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)
• Developed by Gustav Cassel ( Swedish 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 doesn’t happen, then we say that
purchase parity does not exist between the two
currencies
In the United In India
States Rs. 750
$ 40

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 In India
$ 40 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 purchasing

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 equalize 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 foreign
Currency at the beginning of the period
et Is the spot exchange rate in period t
Then
t
et (1  ih ) t (1  ih )
 i. e. et  e0  t
e0 (1  i f ) t (1  i f )
 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 years should be:
3
(1.05)
e3  0.75  3
 $0.7945
(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
 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
 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.