Gikondo on

18th
February ,20
22

College of Business & Economics

NIYIGENA Philomene School of Business

REG NO: 221027797 Master’s in business administration (Finance)

Batch 14 Batch 13& 14

International Finance Module

Facilitated by Dr. Samuel Mutarindwa

Individual assignment
1. Explain the implications of interest rate parity for exchange rate determination
2. Explain purchasing power parity both absolute and relative versions. What causes deviations
from the purchasing power parity
3. Explain and derive the International Fisher Effect
QUESTION 1: Explain the implications of interest rate parity for exchange rate determination
Introduction
Interest rate parity is a theory regarding the relationship between the spot exchange rate
and the forward exchange rate and postulates a relationship between the exchange rate
and the interest rate of two countries. The theory holds that the spot currency exchange
rate times the interest rate of the home countries, divided by the interest rate of the foreign
country. If IRP does not hold true , then there is the potential to profitably an arbitrage
strategies.
INTEREST RATE PARITY FORMULA
SX (1+iA )
F=
1+iB

(1+iA)

ST OR Ft
St

(1+1B)
IA=Interest rate for the countries A
IB=Interest rate for the countries B
St=the spot rate
ST=Expected spot rate a time T
Ft=the forward rate.
THE IMPLICATIONS OF INTEREST RATE PARITY FOR EXCHANGE RATE DETERMINATION
The basic premise of interest rate parity is that hedged returns from investing in different
currencies should be the same ,regardless of the level of their interest rates.
The higher the interest rates offer lenders in an economy a higher relative returns to other
countries. therefore higher interest rate attract foreign capital and cause the exchange rate to rise.
www.investopedia.com
The opposite relationship exists for decreasing interest rates –that is, lower interest rates tend to
decrease exchange rates.
EXAMPLE: Let us assume a spot late of 2.13 USD/EUR, a USD interest rate of 2% and EUR interest
rate of 3%.what will be the forward exchange rate after a year.
Solution
Let as use the below –given data for the calculation of forward exchange rate.

Particulars Rates
Time (years) 1 2 3
Home country’s interest rate 3% 3% 3%
Foreign countries interest 4% 4% 4%
rate
Spot exchange rate 3.13% 3.13% 3.13%

