Exchange Rate Theories: Dr. Amit Sinha

Exchange Rate Theories
Dr. Amit Sinha

dramitksinha@gmail.com
It would be too ridiculous to go about seriously
to prove that wealth does not consist in money
or in gold in silver; but in what money
purchases, and is valuable only for purchasing.
Adam Smith
Exchange Rate
 Is the price of foreign currency.

 INR/USD is usually stated as Indian rupees per
dollar.
 An increase in exchange rate implies depreciation
in currency and vice versa.
Factors affecting Spot Exchange Rate
1. Balance of Payments
2. Inflation
3. Interest rates
4. Money Supply
5. National Income
6. Resource Discoveries
7. Capital Movements
8. Political Factor
9. Psychological Factors and Speculation
10.Technical and Market Factors
 Balance of Payments: When the balance of payments of a
country is continuously at deficit, it implies that the demand
for the currency of the country is lesser than its supply.
Therefore, its value in the market declines. If the balance of
payments is surplus continuously, it shows that the demand
for the currency in the exchange market is higher than its
supply and, therefore, the currency gains in value.
 Inflation: With increase in inflation exchange rate of the
country falls. However it may be noted that that it is relative
rate of inflation in the two countries that causes change in
exchange rate.
 Interest rates: Increase in interest rates strengthens the
currency of the country. Increase in interest rate will vary
the exchange rate only when it is unilateral, unaccompanied
by similar changes in other countries.
 Money Supply: An increase in money supply will affect the
exchange rate through causing inflation in the country. Thus
increase in the supply will pull down its exchange rate.
 National Income: An increase in national income reflects
increase in the income of the residents of the country. This
increase in income increases the demand for goods in the
country. The result is similar to that of inflation, viz. decline
in the value of the currency.
 Resource Discoveries: When a country is able to discover
key resources (like oil), its currency gains in value.
 Capital Movements: Any increase in capital movement due
to relative higher interest rates of the country or due to
large scale external borrowings has favorable effect on the
exchange rate of the currency of the country.
 Political Factor: Political stability induces confidence in
the investors and encourages capital inflow into the
country. This has the effect of strengthening the
currency of the country.
 Psychological Factors and Speculation: In short run,
the exchange rate is affected by the views of the
participants in the market about the likely changes in
the exchange rate.
 Technical and Market Factors: Isolated large
transactions in the market may upset the market’s
ability to balance the supply of and demand for the
currency. The immediate effect will be wide distortion
in the exchange rate.
Theory of Purchasing Power Parity
 This theory was enunciated by Gustav Cassel, a
Swedish economist.
 This theory is for spot rates.
 Purchasing power of a currency is determined by
the amount of goods and services that can be
purchased with one unit of that currency.
 If there is more than one currency, it is fair and
equitable that exchange rate between these
currencies provides the same purchasing power
for each currency. This is referred to as
purchasing power parity and is also known as
Law of One Price. (The connection between
exchange rate and commodity price).
 It is ideal if the existing exchange rate is in tune
with this cardinal principle of purchasing power
parity.
 If the existing rate is such that purchasing
power parity does not exist in economic terms,
it is a situation of disequilibrium and it is
expected that the exchange rate between the
two currencies conforms eventually to
purchasing power parity.
 If the rate of inflation is different in two
countries, the floating exchange rate should
accordingly vary to reflect that difference.
 Example: Let us consider two countries A & B. The rate of
inflation in the country A is higher than that in the
Country B. As a result, imports of the country A increases
since the prices of foreign goods tend to be lower.
Similarly, exports from country A decrease since the
prices of its goods appear to be higher to foreigners
(residents of country B included). In consequence, the
currency of the country A will depreciate with respect to
that of the country B.
Rate of Infl. in the Imports of the Trade Balance

