Chapter-03:

Theories of Exchange Rate

Theories of exchange rate provide frameworks how currencies are valued compared to one another and
why these values change over time.

Here’s an in-depth look at the major exchange rate theories:

1. Interest Rate Parity
2. Purchasing Power Parity
3. International Fisher Effects
4. Balance of Payment

Interest Rate Parity (IRP)

Interest Rate Parity (IRP) explains the link between exchange rates and interest rates. It helps investors
understand how spot exchange rates, foreign exchange rates, and interest rates are related in the foreign
exchange market.

Key Concepts of Interest Rate Parity

1. Nominal Interest Rates

These are the rates shown by banks or companies for loans or investments. For example, if you
borrow $100 at a 6% rate, you will pay $6 as interest.
2. Arbitrage
Arbitrage means buying something cheaper in one place and selling it for more in another. This
price difference helps traders make profits. Examples include currency and stock trading.

Types of Interest Rate Parity

1. Covered Interest Rate Parity (CIRP)

Covered Interest Rate Parity happens when the connection between interest rates, spot exchange
rates (current currency value), and forward exchange rates (future currency value) is balanced. This
means any differences between two countries' interest rates are adjusted through the exchange
rates to ensure no risk of loss for investors.
2. Uncovered Interest Rate Parity (UIRP)
Uncovered Interest Rate Parity says that the price of the same product or financial asset, like a
currency or commodity, should be equal worldwide. If prices differ, the exchange rates will adjust
over time to remove the price gap.

Spot Exchange Rate: This is the current price for exchanging one currency for another at a specific
moment.

Forward Exchange Contract: This is an agreement between a bank and its customer to set an exchange
rate now for buying or selling a currency at a future date.
A visual representation of covered and uncovered interest rate parity
Assumptions of Interest Rate Parity

1. Perfect Capital Mobility

Investors can freely move money between countries without any restrictions, like
government controls or limits.
2. No Transaction Costs
There are no fees, taxes, or other charges when transferring funds between
countries.
3. Homogeneous Risk
Investors believe that the risk level is the same for investments in all currencies,
meaning no currency is seen as riskier than another.

Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) is a theory that says exchange rates will adjust over time so
that the price of the same goods is equal in different countries when measured in the same
currency.

It is often used to compare the cost of living, inflation, and economic performance between
countries. For example, if a basket of goods costs $100 in the U.S. and the same basket
costs 500 units of a foreign currency, the PPP exchange rate would be 5:1.

Key Concepts of PPP

1. Law of One Price

This idea states that the same product should have the same price everywhere when
converted to the same currency. For this to happen, extra costs like transport or
taxes are ignored.
 2. Relative PPP
Relative PPP explains that exchange rates change depending on the difference in
inflation rates between two countries.

Formula:

o EtEn=PtPn\frac{E_t}{E_n} = \frac{P_t}{P_n}EnEt=PnPt
Where:
 EtE_tEt = Future Exchange Rate
 EnE_nEn = Current Exchange Rate
 PtP_tPt = Inflation in Domestic Country
 PnP_nPn = Inflation in Foreign Country
3. Absolute PPP
Absolute PPP says that the exchange rate between two currencies equals the ratio of
price levels in both countries.

Formula:

o S=P1P2S = \frac{P_1}{P_2}S=P2P1
Where:
 SSS = Spot Exchange Rate
 P1P_1P1 = Price Level in Domestic Country
 P2P_2P2 = Price Level in Foreign Country

Applications of Purchasing Power Parity (PPP)

1. Exchange Rate Evaluation

PPP helps check if a currency is overvalued or undervalued, enabling investors to
make better financial decisions.
2. Inflation Analysis
PPP is used to study how inflation affects the purchasing power of money and real
income over time.
3. International Trade Pricing
Businesses use PPP to set competitive prices for their exports and imports, ensuring
fair trade.
4. Policy Analysis
Governments and global organizations rely on PPP data to create effective economic
policies, plan development strategies, and distribute financial aid fairly.