SX (1+iA ) 3.13 %X (1+ 3 %)1

Forward exchange rate year 1¿ = =3.09%
1+iB (1+ 4 %)
1

2
SX (1+iA ) 3.13 %X (1+ 3 %)
Forward exchange rate year 2 ¿ = =3.07
1+iB (1+ 4 %)
2

SX (1+iA ) 3.13 %X (1+ 3 %)3

Forward exchange rate year 3 ¿ = =3.04%
1+iB (1+ 4 %)
3

CONCLUSION
Interest rate parity is of importance due to the fact that if the relationship does not hold good.there
is an opportunity to make an unlimited profit by borrowing and investing in differant currencies at
differant points of time which is termed as arbitrage.if the actual forward exchange rate is greater
than the calculated interest rate parity a person can borrow money,convert it using a spot
exchange rate and invest in the foreign market at their interest rates. At maturity it can be
converted back to a home currency with a fixed certain profit since the locked price is greater than
the calculated price(www.wallstreetmojo.com).IRR can be also used to determine the estimate of
the foreign exchange rate at future rate.for example if the country interest rate of a home country
is increasing keeping the interest rate of foreign country constant we can speculate the home
currency to appreciate in value with respect to the foreign currency.
QUESTION TWO
Explain purchasing power parity both absolute and relative versions. What causes deviations from
the purchasing power parity?
ANSWER: Relative purchasing power parity: is an expansion of the traditional purchasing power
parity. PPP theory includes changes in inflation over time. purchasing power is the power of money
expressed by the number of goods or services that one unit can buy and which can be reduced by
inflation, RPPP suggests that countries with higher rates of inflation will have a devalued currency.
Example of relative PPP: suppose that over the next year, inflation causes average for goods in
kenya to increase by 5%.in the same period prices for products in Burundi increased by 10 %. we
can say that Burundi has had higher inflation than kenya. since prices there have risen faster by five
points. According to the concept of relative purchasing power parity, the five point difference will
drive a five –point change in the exchange rate between kenya and Burundi.so we can expect the
Burundi currency to depreciate at the rate of 5% or that kenya should appreciate at the rate of 5%
per year.
Absolute purchasing power parity is the basic PPP, which states that once two currencies have been
exchanged, a basket of goods exchanged should have the same value. www.ig.com
Usually ,the theory is based on converting other world currencies into the us dollar. For instance , if
the price of a can coca cola is $1.50,APP would suggest that a can of coca cola in any country
should cost 1.50 $ after you have converted USD into local currency.
CAUSES OF DEVIATION FROM PURCHASING POWER PARITY
The deviation from purchasing power parity is influenced by the changes in the equilibrium relative
price between tradable goods, and non tradable goods. ROGOFF(1996) In survey of PPP literature
mentioned that deviation from PPP can be accounted by three factors
1.Productivity differential as suggested by Balassa(1964) And Sameulson(1964).
2.Government spending
3.Current account balances
PRODUCTIVITY DIFFERENTIAL
The Balassa –samuelson hypothesis implies that an increase in productivity of traded goods but not
in non –traded goods leads to an increase in the relative price of non –tradable goods, which
causes the real exchange rate to appreciate . Productivity differentials are only one of several
contributing factors in ex-plaining permanent change in the real exchange rate.
GOVERNMENT SPENDING
The persistent change in the real exchange rate can arise from a change in government
consumption spending that fall largely on the non -traded sector. Suppose a government expands
its spending , allowing government revenue ,nominal exchange rate and price of tradable goods
would increase and thus causes the real exchange rate to appreciate.
CURRENT ACCOUNT BALANCES
The real exchange rate changes are due to imbalances of the current account.
Theoretically ,substantial current account deficits are associated with long run real exchange rate
depreciation. Account deficits are likely to induce significant exchange-rate changes because
different countries tend to exhibit different spending patterns. This implies that the residents of a
country having a current account deficits spend more on tradable goods than non-tradable goods,
this will causes a decrease in the domestic relative price of non -tradable goods, and this will cause
a decrease in the domestic relative price of non- tradable and the real exchange rates to
depreciates.
QUESTION THREE
Explain and derive the International Fisher Effect
ANSWER
IFE: in an economic theory stating that the expected disparity between the exchange rate of tw
currencies is approximately equal to the difference between countries nominal interest rates.
• The fisher effect states that nominal interest rates in each country are equal to the required
real rate of return plus compensation for expected inflation

Or 1+Nominal interest rate = (1+ Real

rate)(1+inflation rate

Example: assume that the real interest rate is 5.5 % and the rate of inflation changes from 2.5% to
3.5% .The nominal interest rates is calculated as follows:

Nominal interest rate 1=(1+0.055)(1.025)-1

=(1.055x1.025)-1=0.081 0r 8.1 %

Nominal interest rate 2=(1.055)(1.035)-1=0.092 02 9.2%

Therefore ,the nominal interest rate would have increased from 8.1 when the inflation was 2.5 % to
9.2 when rates of inflation increases to 3.5 %.

International Fisher Effect (IFE)

o The difference in interest rates between two countries is related to the forecasted change in
the exchange rate between their currencies.
o The Fisher effect can be expanded international into so-called, the International Fisher
Effect.
- That is, IFE = PPP + FE
- A higher interest rate means a higher inflation rate, according to IFE
- A higher inflation rate means a currency depreciation, according to PPP
Therefore, the currency whose country has the higher interest rate will depreciate.
- It suggests that currencies with higher (lower) interest rates will depreciate (appreciate)
because the higher (lower) rates reflect higher (lower) expected inflation and therefore,
implying the lower (higher) real return
For example, if the interest rate is 5 percent per year in the US and 7 percent in the UK., the dollar
is expected to appreciate against the British pound by about 2 percent per year
Example: Suppose the interest rate on one year insured.us bank deposit is 9% and the rate on one
year insured British bank deposit is 10%. what does the IFE predict will happen to the exchange
rate.
ANSWER
(1+9 % )
IFE = −1=0.00909∨O .909 %
1+10 %
We expect euro to depreciate by a little less than 1%.
REFERANCES
1. Roggoff.k.,1992,traded goods consumtion smothing and the randomwalk behavior of the real
exchange rate.Monetry and Economics studies,10,pp 1-29
2. Rogoff k.,1996,the purchasing power puzzle.journal of economic literature,34.pp 647-668.
3. Samwuelson,p.,1964,theoretical note on trade problems.Review of Economics and
statistics,66,pp 145-154
4. www.ratefinance institute .com
6. www.investopedia.com

7.www.ig.com
8.www.wallstreetmojo.com