Exchange Rate Theories

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
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)
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

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
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
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
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

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

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:
(1.05 ) e3 0.75 $ 0 . 7945 3 (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
PPP of GDP for the countries of the world as of 2003. The economy of the 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
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

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

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
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
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 if it intends to borrow from or invest abroad It is also useful for framing a hedging policy
Forecatsing Exchange Rate in Short-term

Three 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

2. Use of Forward Rate as Predictor of Future Spot Rate:
Some authors believe in the efficiency of markets and consider that forward rates are likely to be an unbiased predictor of the future spot rate In other words, the rate of premium or discount should be an unbiased predictor of the rate of appreciation or depreciation of a currency

3. Graphical Methods:
Rate-time Bar
Curve
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
Forecatsing Exchange Rate in Medium and Long-term

1. Economic Approach:

2.
Structure of the balance of payments Reserves in gold or in foreign exchange Interest rates Inflation rates Employment level
Sociological and Political Approach
GOOD LUCK TO YOU

Exchange Rate Theories

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EXCHANGE RATE THEORIES

Exchange Rate Theories

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

taking into account their exchange rate simply

Theory of Purchasing Power Parity (PPP)

Developed by Gustav Cassel ( Swedish

In the United States $ 40

In India Rs. 750

Suppose $ 1 = Rs. 50 today

Theory of Purchasing Power Parity (PPP)

In the United States $ 40 $ 30

In India Rs. 750 Rs. 1200

The rate $ 1 = Rs. 50 changes to Rs. 40

Theory of Purchasing Power Parity (PPP)

PPP theory tells us that price differentials

Moreover, in the long run, having different

Theory of Purchasing Power Parity (PPP)

Because of arbitrage opportunities, market

PPP theory is often used to forecast future

Theory of Purchasing Power Parity (PPP)

The relative version of PPP now commonly used

Suppose, inflation is 5 % in the United States

Theory of Purchasing Power Parity (PPP)

Is the rate of inflation for the home country

i f Is the rate of inflation for the foreign country

Theory of Purchasing Power Parity (PPP)

(1.05 ) e3 0.75 $ 0 . 7945 3 (1.03 )

Interest Rate Parity Theory

Interest Rate Parity Theory

Interest Rate Parity Theory

Looked at differently, interest rate parity says

Covered interest rate parity

Covered interest rate parityExample

Investment in dollar will yield : $ 10,20,000

Covered interest rate parityExample

2. Investment of Euros 11,31,100 will yield : Euros 11,48,066.50

Interest rate parity

BOP and Exchange Rate

Forecasting Exchange Rates

Forecatsing Exchange Rate in Short-term

Forecatsing Exchange Rate in Short-term

Forecatsing Exchange Rate in Short-term

Chart Curve of Resistance Curve of Support

Forecatsing Exchange Rate in Medium and Long-term

Sociological and Political Approach

GOOD LUCK TO YOU

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