MBA (Finance specialisation)

&
MBA Banking and Finance
(Trimester)
Term VI
Module : International Financial Management
Unit II: Foreign Exchange Markets
Lesson 2.2
(Theories of Exchange rate )

Theories of exchange rate determination
The phenomenon of exchange rates movement is an important
issue in international finance and managers of multinational firms,
international investors, importers and exporters and government
officials attach enormous importance to it.
The three theories of exchange rate determination are:
1. Purchasing Power Parity (PPP), which links spot exchange rates
to nations price levels.
2. The Interest Rate Parity (IRP), which links spot exchange rates,
forward exchange rates and nominal interest rates.
3. The International Fisher Effect (IFE) which links exchange rates
to nations nominal interest rate levels.

Purchasing Power Parity
A Swedish economist, Gustav Cassel, stated in 1918
that purchasing power of a currency is determined
by the amount of goods and services that can be
purchased with one unit of that currency. If there
are two currencies, it would be fair to say that the
exchange rate between these two currencies would
be such that it reflects their respective purchasing
power. This principle is referred to as Purchasing
Power Parity (PPP). If the current exchange rate is
such that it does not reflect purchasing power
parity, it is a situation of disequilibrium.
Purchasing Power Parity
Let us illustrate this concept with the help of an
example. Suppose, at the period zero, a basket of
goods and services is costing 100 in the UK and
$180 in USA. There is no restriction of buying this
basket of goods and services either from the UK or
from the USA. Then, it would be correct to
conclude that the two amounts paid in respective
currencies are equivalent. In other words,
100 = $180
or I = $1.80
Purchasing Power Parity
Or, we can simply say that the exchange rate at the time
zero is $1.80/. If we use the symbol S0 to designate this
exchange rate, then we write:
S0 = $1.80/
Say after one year (period 1), the same basket of goods and
services costs 103 in the UK market while it costs $186 in
the USA market. Again, it is reasonable to say that these
two sums are equal. That is,
103=$186
or 1 =$1.8058
or the exchange rate, S1, at the period 1 is: $1.8058/.
Purchasing Power Parity
By looking at the exchange rate S
0
and S
1
, it clear pound
sterling slightly appreciated as compared to dollar over the
period of one year. The reason for this could be understood
from the inflation rate of the two countries
In US , rate of inflation = [(186 -180)/180] x 100 = 3.33%
In UK , rate of inflation = [(103 -100)/100] x 100 = 3%
This shows that the rate of inflation is higher in the US than
in the UK.
It is inferred , then, that the currency of the country where
inflation rate is higher is likely to depreciate in comparison
to the currency of the country with lower rate of inflation.
Purchasing Power Parity
Now this illustration can be generalized by taking two
countries A and B. At the reference point of time (time
zero), the price of the given basket is P
A0
in the country A
and P
B0
be the price of the given basket in country
B.Therefore,
P
A0
= S
0
x P
B0
(equation 1)
At a later period (time 1), the price changes to PA1 and
PB1 respectively.
P
A1
= S
1
x P
B1
(equation 2)
The relation between prices at different points of time is
linked through the inflation.
Purchasing Power Parity
That is
P
A1
= P
A0
(1 + r
A
)

(equation 1)
At a later period (time 1), the price changes to P
A1

and P
B1
respectively.
P
A1
= S
1
x P
B1
(equation 2)
The relation between prices at different points of
time is linked through the inflation.

Purchasing Power Parity
That is,
P
A1
= P
A0
(1 + r
A
) (Equation 3) and
P
B1
= P
B0
(1 + r
B
) (Equation 4)
Where r
A
and r
B
are the rates of inflation in the Country A and
Country B respectively.
From Equation 1 and Equation 2,
S
0
= (P
A0
/ P
B0
)
S
1
= (P
A1
/ P
B1
)
Using Equation 3 and Equation 4, we can write:
S
1
= [P
A0
(1 + r
A
) / P
B0
(1 + r
B
)]
S
1
= S
0
[(1 + r
A
) / (1 + r
B
)] (equation 5).
This equation links the exchange rates with inflation rates in two
countries and it is called Purchasing power parity relationship.

Problems
Q1. In India, prices changed from Rs 4500 to Rs 5500 over a
period of three years for the same basket of goods whereas
they changed from $100 to $110 over the same period in
the U.S.A. What initial exchange rate (S
0
)? What is expected
exchange rate after 3 years (S
3
)?

Q2. Inflation rates in the UK and India are respectively 3% and
6% per annum? What is the expected exchange rate after
one year, if it was Rs 78/ at the beginning ?

Q3. Price indices in the UK and USA are 125 and 200
respectively at the reference period (time zero) . These
indices change to 129 and 205 after one year. Calculate the
exchange rate after one year, given the reference exchange
rate of $1.80/ .