Currency of the
Country A is Country A inc. Of the Country
Country A tends
higher Than that While its exports A tends to be in
To depreciate
in the Country B decrease deficit
 This theory holds that the exchange rate
between two currencies is determined by the
relative purchasing power as reflected in the
price levels expressed in domestic currencies in
the two countries concerned.
 Changes in exchange rates are explained by
changes in the purchasing power of the
currencies caused by inflation in the respective
countries.
 The PPP theory is stated in twp versions:
1. The stronger absolute version
2. The diluted relative version
Absolute Version of PPP
 This theory is based on ‘law of one price’
 This law states that under conditions of free
market with the absence of transportation
costs, tariffs and other frictions to free trade,
the price for identical goods should be the
same at any market when measured in terms
of a common currency.
 While the law of one price relates to single
product, PPP theory does not confine to a
single product. Instead of a single commodity,
we ,may consider a basket comprising a
variety of products.
Absolute Version of PPP
 The absolute version of PPP can be
symbolically stated as:
e=Pd/Pf
where Pd= Price in domestic currency
Pf = Price in foreign currency
 If the price in the domestic market rises
relative to the price level in foreign market, the
domestic currency will depreciate
proportionately against the foreign currency.
Criticism of Absolute Version of PPP
 The absolute version of PPP is based on unrealistic
assumptions of free trade, no transportation costs
and identical commodities.
 Transportation cost is a big hurdle in benefiting
from lower price in another market.
 Movement of goods and services are not free.
 The commodities in any basket are not identical
and they may differ in quality.
 There are certain goods which do not enter
international trade e.g. of non traded goods are
housing and personal services like health and hair
cut.
Relative Version of PPP
 As per the relative version of PPP, the change in exchange rate
should be proportionate to the change in the relative
purchasing power of the currencies concerned. Therefore,
New exchange rate = Proportionate change in domestic price
Old exchange rate Proportionate change in foreign price
 Symbolically, this can be stated as:
et = (1+Id) et = e(1+Id)
e (1+If) (1+If)
where et = expected exchange rate after period t
Id = rate of domestic inflation during period t.
If = rate of foreign inflation during period t
 In practice, price indices are used to compute PPP.
Nominal Exchange Rate and Real Exchange
Rate
 A change in the nominal exchange rate does
not alter the export competitiveness of the
countries, so long as the movement is in
accordance with the inflation differential and
the PPP is not changed.
 Real exchange rate is the nominal exchange
rate as adjusted for inflation.
 If the inflation adjusted exchange rate is same
as the base period exchange rate, then there is
no change in the real exchange rate during the
period.
Rate
 If the inflation adjusted exchange rate is higher
than the base period, then there is a
depreciation of the home currency in real
terms.
 If the inflation adjusted exchange rate is lower
than the base period exchange rate, the home
currency has appreciated in real terms against
the foreign currency.
 The real exchange rate formula is:
ert=et (1+Id)
(1+If)
 Say at reference point (period 1), the price index in the country A
is P1A while that in country B is P1B and the exchange rate is
S1,A/B, the relation between price indices and exchange rate is
expressed as:
P1A= S1,A/B*P1B
Now at period 2,
P2A= P1A(1+rA)
P2B= P1B(1+rB) where rA and rB are the rates of inflation
Thus, at period 2, the exchange rate will be given as:
P2A= S2,A/B*P2B
P1A (1+ rA)=S2,A/B *P1B(1+rB)
P1A /P1B =S2,A/B*(1+ rA)/ (1+rB)
S2,A/B= S1,A/B [(1+ rA)/ (1+rB)]
Thus if the rate of inflation is lower in the country A, the
exchange rate of period 2, will reflect appreciation of the currency
of country A with respect to that of the country B.
 Ex 1: At period 1, a hypothetical consumer spends DM
100 to buy a certain quantity of goods and services.
Alternatively the same quantity can be bought for FFr
300. So the party holds such that
DM 100 = S1,DM/FFr * FFr 300
