EXCHANGE

RATE
THEORIES

Exchange Rate Theories

The important factors affecting exchange rates
are:
1. Rate of inflation
2. Interest rates and
3. Balance of payments
There are two important theories that aptly
explain
fluctuations in exchange rates

Exchange Rate Theories

Theory of
Purchasing Power Parity
(PPP)

Theory of
Interest Rate Parity

Theory of Purchasing Power

Parity
(PPP)
PPP theory measures the purchasing power

of one currency against another after taking

into account their exchange rate

taking into account their exchange rate

simply means that you measure the

strength on $ 1 with that of Rs. 50 and not
with Rs. 1
( assuming the exchange rate is $ 1 = Rs. 50)

Theory of Purchasing Power

Parity
(PPP)
Cassel ( Swedish
Developed by Gustav

economist 1918) , the theory states that in

ideally efficient markets, identical goods
should have one price
The concept is founded on the
law of one price; the idea that in the absence
of transaction costs, identical goods will
have the same price in different markets
However, if it doesnt happen, then we say
that purchase parity does not exist between
the two currencies

In the United
States
$ 40

In India
Rs. 750

Suppose $ 1 = Rs. 50 today

$ 15

Theory of Purchasing Power

Parity
(PPP)
If this happens:
1. American consumers demand for Indian
Rupees would increase which will cause the
Indian Rupee to become more expensive
2. The demand for cricket bats sold in the US
would decrease and hence its prices would
tend to decrease
3. The increase in demand for cricket bats in
India would make them more expensive

In the United States

$ 40

In India
Rs. 750

$ 30

Rs. 1200

The rate $ 1 = Rs. 50 changes to Rs.

40
$ 30

At these levels, you can see that there is a purcha

power parity between both the currencies

Theory of Purchasing Power

Parity
(PPP)

PPP theory tells us that price differentials

between countries are not sustainable in

the long run as market forces will equalise
prices between countries and change
exchange rates in doing so

Moreover, in the long run, having different

prices in the US and India is not sustainable

because an individual or a company will be
able to gain an arbitrage profit

Theory of Purchasing Power

Parity
(PPP)
Because of arbitrage opportunities, market
forces come in to play and bring about an
equilibrium in prices

PPP theory is often used to forecast future

exchange rates , for purposes ranging from

deciding on the currency denomination of
long-term debt issues to determining in which
countries to build plants

Theory of Purchasing Power

Parity
(PPP)
The relative version of PPP now commonly used
states that the exchange rate between the
home currency and any foreign currency will
adjust to reflect changes in the price levels of
the two countries

Suppose, inflation is 5 % in the United States

and 1 % in Japan, then the dollar value of the

Japanese Yen must rise by about 4 % to equalise
the dollar price of goods in the two countries

Theory of Purchasing Power

Parity
(PPP)
If

ih

Is the rate of inflation for the home country

if

Is the rate of inflation for the foreign country

e0

Is the home currency value of one unit of foreig

Currency at the beginning of the period

et

Is the spot exchange rate in

period

Then

(1 ih )
et
(1 ih )
et e0

i.
e.
t
t
(1 i f )
e0
(1 i f )
t

Theory of Purchasing Power

Parity
(PPP)

et appearing in the equation is known as the

purchasing power parity. For example, if the
United States and Switzerland are running annual
inflation rates of 5% and 3% respectively and the
spot rate is SFr 1 = $ 0.75, then the PPP rate for
the Swiss franc in three years3should be:

(1.05)
e3 0.75
$0.7945
3
(1.03)

If purchasing power parity is expected to hold,

then $ 0.7945/SFr is the best prediction for the
Swiss franc spot rate in three years

TWO TYPES OF
PURCHASINGPOWERPARITY

1. Absolute Purchasing Power

Parity
2. Relative Purchasing Power
Parity

The Absolute Purchasing

Power Parity relation is:
e= pd/pf
where
pd
is
the
domestic price index, pf the
foreign price index, and e is
the
spot
exchange
rate
(domestic currency units per
unit of the foreign currency).

