3.

Exchange Rate
Determination
(Fundamental equilibrium relationship
in Forex )
Agenda for Today
 Reasons for change in forex equilibrium.
 Theories of Exchange Rate Determination.
 Purchase power parity.
 Interest parity theory.
Fundamental reasons for changes
in foreign exchange equilibrium.
 Rate of Inflation
 Rate of Interest
 Elasticity of price
Theories of Exchange Rate
Determination
 Meaning:
Theories which determine the prices of
foreign exchange rate considering
inflation, interest rate ,Elasticity of
price etc.
 Methods:
A) Long run theory
B) Short run theory
Long Run Theory of Exchange rate
Determination:
 This are the theories which
predominately take into account the
fundamental changes of economy.
fundamental changes refers to the
change which are going to change the
economic performance of the
economy for all times to come.
Short Run Theory of Exchange rate
Determination:
 This theories are based more on
current information or immediate
performance of economic variables.
 This theories try to take into account
the short run factor which may be
eliminated in the long run.
Long Run Theory of Exchange rate
Determination:
 Types of theory:
I) Purchasing power parity.
1) Absoulte purchasing power parity.
2) Relative purchasing power parity.
II) Interest Rate parity
1) Covered Interest Rate parity
2) UnCovered Interest Rate parity
Purchasing power parity theory
 Founder –Swedish economist Gustav Cassel in
1918
 Meaning : According to this theory ,the price
levels and the changes in these price levels in
different countries determine the exchanges
rates of these countries currencies.
 The basic principle of this theory is that the
exchange rates between various currencies
reflect the purchasing power of these
currencies .This theory is based law of one
price.
Assumption of PPP theory
 Movement of goods
 No Transportation costs
 No Transaction costs
 No Tariffs.
Example of PPP theory
 If one gram of the gold cost Rs480 in
India and it cost US$ 10is the united
states,the RS 480=US$10 i.e
RS/US$48
Absolute form of PPP Theory
 If the law of one price were to hold good for each and
every commodity then the theory is termed as
Absolute form of PPP Theory.
 This theory describes the link between the spot
exchange rate and price levels at a particular point of
time
For eg:- if the cost of a particular goods were Rs 2,125 in
india and the same cost $50 in the us , the exchange
rate between the rupee and the dollar would be
2,215/50 =RS 42.50/$.
That is the rate of goods in the both country and their
exchange rate should be equal.
The Relative form of PPP
 This theory describes the link between the
changes in spot exchange rate and in the price
levels over a period of time.
 According to this theory ,changes in spot rates
over a period of time reflect the changes in the
price level over the same period in the
concerned economies.
 This theory relaxes three assumptions of PPP ie
Absences of transportation cost ,transaction
costs and tarriffs.
 Example of Relative Form of PPP
 This theory implies that if the domestic
inflation is greater than foreign inflation,
the domestic currency is expected to
depreciate by the difference in inflation
rates

 For eg. If Indian inflation rate is 5% and US

inflation is 3%, then the domestic currency
(rupee) is expected to depreciate by
(5% - 3%)=2%
 Reasons for PPP not holding Good
 Constraints on movement of
commodities

 Price index construction

 Effect of the statistical method

Employed For calculating inflation
rate and their difference in two
economics.
 Interest Rate Parity Theory
 Definition :
The process that ensures that the annualized forward premium or
discount equals the interest rate differential on equivalent securities
in two currencies.

 International Fisher effect:

Expected Rate of change = Interest rate

of the exchange rate differential

Interest Rate = Real Interest Expected

Differential Rate + inflation rate
 Covered Interest Rate Parity
 CIP states the inbterest rate difference off
set forward spot exchange rate difference

F = S X (1 + ih)
(1 + if)
Where
F = Forward rate
S = Spot rate
ih = Interest rate of home currency
if = Interest rate of foreign currency
 Example of CIRP

 The current exchange rate between

US dollar and Euro is $ 1.1 / Euro.
Interest rate in the US and Euro
region is 5% and 6% respectively.

what is expected rate after 6 months.

 Solution:
 As the amount expressed is in US $ per Euro
here US $ is home currency and Euro pound is foreign currency
Applying Interest rate parity theorem
F = SX (1+ih)
(1+ if)
F = 1.1 x 1+ 0.05 X 180
360
1+ 0.05 X 180
360
F = 1.1 X 1.025 = 1.09466
1.030
Hence Euro depreciates. Dollar is at premium
Covered Interest Arbitage
 Definition
 Borrowing one currency converting the
proceed into another currency where it is
invested and simultaneously selling this
other currency forward against the intial
currency
 Covered interest arbitage takes advantage
of any temporary discrepancies between
the forward rate and interest rate
differential of the two currencies.
 Steps in CIR
 Step 1:
First decide from where to borrow and where to invest. This
decision can be taken with the help of this equation.
 Forward premium % = F – S x 100
S
a) If F.P% = ih –if : No invest No Borrow
b) If F.P% > ih –if : then borrow in home
currency & invest in
foreign currency
c) If F.P% < ih –if : then borrow in foreign
currency & invest in
home currency
 Step 2
If for e.g. F.P % > ih – if then borrow from home
currency. Covert this to Foreign currency at spot
(Ask) rate

 Step 3
Invest this foreign money at interest rate in foreign
country. Calculate sum on maturity.

 Step 4
Covert this foreign sum back to home currency at
forward (bid rate) (Sum A)
 Step 5
Calculate maturity/ repayment value if
invested/borrowed in home currency at
home interest rate
(Sum B)
 Step 6
Compare A & B and decide which is
profitable
Illustration
 1) Exchange Rates
Rs 35.0020 /$ (spot)
Rs 35.9010 /$ (6 months)
Interest rate:
$ 7% per annum
Rs 12% per annum
Work out arbitrage possibilities

 2) Exchange Rates
CHF 1.3829 /$ (spot)
CHF 1.3849 /$ (3 months)
Interest rate:
$ 4% per annum
CHF 5% per annum
Work out arbitrage possibilities