exchange rate theories

EXCHANGEEXCHANGERATERATE

THEORIESTHEORIES

Exchange Rate Theories

The important factors affecting exchange ratesare:

1. Rate of inflation2. Interest rates and3. Balance of payments

There are two important theories that aptly explain

fluctuations in exchange rates

Theory of Purchasing Power Parity

(PPP)

Theory ofInterest Rate Parity

Exchange Rate Theories

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)


•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 UnitedStates$ 40

In IndiaRs. 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 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


•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 long-term 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


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Is the spot exchange rate in period Then

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te 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:

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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 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

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

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

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 country’s 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’ valueof 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 Curve Bar Chart Curve of Resistance Curve of Support

The charts or graphs are prepared to gain insightinto 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:

• 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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exchange rate theories

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