Exchange Rate Theories

EXCHANGE RATE
THEORIES
1
INTRODUCTION
 Foreign Exchange markets are influenced by numerous
economic factors such as imports and exports, investment and
divestment, financial operations, psychological factors, socio-
political factors.
 Factors affecting the exchange rates are:

 Balance of payments
 Rate of inflation
 Interest rates
2
BALANCE OF PAYMENTS AND EXCHANGE RATES
 INTERNATIONAL TRANSACTIONS IN GOODS:

 Demand for foreign money comes from importers (Indian residents buying
American goods will need $), while the supply is made by exporters (Indians goods
used by Americans will supply $).
 INTERNATIONAL SERVICES AND TOURISM:

 American tourist in India will supply $ while Indian visiting USA will demand $
for expenses there.
 INTERNATIONAL DIRECT INVESTMENT:

 American MNCs wanting to set up plant in India and funds it in $, will supply $
while Indian companies opening a subsidiary in New York will demand $.
 INTERNATIONAL TRADE IN FINANCIAL ASSETS: 3
 Portfolio purchases of American shares by Indians will demand $ while portfolio

investment of US resident will supply $.
INFLATION & EXCHANGE RATE
 Greater inflation at home leads to deterioration in value of
domestic currency.
 For example – INR and USD
 Rupee supply increases in India  Inflation in India  Price of

Indian goods will rise relative to American goods  Americans
will buy lesser of Indian goods  Decrease in the supply of $ 
Rupee depreciates
 Higher prices of Indian products  More substitution by the US

products  demand for US $ will be higher  Rupee depreciates4
PURCHASING POWER PARITY
(PPP)
 This theory was enunciated by Gustav Cassel a Swedish
Economist in 1918.
 According to him, Purchasing power of a currency is

determined by the amount of goods and services that can be
purchased with one unit of that currency.
 Purchasing power parity is based on the law of one price,

which applies to any product irrespective of its geographical
location and the currency in which it is bought or sold.
 A single price of the product must prevail no matter where it5

is sold or in which currency its price is denominated.
 On the contrary, if the existing exchange rate is such that
purchasing power parity does not exist in economic terms, it
is a situation of disequilibrium.
 It is expected that the exchange rate between the two

currencies conforms eventually to purchasing power parity.
 Likewise, if the rate of inflation is different in two countries,

the floating exchange rate should accordingly vary to reflect
that difference
6
 If there is more than one currency, it is fair and equitable that the
exchange rate between these currencies provide the same
purchasing power for each currency. This is referred to as
purchasing power parity.
 As per the Purchasing Power Parity the spot exchange rate must be
in the ratio of prices of common basket of goods in two currencies
 It is ideal if the existing exchange rate is in tune with this cardinal

principle of purchasing power parity. This is absolute form of PPP.
7
RELATIVE FORM OF PPP
 Relative Purchasing Power Parity is concerned with the changes in
the exchange rates. Though resting on the same principle as PPP in
its absolute version, the relative version is more likely to hold.
 Annual change in spot rates would be approximately equal to

differential in the annual inflation rates in two countries with
currency with higher inflation rate depreciating as much.
 If the change in the nominal exchange rate is in accordance with

PPP the real exchange rate do not change from one period to
another.
8
CRITICISMS OF PPP THEORY
 Conceptually this theory is sound. However, there are number of
recognized factors that prevent this theory from determining exchange
rates in practice.
 Some of the major factors in this regard are:

 Transport Cost – Goods that are unavailable locally must be imported,
resulting in transport costs
 Tax Differences – taxes can spike prices in one country, relative to another
 Government intervention – directly in the exchange markets or indirectly

through trade restrictions
 Speculation in the exchange markets
 Structural changes in the economies of the countries 9
 Continuation of long term flows in spite of the disequilibrium between

THE INTERNATIONAL FISHER EFFECT
 Fisher effect deals with the phenomenon of varying interest
rates in different countries. Interest is essentially the reward
for waiting.
 A person who makes fixed deposits in the bank is committing

his funds to bank for specified period and interest that he
receives is the reward for waiting.
 In a perfect market situation and where there is no restriction

on flow of money, one should be able to gain the same real
value on one’s monetary assets irrespective of the country
where they are held. 10
INTEREST RATE AND
EXCHANGE RATES
 Greater interest at home leads to appreciation in value of
domestic currency.
 For example – INR and USD
 Interest rate in India increase  US investors invest more in