Limitations of Purchasing Power Parity (PPP)

1. Trade Barriers
PPP assumes goods can be traded easily, but things like taxes, shipping costs, and
restrictions make this hard in real life.
 2. Local Goods
Some goods and services are only available in one country or have different prices, so
PPP doesn’t always work well.
3. Changing Exchange Rates
Exchange rates change a lot because of politics or the economy, which PPP doesn’t
fully explain.
4. Data Problems
It can be hard to get correct price information, especially in poorer countries.
5. Short-term Issues
PPP works better over a long time. In the short term, prices can change because of
guesses or emotions in the market.

International Fisher Effect (IFE)

The International Fisher Effect (IFE) explains that exchange rates change depending on the
difference in interest rates between two countries. Countries with higher interest rates
often see their currencies lose value over time.

Key Concepts of International Fisher Effect (IFE)

1. Nominal Interest Rates

When a country has higher interest rates, its currency is expected to lose value over
time.
2. Exchange Rate Movements
Currencies with higher interest rates are likely to weaken because investors expect
inflation to affect their value.

Formula for International Fisher Effect (IFE):

The formula to calculate the expected future exchange rate based on interest rate
differences is:

Where:

 E(St)E(S_t)E(St): Expected future exchange rate

 S0S_0S0: Current exchange rate
 idi_did: Domestic interest rate
 ifi_fif: Foreign interest rate

This formula shows how interest rate differences between two countries impact the
expected change in exchange rates.

Implications of International Fisher Effect (IFE)

 1. Investment
Higher interest rates attract investors, but if the currency loses value, their returns
may be lower.
2. Hedging
IFE helps businesses and investors handle currency risks better.
3. Interest Rate Policy
Central banks use IFE to control how interest rates affect exchange rates.

Limitations of International Fisher Effect (IFE)

1. Market Imperfections
Taxes, rules, and extra costs can affect how well IFE predictions work.
2. Short-Term Influences
Exchange rates can change quickly due to events like politics or market speculation.
3. Inflation
IFE does not consider inflation differences, which also impact exchange rates.
4. Mixed Evidence
Real exchange rate changes often do not fully match what IFE predicts.

The Balance of Payment

The Balance of Payment is a record of all financial transactions between a country and the
rest of the world over a specific time, usually a year. It includes transactions for goods,
services, and assets made by individuals, businesses, and the government.

The Balance of Payment (BOP) Accounts

1. Current Account
o Definition: Records transactions for exports and imports of goods, services,
income, and money transfers.
o Sub-components:
 Trade Balance: Difference between exports and imports of goods. A
surplus means more exports, and a deficit means more imports.
 Services: Trade in services like tourism, banking, and insurance.
 Income: Earnings from investments (dividends, interest) and wages of
residents working abroad.
 Current Transfers: Money transfers without goods or services, such as
remittances and foreign aid.
2. Capital Account
o Definition: Records transactions for buying and selling assets between
residents and non-residents.
o Sub-components:
 Capital Transfers: Debt forgiveness, migration-related transfers, and
non-repayable transactions.
 Non-Produced, Non-Financial Assets: Transactions like patents,
copyrights, and leases.
 3. Financial Account
o Definition: Records investments in foreign assets by residents and foreign
investments in domestic assets.
o Sub-components:
 Direct Investment: Long-term investments in foreign businesses or
assets (e.g., creating subsidiaries).
 Portfolio Investment: Short-term investments in foreign stocks or
bonds.
 Other Investments: Loans, deposits, and trade credits.
 Reserve Assets: Changes in a country's foreign exchange reserves
managed by the central bank.

Balance of Payments Equilibrium

The Balance of Payments (BOP) should theoretically balance, meaning the total of the
current account, capital account, and financial account equals zero. In reality, small
differences occur due to errors in data or timing mismatches.

