MBA (Finance specialisation)

&
MBA Banking and Finance
(Trimester)
Term VI
Module : International Financial Management
Unit II: Foreign Exchange Markets
Lesson 2.3
(Theories of Exchange rate Interest rate parity theory and International fisher effect )

Interest Rate Parity relationship
This relationship links interest rates of two countries
with spot and future exchange rates. It was made
popular in 1920s by economists such as John M.
Keynes. The theory underlying this relationship says
that premium or discount of one currency against
another should reflect interest rate differential
between the two countries. In perfect market
conditions, where there are no restrictions on the
flow of money and there are no transaction costs, it
should be possible to gain the same real value of
one's monetary assets irrespective of the country (or
currency) in which they are invested.
Interest Rate Parity relationship
For example, an investor has one unit of pound sterling. He
can invest it in the UK money market and earn an interest of
it on it. The resulting value after one year will be:
1 (1 +i

)
Alternatively, he can buy So dollars (the current exchange
rate being So dollars = 1 pound sterling) and invest this
dollar amount in US money market. The end value after
one year will be:
$S
o
(1 + i
$
)
The equilibrium condition demands that these two sums be
equal. If the two sums were not equal, then the investor
would invest in that currency where the end value of
their monetary assets is going to be more.
Interest Rate Parity relationship
But once this action is generalized by the similar expectations of
all investors, equilibrium is going to be reestablished. Thus, in
equilibrium situation,
$S
0
(1 + i
$
) = 1(1 + i

)
$S
0
[ (1 + i
$
)/(1 + i

) ] = 1
This expression on the left side of the above equation is future
exchange rate. We can write
S
1
= S
0
[ (1 + i
$
)/(1 + i

) ]
This expression can be written for any two currencies, A and B,
by replacing dollar and pound sterling. Thus,
S
1
= S
0
[ (1 + i
A
)/(1 + i
B
)].
The above equation is known as Interest rate parity relationship.

Problems Based on IRP
Problem1 If the current exchange rate between US dollar and
euro is $1.20/ and , the interest rates are 4% p.a. on dollar
and 3% p.a. on euro, respectively, what is expected rate after
one year?

Problem2 Six month interest rates on Indian rupees and
pound sterling are 8% and 5% p.a. respectively. The current
exchange rate is Rs 79/.Estimate the exchange rate of 6 month
later.

Problem3 Exchange rate between rupee and Swiss franc is Rs
33/SFr at the reference period and is found to be Rs 33.40/SFr
after 9 months. Nine month interest rate on rupee is 8% p.a.
What should have been corresponding interest on Swiss franc?

International Fisher effect
According to relative form of purchasing parity theory
Forward /premium discount = difference in inflation rate of two countries
According to interest rate parity theory
Forward /premium discount = difference in interest rate of two countries.
Combining the two , we have ,
Difference in inflation rate = Difference in interest rate , or
(r
home
r
foreign
) = (i
home
i
foreign
)
(r
home
i
home
) = (r
foreign
i
foreign
)
The above equation implies that , in the absence of
restrictions on trade flows and capital flows the expected
real rate of return on capital tends to equalise. The above
equation is referred as Fisher Open Condition or
International fisher effect.



Deviations from Purchasing Power Parity
Relationship
Though this relationship has a sound theoretical base, in practice, it
does not always give satisfactory results. There are differences
between the exchange rate predicted by the PPP and the actual
future rate. Several factors could be responsible for the deviation.

a) One factor could be inflation rates themselves that are used for
calculating future exchange rates.
b) PPP takes into account only movement of goods and services. It
does not factor in the capital flows.
c) Government intervention in the exchange market directly or
through trade restrictions.
d) Speculative activity in the exchange market.




Deviations from IRP relationship
Reasons

a) Capital controls
b) Transaction costs.



Exchange Rate and Foreign exchange reserves

Foreign Exchange reserves have an impact on exchange rate.
Though there is no direct mathematical relationship between
the level of reserves and exchange rate, yet there is a logic
that links the two. First, let us see what the reserves are
meant for. Why does any country maintain foreign exchange
reserves? A country has to meet its financial obligations to
the outside world. These obligations are broadly in the form
of debt service requirements and payments to be made for
imports. Debt service includes both interest and installments
of the principal falling due for payment. In case, the reserves
are able to meet these obligations comfortably, the level of
reserves going up or down slightly does not have nay visible
impact on exchange rate.
Exchange Rate and Balance of Payment

It has been established through observation and empirical studies
that a deficit in Balance of Payment (BOP) causes depreciation of the
domestic currency. When a country is importing more than its
exports, the demand for foreign currencies increases. This increasing
demand can be met by increasing capital inflows. As a result, the
trade deficit may not have very significant impact on the exchange
rate. However, if the demand for foreign currency is met by drawing
down the existing foreign exchange resources, then the adverse
impact on exchange rate will be more pronounced. The foreign
currency due to its increased demand will harden while the domestic
currency will depreciate.
Exchange Rate and Technical Analysis

Technical analysis refers to the process of estimating exchange rate
by extrapolating the past data. The technical analysts (or chartists as
they are also called) use daily, weekly or monthly data to generate
charts and then try to discern certain definite patterns. They believe
that these patterns are likely to repeat for some time in future,
enabling the chartists to predict exchange rates.
Practice Problems
Problem 1: Given ( Home Country : India , Foreign Country : U.S.)
Spot Rate (Rs/$) = 62
6 mths Forward rate = 62.5
Interest rate in India = 12%
Interest rate in U.S. = 8%
Is there any arbitrage possibility in the above case ? If yes, how an arbitrager can
benefit from the same.

Problem 2: Given Home Country : India , Foreign Country : U.S.
Spot Rate (Rs/$) = 62
6 mths Forward rate = 63
Interest rate in India = 12%
Interest rate in U.S. = 10%
Is there any arbitrage possibility in the above case ? If yes, how an arbitrager can
benefit from the same.