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7/31/2019 Green Ppts

1/19

EXCHANGE

RATE

THEORIES


2/19

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


3/19

Theory of

Purchasing Power Parity(PPP)

Theory ofInterest Rate Parity


4/19

PPP theory measures the purchasing power ofone 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)


5/19

Developed by Gustav Cassel ( Swedisheconomist 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


6/19

In the United

States

$ 40

In IndiaRs. 750

Suppose $ 1 = Rs. 50 today

$ 15


7/19

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


8/19

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


9/19

PPP theory tells us that price differentialsbetween 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


10/19

Because of arbitrage opportunities, marketforces 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


11/19

The relative version of PPP now commonly usedstates 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


12/19

fi

tf

tht

i

i

e

e

)1(

)1(

0

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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

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)1(0


13/19

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


14/19

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


15/19

Thus, the forward discount or premium is closelyrelated 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


16/19

Interest parity ensures that the return on ahedged ( 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


17/19

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


18/19

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


19/19

Interest rate parity says that high interest rateson 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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