Law of one Price

This states that the domestic

price of domestic and foreign
items shall be equal. If this is
not true then people will buy
only less expensive item out of
foreign or domestic item.
Price of foreign goods in domestic
market are determined by
exchange rate
DPfg = ER X FPfg
Where, DPfg = Domestic price of foreign goods.
FPfg = Foreign price of Foreign Goods
ER = Exchange Rate (Domestic
currency/ foreign currency).

Law of one Price requires  DPdg = FPdg

Where, DPdg = Domestic price of domestic goods
FPdg = Domestic price of foreign goods.

“There is only one success - to spend your life in your own way."
 International parity relationship
[A]. Interest rate parity:
It is relationship between interest rates &
exchange rates of two countries.

Interest Differential = Exchange rate differential

(1+ro) = SF/D
(1+ rf) FF/D

"Happiness is like jam. You can't spread even a little without getting some on
yourself."
[B] Purchasing Power Parity

Exchange rate of two countries currencies equal the

ratio between the prices of goods in these countries.
Further the exchange rate must change to adjust to
changes in prices of goods in the two countries.
Inflation rate = Current spot rate & expected
differential spot rate differential

(1+id) = SF/D
(1+ if) E(SF/D)

It's not what you know, it's what you use that makes a difference.
 [c]. Expectation theory of forward rates:
If market participants are risk-neutral then
forward rate must equal to expected future
spot rate.
Forward Rate & = Expected & current spot
spot rate differential rates differential

FD/F = E(SD/F) OR FD/F = E(SD/F)

SD/F SD/F

“To be a great champion you must believe you are the best. If you’re not, pretend
you are.”
 [D]. International Fisher Effect
 Nominal interest rate = real interest rate + inflation
 Nominal interest = Expected interest rate
differential differential

(1+rD) = E(1+iD)
(1+ rf) E(1+if)

In effect, Fisher effect implies that expected future spot rate

of a currency with a higher interest rate will tend to fall in
value in long run & future (exp.) spot rate of currency with
lower interest rate will tend to rise in long run. Thus :-
(1+rD) = E(SD/F)
(1+ rf) SD/F

"Two men look out the same prison bars; one sees mud and the other stars."
 Foreign Currency rates

Direct Indirect

A). Spot Exchange Rate

- BID-ASK spread
Percentage spread = Ask Price – Bid Price
ASK Price
e.g.
Currency Buying Selling
Australian 25.75 26.00
$

"The optimist sees opportunity in every danger; the pessimist sees danger in every
opportunity."
B). Cross rates
A cross rate is an exchange rate between the currencies of
two countries that are not quoted against each other, but
are quoted against common currencies.
e.g. US$ 0.02339/ Baht
US$ 0.02583/ INR
C). Forward Exchange Rates:-
- Forward Premium/ Discount  It refers
as annualized % Deviation from spot rate.

Forward premium = Spot rate – Forward rate X 360

Forward rate Days
Forward Discount = Forward rate – Spot rate X 360
Spot Rate Days
Currency Arbitrage
 The foreign Exchange Market

Customer Buys $
with DM
Stock Broker

Local Bank

Foreign Major Banks IMM

Exchange Inter bank LIFFE
Broker Market PSE

Participants:
Local Bank
1.Arbitrageurs
Stock Broker
2. Traders
3. Hedgers Customer
4. Speculators Buys DM with
$
 Exchange rate forecasting
1). Trend Analysis
ER( T+1) = A +B X ER(T)
2). Moving Standard deviation.
3). Using Purchasing Power Parity
4). Forward Exchange Rate as a
forecast of Future Spot Exchange
Rates

"Circumstances do not make a man, they reveal him."