S1,DM/FFr = DM 100/FFr 300 =DM 0.33/FFr
Let us say, to buy the same quantity of goods and
services at the period 2, we spend either DM 110 or FFr
360. So the resultant relationship is :
DM 110 = S2,DM/FFr* FFr 360
S2,DM/FFr=DM 110/ FFr 360= DM 0.3055/FFr
We see that Deutschmark has appreciated with respect to
French Franc.
Why?
 The answer lies in the rate of inflation.
In Germany, rDM= (110-100)/100 = 0.10 =10%
In France, rFFr =(360-300)/300 =0.2 =20%
Therefore, S2,DM/FFr = 1/3* [(1+ rDM)/(1+ rFFr)]
= DM 0.3055/ FFr
 Ex 2: The US inflation rate is expected to average about
4% annually, while the Indian rate of inflation is expected
to average about 12% annually. If the current spot rate of
the rupee is USD 0.0285, what is the expected spot rate
in two years?
Sol. According to PPP theory, the expected spot rate for
the rupee in one year would be:
USD 0.0285*1.04/1.12
Similarly, the spot rate for the rupee in two years is going
to be
USD 0.0285*1.04/1.12*1.04/1.12= USD 0.0245
 Ex 3: Two countries A & B produce only one
commodity, say rice. Suppose the price of rice in
the country A is CA 2.5 and in the country B, CB
3.5
a) According to the PPP, what should CA:CB spot
exchange rate be?
b) Suppose the price of rice over next year is expected to
rise to CA 3 and CB 4 in the countries A & B
respectively. What should be the one year CA:CB spot
exchange rate be?
 Sol:
a) According to PPP, the spot exchange rate is:
CA 2.5 = CB 3.5
CA 1 =CB 3.5/2.5
CA 1= CB 1.4
b) Again in one year time, according to the PPP
CA 3 = CB 4
CA 1 = CB 4/3 = CB 1.33
The currency of country A has depreciated over
the year.
 Ex 4: Suppose over a period of two years, the
US price index moves from 110 to 125 and the
Japanese Yen index moves from 105 to 110. The
spot exchange rate is USD 1= JPY 112. What
should be the exchange rate in 2 years?
 Sol:
The rate of inflation of USA is found by using the
equation:
(1+r1)2 =125/110, r1=(125/110)1/2-1= 0.066
Similarly the rate of inflation in Japan is found
r2 = (110/105)1/2- 1=0.0235
The exchange rates in two years will be
S2=S1*(1+r2/1+r1)2
= 112* (110/105*110/125)
1 USD = JPY 103.25
Rate- Example
 Ex 6: On 2nd January 2006, the exchange rates for dollar and
sterling against rupee were as follows:
USD 1= INR 45
GBP 1= INR 85
During the year, the inflation rates in the countries were:
India 7%
USA 4%
UK 3%
On 2nd January 2007, the exchange rates in the market were as
under:
USD 1 = INR 46.70
GBP 1 = INR 87.50
1. What should be the exchange rate on 2 nd January, 2007 if PPP
prevailed?
2. What were the real exchange rates on 2 nd January 2007 for
each currency?
3. Comment on the real exchange rates.
Rate- Example
 Expected exchange rate on 1st January 2007
If the PPP prevailed, the exchange rate for USD and
GBP should have been as follows:
USD 1 = 45 (1.07) = Rs.46.30
(1.04)
GBP 1 = 85 (1.07) = Rs.88.30
(1.03)
 Real Exchange rate for dollar and GBP is
USD 1 = 46.70 (0.93) = Rs.45.24
(0.96)
GBP 1 = 87.50 (0.93) = Rs.84.77
(0.96)
Criticism of Purchasing Power Parity Theory
 There are number of factors which restrict this theory from
determining exchange rates. Some of the factors are:
1. Government intervention, directly in the exchange markets or
indirectly through trade restrictions.
2. Speculation in the exchange market.
3. Structural changes in the economies of the countries.
4. Continuation of long term flows inspite of the disequilibrium
between purchasing power parity and exchange rate.
5. Price Indices: Different price indices ( like WPI & CPI and for
different countries the composition and weights are different.
Question pertaining to what constitutes an appropriate sample
and weight assigned to each commodity are not satisfactorily
answered. For example, should sample represent all goods
and services or only those that are traded internationally?)
6. Inclusion of Non Traded goods in calculating price
indices.
7. Stickiness of Goods Price due to administered prices
of goods and which do not change with the inflation
in the economy.
8. Liberalization of Markets has resulted in cross border
movement of cash for capital transactions and have
led to speculative activities.
9. Price discrimination by MNCs through market
segmentation leading to same product being priced
differently in different markets.
10) The theory takes into account only movement of

