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EXCHANGE

RATE

THEORIES


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Exchange Rate TheoriesThe 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


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Theory of

Purchasing Power Parity(PPP)

Theory ofInterest Rate Parity

Exchange Rate Theories


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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 $ 1with that of Rs. 50 and not with Rs. 1

( assuming the exchange rate is $ 1 = Rs. 50)


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Theory of Purchasing Power Parity(PPP) Developed by Gustav Cassel ( Swedish

economist 1918) , the theory states that inideally efficient markets, identical goods shouldhave 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 indifferent markets

However, if it doesnt happen, then we say thatpurchase parity does not exist between the twocurrencies
http://en.wikipedia.org/wiki/Law_of_one_pricehttp://en.wikipedia.org/wiki/Law_of_one_price


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In the United

States

$ 40

In IndiaRs. 750

Suppose $ 1 = Rs. 50 today

$ 15


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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 USwould decrease and hence its prices would

tend to decrease3. The increase in demand for cricket bats in

India would make them more expensive


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In the United States$ 40

$ 30

In IndiaRs. 750

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


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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 pricesbetween countries and change exchange ratesin doing so

Moreover, in the long run, having differentprices in the US and India is not sustainablebecause an individual or a company will be ableto gain an arbitrage profit


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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 fromdeciding on the currency denomination of long-term debt issues to determining in whichcountries to build plants


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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 toreflect changes in the price levels of the twocountries

Suppose, inflation is 5 % in the United Statesand 1 % in Japan, then the dollar value of theJapanese Yen must rise by about 4 % toequalise the dollar price of goods in the two

countries


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Theory of Purchasing Power Parity(PPP)

fi

tf

tht

i

i

e

e

)1(

)1(

0

te

If

0e

hi

t

Is the rate of inflation for the home country

Is the rate of inflation for the foreign country

Is the home currency value of one unit of foreignCurrency at the beginning of the period

Is the spot exchange rate in period

Then

t

f

t

ht

i

iee

)1(

)1(0

i. e.


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Theory of Purchasing Power Parity(PPP)t

e appearing in the equation is known as the purchasingpower parity. For example, if the United States andSwitzerland are running annual inflation rates of 5% and

3% respectively and the spot rate is SFr 1 = $ 0.75, thenthe PPP rate for the Swiss franc in three years should be:

7945.0$)03.1(

)05.1(75.0

3

3

3e

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


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PPP of GDP for the countries of the world as of 2003. The economy ofthe 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 State


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Interest Rate Parity Theory

This theory states that premium or discount of

one currency against another should reflect theinterest differential between the two currencies

The currency of the country with a lower interest

should be at a forward premium in terms of thecurrency of the country with a higher rate


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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 issaid to be at interest rate parity and equilibrium

prevails in the money markets


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Interest Rate Parity TheoryThus, the forward discount or premium is closely

related to interest differential between the two

currencies

Looked at differently, interest rate parity saysthat the spot price and the forward, or futures

price, of a currency incorporate any interest ratedifferentials between the two currenciesassuming there are no transaction costs or taxes


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Covered interest rate parity Interest parity ensures that the return on a

hedged ( or covered) foreign investment will

just equal the domestic interest rate oninvestments of identical risk

Which means the covered interest differentialthe difference between the domestic interestrate and the hedged foreign rate- is zero


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Covered interest rate parity-Example 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


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Covered interest rate parity-Example 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


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Interest rate parity Interest rate parity says that high interest rates

on a currency are offset by forward discounts andthat 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 forwardrate is calculated from the interest rate differentialbetween the two currencies using the no-arbitrage condition


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BOP and Exchange Rate

This theory asserts that the consistent adverse

balance of payment will make the currency todepreciate in near future and the consistentsurplus in balance of payment will make thecurrency appreciate in near future


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Forecasting Exchange Rates Forecasting future exchange rates is virtually a

necessity for a multinational enterprise, inter-alia,

to develop an international financial policy

It is particularly useful for an international firm ifit intends to borrow from or invest abroad

It is also useful for framing a hedging policy


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Forecatsing Exchange Rate inShort-termThree 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


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Forecatsing Exchange Rate inShort-term2. Use of Forward Rate as Predictor of Future Spot Rate:

Some authors believe in the efficiency ofmarkets and consider that forward rates arelikely to be an unbiased predictor of thefuture spot rate

In other words, the rate of premium ordiscount should be an unbiased predictor ofthe rate of appreciation or depreciation of acurrency


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Forecatsing Exchange Rate inShort-term3. 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


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Forecatsing Exchange Rate inMedium and Long-term1. 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


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