Importance of the Balance of Payments (BOP)

1. Economic Analysis
The BOP helps understand a country’s economic performance, showing trade
strength, currency stability, and overall economic health.
2. Policy Formulation
Governments use BOP data to create policies for trade, taxes, and currency
management.
3. Investment Decisions
Investors study BOP trends to evaluate a country’s economy and decide where to
invest.
4. International Relations
BOP impacts a country’s trade agreements and partnerships with other nations.

Limitations of the Balance of Payments (BOP)

1. Data Accuracy
Errors in reporting, especially for informal transactions, can make BOP data less
reliable.
2. Time Lag
Delays in reporting transactions can cause differences in real-time analysis.
3. Subjectivity in Classification
Countries may classify transactions differently, making global comparisons difficult.
4. Focus on Monetary Transactions
The BOP mainly tracks money-related transactions and may not show all economic
activities.
Forward Rate
A forward rate is the expected interest or exchange rate for a future transaction. It is
determined by the difference in interest rates between two currencies and the time until
the transaction is completed.

Spot Exchange Rate

A spot exchange rate is the current price at which one currency can be exchanged for
another. It refers to the cost of exchanging currency immediately, without delay.

Differences among IRP, PPP and IFE:

Aspect Interest Rate Parity Purchasing Power International Fisher

(IRP) Parity (PPP) Effect (IFE)
Definition Shows how interest Links exchange rates to Links exchange rates to
rates and exchange price differences interest rate differences.
rates are linked. between countries.
Key Focus Interest rates and Inflation and current Interest rates and future
future exchange exchange rates. exchange rates.
rates.
Practical Use Helps predict future Helps predict long- Helps predict if a
exchange rates and term changes based on currency will go up or
safe trading. inflation. down.
Application Short-term. Long-term. Medium to long-term.
Horizon
Key Assumes no extra Needs accurate Assumes markets are
Limitation costs or barriers. inflation data and no always smart and ignores
trade barriers. other factors.
Key Variables Interest rates (home Inflation rates (home Interest rates and
and foreign). and foreign). inflation expectations.
 o Interest Rate Policy
 Limitations of IFE
1. Theories of Exchange Rate o Market Imperfections
o Short-Term Influences
 Interest Rate Parity (IRP) o Inflation
 Purchasing Power Parity (PPP) o Mixed Evidence
 International Fisher Effect (IFE)
 Balance of Payment
5. Balance of Payment (BOP)
2. Interest Rate Parity (IRP)
 BOP Accounts
 Key Concepts of Interest Rate Parity o Current Account
o Nominal Interest Rates  Trade Balance
o Arbitrage  Services
 Types of Interest Rate Parity  Income
o Covered Interest Rate Parity (CIRP)  Current Transfers
o Uncovered Interest Rate Parity (UIRP) o Capital Account
 Assumptions of Interest Rate Parity  Capital Transfers
o Perfect Capital Mobility  Non-Produced, Non-Financial
o No Transaction Costs Assets
o Homogeneous Risk o Financial Account
 Direct Investment
 Portfolio Investment
3. Purchasing Power Parity (PPP)  Other Investments
 Reserve Assets
 Balance of Payments Equilibrium
 Key Concepts of PPP
 Importance of BOP
o Law of One Price
o Economic Analysis
o Relative PPP
o Policy Formulation
o Absolute PPP
o Investment Decisions
 Applications of PPP
o International Relations
o Exchange Rate Evaluation
 Limitations of BOP
o Inflation Analysis
o Data Accuracy
o International Trade Pricing
o Time Lag
o Policy Analysis
o Subjectivity in Classification
 Limitations of PPP
o Focus on Monetary Transactions
o Trade Barriers
o Local Goods
o Changing Exchange Rates 6. Forward and Spot Exchange Rate
o Data Problems
o Short-Term Issues  Forward Rate
 Spot Exchange Rate
4. International Fisher Effect (IFE)
7. Differences among IRP, PPP, and IFE
 Key Concepts of IFE
o Nominal Interest Rates  Definition
o Exchange Rate Movements  Key Focus
 Formula for IFE  Practical Use
 Implications of IFE  Application Horizon
o Investment  Key Limitation
o Hedging  Key Variables