goods and not that of capital. In operational
terms, it is concerned only with the current
account segment of the BoP and not the total BoP.
11) This theory ignores the fact that a currency may
be an instrument of payment by other countries
(e.g. USD). In this situation, the exchange rate
may evolve in a manner that has nothing to do
with the price levels of the country (i.e. USA)
 Empirically it is found that PPP holds only in a very

long period. During short term and over the medium
term, the exchange rate in the market differs
significantly from the PPP due to reasons stated
above.
 The PPP theory can be considered ideal theory to
determine exchange rates in specific situations, such
as high inflation or monetary disturbances. In such
situation, the response of individuals to changes in
value of real and monetary assets can be expected
to be strong and the exchange rate prediction by PPP
theory may turn out to be realistic.
Exchange Rate Index
 An index of exchange rate provides/ indicates the
mean rate of the country’s currency with respect to the
currencies of trade partners weighted in terms of trade
flows.
 The index for a country is obtained by finding the
weighted average of bilateral exchange rates of the
country and its major trade partners.
 It indicates the extent by which purchasing power of a
currency has changed over the period/in the current
year with respect to the base year.
 If the exchange rate variations compensated exactly
the differential of inflation rates, the index would
remain unchanged at 100.
Exchange Rate Index
 If an exchange rate becomes stronger than what

is justified by the rate of inflation (i.e. the index
becomes higher than 100), the exchange rate is
considered overvalued from the point of
competitiveness.
 If the index is less than 100, it is regarded
undervalued from the point of competitiveness.
Exchange Rate Pass Through
 The degree to which the prices of imported and

exported goods change as a result of exchange rate
changes is termed pass through
Ex: To illustrate the exchange rate pass through,
assume BMW produces automobile in Germany and all
production expenses are in euros. When the firm
exports the automobiles to US, the price of the BMW in
the US market should simply be the Euro value
converted to dollars at the spot exchange rate. Thus if
the price in dollars increase by the same percentage
change as the exchange rate, the pass through of
exchange rate changes is complete (or 100%)
Exchange Rate Pass Through
 If the price in dollars rises by less than the percentage

change in exchange rates, the pass through is partial.
 The 71% pass through (US dollar prices rose only by
14.29% when the Euro appreciated 20%) implies that
BMW is absorbing a portion of the adverse exchange
rate. This absorption could result from smaller profit
margins, cost reductions or both.
 The concept of price elasticity of demand is useful when
determining the desired level of pass through. If the
product is relatively price inelastic, meaning that the
quantity demanded is relatively unresponsive to price
change, may often demonstrate a high degree of pass
through.
Theory of Interest Rate Parity
 The theory states that premium or discount of

