the future value of both
the loan repayments and real interest rate payments
eflects the real time value of money that lenders require in order to be willing to forego consumption or other investment opportunities
Real interest rate
- (1+r+R)gP
complete: i = r + R + (l + r + R) gPe
- represents the compensation for the expected loss in purchasing power attributable to inflation.
R: risk factor, measures the compensation lenders demand to cover the possibility of the borrower defaulting on the loan,
r: real interest rate, which reflects the real-time value of money that lenders require in order to be willing to forego consumption or other investment opportunities
When both risk and inflation are zero, a lender would want to recover at least the real-time value of money. If the real interest rate r is 5 percent, then the lender would charge at least X percent nominal interest rate.
5
Nominal interest rate adjustment has little or no direct effect on the overall economic viability of the project as measured by its X; however, it may impose very
severe constraints on the Y
NPV
liquidity
Nominal interest rate adjustment when
project refinancing
