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 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 $ 30

In India Rs. 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

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 longterm 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
e0
et

Is the rate of inflation for the home country

i f Is the rate of inflation for the foreign country

Is the home currency value of one unit of foreign Currency at the beginning of the period Is the spot exchange rate in period t
t

Then

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

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 noarbitrage condition