India as returns become more attractive  supply of $
increases  Rupee appreciates
 Interest rates in India Increase  Indian investors invest less

abroad as returns abroad become relatively less attractive 11
demand of $ decreases  Rupee appreciates
 International Fisher effect theory states that the anticipated
changes in the exchange rate between two currencies would
equal the inflation rate differential between the two countries
which, in turn, would equal the nominal interest rate
differential between these two countries.
 Mathematically, this relationship can be expressed as:
12
THEORY OF INTEREST RATE PARITY
 The theory of interest rate parity is very useful reference for
explaining the differential between the spot and future exchange
rate, and international movement of capital.
 This theory states that forward premium or discount of one country

against another should reflect the interest differential between two
currencies.
 Accepting this theory implies that international financial markets are

perfectly competitive and function freely without any constraints.
(1  rh )
F S 13
(1  rf )
CRITICISMS OF IRP THEORY
 Availability of funds that can be used for arbitrage is not
infinite.
 The importance of capital movement, when they are

available, depends on the credit conditions practiced
between the financial places and on the freedom of actions of
different operators as per the rules of the country in vogue.
14
 Q.1. The US inflation rate is expected to average about 4%
annually, while the Indian rate of inflation is expected to
average about 6% annually. If the current spot rate is 1USD =
INR 83.1500, what is the spot rate in two years?
15
 Q.2. If the spot rate is $ 1 =Yen 110 and interest rates in Tokyo
and New York are 3% and 4.5% respectively, what is the
expected dollar yen exchange rate one year hence?
16
 Q.3. In January, the one-year interest rate is 6% on euro and 4%
on pound sterling. The spot exchange rate is 1 GBP = 1.4500
EUR. If the future spot rate is likely to rise to 1 GBP = 1.4700,
what would happen to the UK interest rate?
17
 Q.4. Two countries A and B produce only one commodity, say
rice. Suppose the price of rice in the country A is CA 2.5 and
in the country B, CB 3.5.
 a. According to the PPP, what should CA:CB spot exchange
rate?
 b. Suppose the price of rice over the next year is expected to
rise to CA 3 and CB 4 in the countries A and B respectively.
What should the one –year CA:CB spot exchange rate?
18
 Q.5. On April 1, interest rate in US and UK are 6.5% and
4.5% per annum, respectively. The US $/UK £ spot rate is
$1.099/ £. What would be the forward rate for £, for delivery
on 30th June?
19
 Q.6. Assume the spot rate between the Indian Rupee and US $
is Rs.75 in year 1. In first quarter of year 2, the price index of
India is 108 and that of US 102 (with year 1 as base year).
Based on this data, determine the likely exchange rate of
Indian Rupee and US $.
20
 Q.7. Suppose over a period of two years, the US price index
moves from 110 to 125 and the Japanese price index moves
from 105 to 110. The spot exchange rate is $ 1 =Yen 112.
What would be the spot exchange rate in 2 years?
 Hint: : V0(1+r)n =Vn
21

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EXCHANGE RATE

 Factors affecting the exchange rates are:

 INTERNATIONAL TRANSACTIONS IN GOODS:

 INTERNATIONAL SERVICES AND TOURISM:

 INTERNATIONAL DIRECT INVESTMENT:

 INTERNATIONAL TRADE IN FINANCIAL ASSETS: 3

 Portfolio purchases of American shares by Indians will demand $ while portfolio

 For example – INR and USD

 Rupee supply increases in India  Inflation in India  Price of

 Higher prices of Indian products  More substitution by the US

 According to him, Purchasing power of a currency is

 Purchasing power parity is based on the law of one price,

 A single price of the product must prevail no matter where it5

 It is expected that the exchange rate between the two

 Likewise, if the rate of inflation is different in two countries,

 It is ideal if the existing exchange rate is in tune with this cardinal

 Annual change in spot rates would be approximately equal to

 If the change in the nominal exchange rate is in accordance with

 Some of the major factors in this regard are:

 Government intervention – directly in the exchange markets or indirectly

 Speculation in the exchange markets

 Structural changes in the economies of the countries 9

 Continuation of long term flows in spite of the disequilibrium between

 A person who makes fixed deposits in the bank is committing

 In a perfect market situation and where there is no restriction

 For example – INR and USD

 Interest rate in India increase  US investors invest more in

 Interest rates in India Increase  Indian investors invest less

 Mathematically, this relationship can be expressed as:

 This theory states that forward premium or discount of one country

 Accepting this theory implies that international financial markets are

 The importance of capital movement, when they are

 Hint: : V0(1+r)n =Vn

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