one currency against another should reflect the
interest rate differential between the two
currencies.
 In a perfect market situation and when there is
no restriction on the flow of money, one should
be able to gain the same value on one’s
monetary assets irrespective of the country they
are held.
 Say an investor has a sum of DM 1 today. The exchange
rate say $ C0/ DM i.e. he can convert his DM to get $ C0 if
he so desires. Further say, the net interest per dollar is t$
while per DM it is tDM. The investor has two choices before
him:
1. He places his money in DM to receive 1*(1+tDM) after a
period T.
2. He converts his money in US dollars and places it in
dollars market to receive C0(1+t$) at the end of period T.
 In order that he be indifferent in placing his money either
in DM or in US dollars, the two sums, at the end of the
period T, should be equal
C0(1+t$) USD = 1*(1+tDM) DM
DM 1 = USD C0[(1+t$)/(1+tDM)]
The rate of exchange after the period T is USD C T/DM
Therefore CT= C0[(1+tD)/(1+tE)]
The above equation can be rearranged as
CT-C0/C0=tD-tE/1+tE
Where CT= forward rate
C0=spot rate
tD=domestic rate of interest
tE= interest rate in foreign country
If tE is considered very small compared to 1, then C T-
C0/C0=tD-tE
Thus premium or discount should be almost equal to
difference between the rates of interest of two currencies.
Ex 1 : If the current exchange rate between US dollars
and French Franc is FFR 5.0150/USD and the interest for
the period of one year are 7% (USD) and 8.5% (FFr)
respectively, determine the expected exchange rate after
one year.
Sol: Here C0= FFr 5.0150/USD
T=1 year
CT= C0[(1+tD)/(1+tE)]
= 5.0150[(1+0.085)/(1+0.07)]
= 5.0853
The expected exchange rate is given by FFr 5.0853/USD.
French Franc is expected to depreciate vis-à-vis dollar. The
premium on dollar (or discount on French Franc should be
equal to the interest rate differential).
Ex 2 : If USD/ JPY spot rate is USD 1=JPY 110

and the interest rates in Tokyo and New York
are 3 & 4.5% respectively, what is the expected
dollar yen exchange rate one year hence?
Sol: According to IRP,
CT= C0[(1+tD)/(1+tE)]
= 110[(1+0.03)/(1+0.045)]
= 108.42 or
USD 1 = JPY 108.42
As US interest rates are relatively higher, dollar
has undergone depreciation with respect to Yen.
The Fisher Effect
 The Fischer Effect, first theorized by economist