Relative PPP is said to hold if

e=pd - pf
Relative PPP states that the
percentage
change
in
the
exchange rate is equal to the
percentage
change
in
the
domestic price level minus the
percentage change in the foreign
price level

PPP of GDP for the countries of the world as of 2003. The

economy of the US is used as a reference, so that country is set
at 100. Bermuda has the highest index value, 154, thus goods
sold in Bermuda are 54% more expensive than in the United

Interest Rate Parity Theory

This theory states that premium or discount of

one currency against another should reflect
the interest differential between the two
currencies
The currency of the country with a lower
interest should be at a forward premium in
terms of the currency of the country with a
higher rate

Interest Rate Parity Theory

In an efficient market with no transaction
costs, the interest differential should be
( approximately) equal to the forward
differential
When this condition is met, the forward rate
is said to be at interest rate parity and
equilibrium prevails in the money markets

Interest Rate Parity Theory

Thus, the forward discount or premium is
closely related to interest differential
between the two currencies

Looked at differently, interest rate parity

says that the spot price and the forward, or

futures price, of a currency incorporate any
interest rate differentials between the two
currencies assuming there are no transaction
costs or taxes

Covered interest rate parity

Interest parity ensures that the return on a
hedged ( or covered) foreign investment
will just equal the domestic interest rate
on investments of identical risk
Which means the covered interest
differential the difference between the
domestic interest rate and the hedged
foreign rate- is zero

Covered interest rate parityExample

Investment of $ 10,00,000 for 90 days

New York ( Dollar) Interest Rate : 8%

p.a.

Frankfurt ( Euro) Interest Rate : 6% p.a.

Investment in dollar will yield : $

10,20,000

Covered interest rate parityExample

Suppose, the current spot is Euro 1.13110/$

The 90 day forward is Euro 1.1256/$
If he chooses to invest in euros on a hedged
basis, he will:
1. Covert dollars to euros at spot rate i.e.
10,00,000x1.1311 = Euros 11,31,100
2. Investment of Euros 11,31,100 will yield :
Euros 11,48,066.50
3. Sell forward Euros 11,48,066.50 will yield
$10,20,000

Interest rate parity

Interest rate parity says that high interest
rates on a currency are offset by forward
discounts and that low interest rates are
offset by forward premiums
Interest rate parity is one of the best
documented relationship in international
finance
In fact, in the Eurocurrency markets, the
forward rate is calculated from the interest
rate differential between the two currencies
using the no-arbitrage condition

BOP and Exchange Rate

This theory asserts that the consistent

adverse balance of payment will make the
currency to depreciate in near future and
the consistent surplus in balance of
payment will make the currency
appreciate in near future

Forecasting Exchange Rates

Forecasting future exchange rates is virtually a
necessity for a multinational enterprise, interalia, to develop an international financial
policy
It is particularly useful for an international firm
if it intends to borrow from or invest abroad
It is also useful for framing a hedging policy

Forecatsing Exchange Rate in

Short-term
Three methods are used for the purpose:
1.

Method of Advanced Indicators:

- the ratio of countrys reserves ( gold, foreign

currencies and SDRs) to its imports
- The ratio indicates the number of months (N)
imports, covered by the reserves (R)
N = R/I x12

N= (30/80) x 12 = 4.5 months

As a general rule, if reserves are than 3 moths value

of imports, the currency is vulnerable and may face
devaluation

Forecatsing Exchange Rate in

Short-term
2. Use of Forward Rate as Predictor of Future Spot
Rate:

Some authors believe in the efficiency of

markets and consider that forward rates
are likely to be an unbiased predictor of
the future spot rate
In other words, the rate of premium or
discount should be an unbiased
predictor of the rate of appreciation or
depreciation of a currency

Forecatsing Exchange Rate in

Short-term
3. Graphical Methods:

Rate-time Curve
Bar Chart
Curve of Resistance
Curve of Support

The charts or graphs are prepared to gain insight

into the trend of fluctuations and forecast the
moment when the trend is likely to reverse

Forecatsing Exchange Rate in

Medium and Long-term
1. Economic Approach:

Structure of the balance of payments

Reserves in gold or in foreign exchange
Interest rates
Inflation rates
Employment level

2. Sociological and Political Approach

GOOD LUCK TO YOU