Exchange Rate Theories


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Exchange Rate Theories

  2. 2. Exchange Rate Theories <ul><li>The important factors affecting exchange rates </li></ul><ul><li>are: </li></ul><ul><ul><ul><li>1. Rate of inflation </li></ul></ul></ul><ul><ul><ul><li>2. Interest rates and </li></ul></ul></ul><ul><ul><ul><li>3. Balance of payments </li></ul></ul></ul><ul><li>There are two important theories that aptly explain </li></ul><ul><li>fluctuations in exchange rates </li></ul>
  3. 3. Theory of Purchasing Power Parity (PPP) Theory of Interest Rate Parity Exchange Rate Theories
  4. 4. Theory of Purchasing Power Parity (PPP) <ul><li>PPP theory measures the purchasing power of one currency against another after taking into account their exchange rate </li></ul><ul><li>‘ 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 </li></ul><ul><li>( assuming the exchange rate is $ 1 = Rs. 50) </li></ul>
  5. 5. Theory of Purchasing Power Parity (PPP) <ul><li>Developed by Gustav Cassel ( Swedish economist – 1918) , the theory states that in ideally efficient markets, identical goods should have one price </li></ul><ul><li>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 </li></ul><ul><li>However, if it doesn’t happen, then we say that purchase parity does not exist between the two currencies </li></ul>
  6. 6. <ul><li>In the United </li></ul><ul><li>States </li></ul><ul><li>$ 40 </li></ul>In India Rs. 750 Suppose $ 1 = Rs. 50 today $ 15
  7. 7. Theory of Purchasing Power Parity (PPP) <ul><li>If this happens: </li></ul><ul><ul><li>American consumers’ demand for Indian </li></ul></ul><ul><ul><li>Rupees would increase which will cause the Indian Rupee to become more expensive </li></ul></ul><ul><ul><li>2. The demand for cricket bats sold in the US would decrease and hence its prices would tend to decrease </li></ul></ul><ul><ul><li>3. The increase in demand for cricket bats in India would make them more expensive </li></ul></ul>
  8. 8. <ul><li>In the United States </li></ul><ul><li>$ 40 </li></ul><ul><li>$ 30 </li></ul>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
  9. 9. Theory of Purchasing Power Parity (PPP) <ul><li>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 </li></ul><ul><li>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 </li></ul>
  10. 10. Theory of Purchasing Power Parity (PPP) <ul><li>Because of arbitrage opportunities, market forces come in to play and bring about an equilibrium in prices </li></ul><ul><li>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 </li></ul>
  11. 11. Theory of Purchasing Power Parity (PPP) <ul><li>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 </li></ul><ul><li>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 </li></ul>
  12. 12. Theory of Purchasing Power Parity (PPP) If 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 foreign Currency at the beginning of the period Is the spot exchange rate in period Then i. e.
  13. 13. Theory of Purchasing Power Parity (PPP) 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: 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
  14. 14. 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
  15. 15. Interest Rate Parity Theory <ul><li>This theory states that premium or discount of one currency against another should reflect the interest differential between the two currencies </li></ul><ul><li>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 </li></ul>
  16. 16. Interest Rate Parity Theory <ul><li>In an efficient market with no transaction costs, the interest differential should be ( approximately) equal to the forward differential </li></ul><ul><li>When this condition is met, the forward rate is said to be at interest rate parity and equilibrium prevails in the money markets </li></ul>
  17. 17. Interest Rate Parity Theory <ul><li>Thus, the forward discount or premium is closely related to interest differential between the two currencies </li></ul><ul><li>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 </li></ul>
  18. 18. Covered interest rate parity <ul><li>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 </li></ul><ul><li>Which means the covered interest differential – the difference between the domestic interest rate and the hedged foreign rate- is zero </li></ul>
  19. 19. Covered interest rate parity- Example <ul><ul><li>Investment of $ 10,00,000 for 90 days </li></ul></ul><ul><ul><li>New York ( Dollar) Interest Rate : 8% p.a. </li></ul></ul><ul><ul><li>Frankfurt ( Euro) Interest Rate : 6% p.a. </li></ul></ul><ul><ul><li>Investment in dollar will yield : $ 10,20,000 </li></ul></ul>
  20. 20. Covered interest rate parity- Example <ul><li>Suppose, the current spot is Euro 1.13110/$ </li></ul><ul><li>The 90 day forward is Euro 1.1256/$ </li></ul><ul><li>If he chooses to invest in euros on a hedged basis, he will: </li></ul><ul><ul><li>Covert dollars to euros at spot rate i.e. 10,00,000x1.1311 = Euros 11,31,100 </li></ul></ul><ul><ul><li>2. Investment of Euros 11,31,100 will yield : Euros 11,48,066.50 </li></ul></ul><ul><ul><li>3. Sell forward Euros 11,48,066.50 will yield $10,20,000 </li></ul></ul>
  21. 21. Interest rate parity <ul><li>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 </li></ul><ul><li>Interest rate parity is one of the best documented relationship in international finance </li></ul><ul><li>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 </li></ul>
  22. 22. BOP and Exchange Rate <ul><li>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 </li></ul>
  23. 23. Forecasting Exchange Rates <ul><li>Forecasting future exchange rates is virtually a necessity for a multinational enterprise, inter-alia , to develop an international financial policy </li></ul><ul><li>It is particularly useful for an international firm if it intends to borrow from or invest abroad </li></ul><ul><li>It is also useful for framing a hedging policy </li></ul>
  24. 24. Forecatsing Exchange Rate in Short-term <ul><li>Three methods are used for the purpose: </li></ul><ul><li>Method of Advanced Indicators: </li></ul><ul><li>- the ratio of country’s reserves ( gold, foreign </li></ul><ul><li>currencies and SDRs) to its imports </li></ul><ul><li>- The ratio indicates the number of months (N) </li></ul><ul><li>imports, covered by the reserves (R) </li></ul><ul><li>N = R/I x12 N= (30/80) x 12 = 4.5 months </li></ul><ul><li>As a general rule, if reserves are than 3 moths’ value </li></ul><ul><li>of imports, the currency is vulnerable and may face </li></ul><ul><li>devaluation </li></ul>
  25. 25. Forecatsing Exchange Rate in Short-term <ul><li>2. Use of Forward Rate as Predictor of Future Spot Rate: </li></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>In other words, the rate of premium or discount should be an unbiased predictor of the rate of appreciation or depreciation of a currency </li></ul></ul>
  26. 26. Forecatsing Exchange Rate in Short-term <ul><li>Graphical Methods: </li></ul><ul><ul><ul><ul><li>Rate-time Curve </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Bar Chart </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Curve of Resistance </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Curve of Support </li></ul></ul></ul></ul><ul><ul><li>The charts or graphs are prepared to gain insight </li></ul></ul><ul><ul><li>into the trend of fluctuations and forecast the </li></ul></ul><ul><ul><li>moment when the trend is likely to reverse </li></ul></ul>
  27. 27. Forecatsing Exchange Rate in Medium and Long-term <ul><li>Economic Approach: </li></ul><ul><ul><ul><li>Structure of the balance of payments </li></ul></ul></ul><ul><ul><ul><li>Reserves in gold or in foreign exchange </li></ul></ul></ul><ul><ul><ul><li>Interest rates </li></ul></ul></ul><ul><ul><ul><li>Inflation rates </li></ul></ul></ul><ul><ul><ul><li>Employment level </li></ul></ul></ul><ul><li>2. Sociological and Political Approach </li></ul>
  28. 28. GOOD LUCK TO YOU