Irving Fisher which states that nominal interest
of each country are equal to the required real
rate of return plus compensation for expected
inflation.
International Fisher Effect
 The relationship between forward rate and spot
rate is explained by the International Fisher Effect.
 According to this concept, the forward rate and
spot rate tend to move together through the
linkage between the fundamental factors affecting
spot and forward rates.
 Spot rate is affected by the relative inflation in the
countries concerned. The currency of the country
with a lower rate of inflation will appreciate in
relation to the currency with higher rate of inflation.
The level of appreciation will approximately equal
the differential in the inflation rate between the two
countries. This argument forms the core of the
Purchasing Power Parity (PPP) theory of exchange
rates.
 The forward rates are influenced by the relative rates of
interest in the two countries concerned. The currency of
the country with lower rate of interest will be quoted in
the forward market at a premium. The size of the
premium will be approximately equivalent to the interest
rate differential between the two countries. This is
known as Fisher Effect.
 Interest Rates in the money market are linked to the
inflation rate in the economy. The interest rate should at
least cover the inflation so that the purchasing power of
the people who postpone their present consumption is
not adversely impacted. In addition, there should be an
incentive to induce them to save.
 Thus in economic terms, the nominal rate of interest
should be higher than the inflation rate so that there is
positive real interest rate in the economy.
 It is observed interest differential and inflation
differential between two countries go together.
 The currency having tendency to appreciate in the
spot market will be seen to quoted at a premium in
the forward market.
 If the inflation differential between the countries
increases, the rate of appreciation of the currency
of the country with lower inflation will also increase.
 The increase in inflation differential will widen the
interest differential. The forward premium of the
currency with lower interest rate will accordingly
increase. This linkage between spot rate and the
forward rate is known as the International Fisher
Effect.
Forward Rates and Interest Rate Arbitrage
 When the forward margin in the market does not
fully reflect the interest differential, it may lead to
arbitrage opportunities.
 By borrowing in one currency and investing in
another currency, with simultaneous forward cover,
a deal can indulge in covered interest rate
arbitrage.
 The opportunity of arbitraging can be identified by
annualizing the forward margin and comparing with
the interest differential.
 The formula for annualizing the forward margin is:
Forward margin * 360 . * 100
Spot rate Forward period in days
Forward Rates and Interest Rate Arbitrage-Ex.
Ex1 : Euro is quoted in the Chennai market at spot
Rs.58.05 and 6 mths forward Rs.58.40. Interest
rate at Chennai is 6% p.a. and 5%p.a. at Frankfurt.
Find out if any arbitrage opportunity is available. If
possible, what will be the arbitrage profit if the
transaction is carried out for Rs.1 crore.
Solution: The forward margin is Re 0.35 premium.
The annualized forward premium is
(0.35/58.05)*(360/180)*100 = 1.21%
The forward premium is 1.21% whereas the
interest differential in the money market is only
1%. Therefore Euro is costlier in the forward
market. The arbitrage profit can be made by selling
the Euro in forward market.
 The strategy of the arbitrager will be to buy
euro spot and sell it forward for six months.
The operations involved are:
1. Borrow Rs. 1crore for six months at 6% pa
2. Acquire euros against 1 crore at spot rate of
Rs. 58.05 ( Euro 1,72,265.29)
3. Invest the Euros for six months at 5%.
4. Sell forward Euros (principal plus interest) at
Rs.58.40
5. On due date realise the deposit and repay the
rupee loan.
 The cash flows can be depicted as :
Borrowing Investment
Principal Rs.100,00,000 Principal Euro 172265.29
Interest@ 6% Rs.3,00,000 Interest@5%Euro 167.96
Amount rep. Rs.1,03,00,000 Amt rec. Euro 177433.25
Rupee realization of Euro 177433.25 @Rs.58.40 Rs.10362102
Repayment of rupee borrowing Rs.10300000
Arbitrage profit 62102
Ex 2:The following quotes are current in the Singapore
market:
Spot USD1= SGD2.1500/60
6 mths 120/100
Interest rate at Singapore 4.5%/4.7%
Interest rate at New York 5.8%/6.00%
Explain the possibility of arbitrage under the given case.
If possible, what profit will the arbitrageur make in US
dollars, if he undertakes transaction for USD 1 million.
 Solution: The exchange rates are
Buying Selling
Spot SGD 2.1500 SGD2.1560
6 mths SGD 2.1380 SGD2.1460
Two set of transactions are possible. First is to borrow in
Singapore and invest in New York. The second is to borrow in
New York and invest in Singapore.
 Option 1: Borrow in Singapore and invest in New York.
In money market the arbitrageur can borrow at 4.7% in Singapore
and invest in New York at 5.8% and thus gain 1.1% p.a.
For making investment in US dollars borrowed SGD will have to be
converted at spot rate of 2.1560 and selling it forward at rate of
2.1380. The loss per dollar of on swap is 0.0180. On annualized
basis the loss is
0.0180/2.1560*360/180*100=1.67%
The loss in the foreign exchange market is greater than the profit in
money market. Hence there is no arbitrage opportunity.
 Option 2: Borrow in New York and invest in
Singapore
The arbitrageur can borrow in New York at 6% and
invest in Singapore at 4.5%. The loss in money
market is 1.5%.
In foreign exchange market he will sell US dollar spot
at the market buying rate of 2.1500 and buy
forward at the market selling rate at 2.1460. The
gain in foreign exchange market is SGD 0.0040.
On annualized basis the gain is
0.0040/2.1500*360/180*100=0.37%
The gain in foreign exchange market is lower than
the loss in the money market and hence there is
no possibility of arbitrage.
Ex 3: The following quotes are current in the Hong Kong
market:
Spot USD1= NZD 1.5045/5095
3 mths 140/170
USD Interest rate 4.2%/4.4%
NZD Interest rate 5.2%/5.8%
Explain the possibility of arbitrage under the given case.
If possible, what profit will the arbitrageur make in US
dollars, if he undertakes transaction for USD 1 million.
 Solution: The exchange rates are
Buying Selling
Spot NZD1.5045 NZD1.5095
3 mths NZD1.5185 NZD1.5265
 Option 1: Borrow in NZD and invest in USD
In money market the arbitrageur can borrow in NZD at 5.8% and
invest in USD at 4.2%. The loss in money market is 1.6% per
annum.
In foreign exchange market, he will buy USD dollar at spot at the
market selling price of NZD1.5095 and sell USD forward at the
NZD 1.5185. The gain is 0.0090. The annualized gain is
(0.0090/1.5095)*360/90*100=2.39%. Since the gain in the
foreign exchange market is more than the loss in money
market arbitrage opportunity exists.
 Strategy:
Borrowing
Principal USD 1 million converted at NZD 1.5095 =NZD 1509500
Interest at 5.2% for 3 mths = NZD 19624
Amount payable at maturity = NZD 1529124
Investment
Principal =USD 1000000
Interest at 4.2% for 3 mths =USD 10500
Amount receivable on maturity = UD 1010500
Arbitrage Gain
USD received from investment =USD 1010500
USD required to repay borrowing at NZD 1.5185=USD 1006996
Arbitrage profit USD 3504
 Option 2: Borrowing in USD and investing in NZD
The arbitrageur can borrow in USD at 4.4% and
invest in NZD at 5.2%. The gain in money
market is 0.8%
In foreign exchange market he will sell USD spot at
the market buying rate of 1.5045 and buy
forward at the market forward selling rate of
1.5265. The loss in price is of Re. 0.0220. On an
annualized basis the loss is
0.0220/1.5045*360/90*100= 5.76%
The gain in money market is less than the loss in
foreign exchange market therefore no arbitrage
opportunity exists.
Criticism of the theory of Interest Rate Parity
 This theory is very useful reference for explaining the
differential between the spot and future exchange
rate and international movement of capital.
 The drawbacks of this theory are:
1. Availability of funds that can be used for arbitrage is
not infinite. Further, the importance of capital
movements, when they are available depends on the
credit conditions practiced between the financial
places and on the freedom of action of different
operators as per the rules of the country in vogue.
2. Exchange controls place obstacles in the way of
theory of interest rate parity. The same is true about
the indirect restrictions that can be placed on capital
movements in short run.
Criticism of the theory of Interest Rate Parity
3. According to this theory, interest rate is only

one factor affecting the attitude and behavior
of arbitrageurs. However capital movement do
not depend only on the interest rates. Other
important factors are concerned with liquidity
and ease of placement.
4. Speculation is an equally important element.
This becomes very significant during the crisis
of confidence in the future of a currency. The
crisis manifests in terms of abnormally high
premium or discount- much higher than what
IRP can explain.
Relation Between Nominal Interest Rates, Rates of
Inflation and Future Spot Exchange Rate
 Variations of future spot rates should reflect:
i. Difference of nominal interest rates
ii. Difference of anticipated inflation
 Nominal interest rate difference, tE-tD, should be equal
to premium or discount.
 If markets are efficient, the forward rate is an unbiased
predictor of the future spot exchange rate.
Ex: If the nominal interest rate on USD is 4% less than
that on INR, this difference of 4% can be explained by
the fact that an anticipated inflation rate is
apprehended to be 4% higher in India than that in the
USA. Consequently this difference is expected to be
reflected in the future spot rate leading to depreciation
of INR by 4%.
Balance of Payments (BoP) and Exchange
Rate
 A deficit or surplus in BoP may also explain

the level of exchange rates as disequilibrium
indicates the level of demand and supply of
foreign currencies.
 Deficit increases the demand of foreign
exchange. This reduces, all other things being
the same, the value of national currency; on
contrary, surplus increases the value of
national currency on the exchange market.
Methods of Forecasting Exchange Rates
Forecasting the Exchange Rate in Short Term
 The theories explaining exchange rate
variations are not satisfactory to forecast how
the rates are going to evolve. Under
circumstances recourse is taken to less than
perfect methods. The following three methods
are generally employed for the purpose:
1. Method of advanced indicators
2. Use of forward rate as a predictor of the
future spot rate.
3. Graphical method
Method of Advanced Indicators:
 Several indicators are used for prediction of exchange rates.
 One important indicator widely used is to determine the
ratio of country’s reserve to its imports. The reserves
consists of gold, foreign currencies and SDRs. The ratio
indicates the number of months (N) imports, covered by the
reserves (R).
N=R/I*12
Ex: Let us assume that annual imports of India cost of
Rs.30 billion, the number of months of imports covered by
reserves are:
N=30/80*12=4.5 months
 The general rule that seems to be followed in this regard is
that if amount of reserves is less than the value of 3
months imports, the currency is vulnerable and may face
devaluation.
Use of Forward Rate as Predictor of Future
Spot Rate:
 In efficient markets, the rate of premium or
discount should be an unbiased predictor of
the rate of appreciation or depreciation of
currency.
Graphical Methods
 The objective of making charts or graphs is to
gain insight into the trend of fluctuations and
forecast the moment when the trend is likely
to reverse.
 Technical analysts consider that the behavior
of operator remains stable over a period. They
identify certain configurations then forecast
rates.
 One type of graph is in the form of curve.
Everyday, the closing rate is marked on a
vertical scale while horizontal scale is for time.
Different points are linked to prepare a curve.
Graphical Methods
 Another type of graph can be in the form of bars.
Every day or every week or every month, high and
low rates are indicated while closing rates are
indicated by a small horizontal bar on the vertical
line joining high and low.
 Joining the points of high also called resistance
points a curve of resistance is obtained. On the other
hand, by joining low points, a curve of support is
obtained.
 The two curves joining high and low points form
tunnel.
 If rates become significantly distant from these
curves, that indicates a change in the market
behavior.
Forecasting the Exchange Rate in Medium
Term & Long Term
 There are two important methods used to
forecast medium and long term exchange
rates:
1. Economic Approach
2. Sociological and Political Approach
Economic Approach
 This approach takes into consideration fundamental
factors , reflecting strengths and weaknesses of the
economy in the long run. A selective list of decisive
factors used under this approach is as follows:
a) Structure of the BoP: If country imports more than it
exports during a long period, the probability of
depreciation of its currency becomes high.
b) Examination of reserves in gold or in foreign exchange:
A deficit in BoP results into decrease of reserves. A
significant reduction in reserves of a country increases
the probability of depreciation of its currency.
c) Comparative examination of interest rates :Relatively
speaking, the higher interest rates (in comparison to
other countries) is indicative of likely depreciation of
the currency. If higher rates persist for a long period,
the devaluation is virtually imminent.
d) Comparative study of inflation rates: A higher inflation
rate than those of major competing countries increase
the risk of depreciation of the currency.
e) Study of a activity and employment level: Higher level
of economic activity and full employment are likely to
have positive bearing on exchange rates.
Sociological & Political Approach
 The analysis based on sociological & political
approach is important to supplement the
economic analysis.
 It has been observed that the attitude of
government with respect to the value of its
currency depends on several factors. The
important factors included in this category are
the proximate of elections, behavior of
opposition parties, recommendations of the
IMF etc.
Sociological & Political Approach
 Government, confronted with the risk of depreciation
of its currency may initiate any one or more of the
following remedial measures to overcome the
problem:
1. Rigorous control of foreign exchange
2. Interest rate hike
3. Deflationary policy
 However the negative effects of one or several of
these steps should be weighed by the government
before implementing them.

Exchange Rate Theories: Dr. Amit Sinha

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Exchange Rate Theories: Dr. Amit Sinha

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Exchange Rate Theories

Dr. Amit Sinha

 Is the price of foreign currency.

Rate of Infl. in the Imports of the Trade Balance

10) The theory takes into account only movement of

 Empirically it is found that PPP holds only in a very

 If an exchange rate becomes stronger than what

 The degree to which the prices of imported and

 If the price in dollars rises by less than the percentage

 The theory states that premium or discount of

Ex 2 : If USD/ JPY spot rate is USD 1=JPY 110

 The Fischer Effect, first theorized by economist

3. According to this theory, interest rate is only

 A deficit or surplus in BoP may also explain

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