THEORY 1 THEORY 2 THEORY 3

(INTEREST RATE PARITY) (PURCHASING POWER PARITY) (INTERNATIONAL FISHER EFFECT)

Meaning Market forces cause the forward rate to differ It refers to a situation where the inflation It proposes that differences in nominal interest rates
from the spot rate by an amount that is differential between two countries is exactly between countries are reflective of differences in
sufficient to offset the interest rate differential offset by the depreciation of the higher expected inflation.
between the two currencies.
inflation currency.
Then, covered interest arbitrage is no longer
feasible, and the equilibrium state achieved is
referred to as interest rate parity (IRP).

Implication It basically implies that investor cannot earn a
rate of return higher than that attainable in his
or her home country by investing in foreign
market.
Variables Interest rate differential (%)
Forward discount/premium of foreign country
When PPP exists customers will be
indifferent between purchasing goods in
their own country versus purchasing goods
in the foreign country.
Inflation Rate Differential (%)
% Δ in the foreign currency’s spot rate
If interest rates in a country are higher, that is a sign of
higher anticipated inflation. Hence, according to PPP the
higher interest currency will depreciate and investors will
earn the same return whether they invest in the home
country or the foreign country.
Interest rate differential (%)
% Δ in the foreign currency’s spot rate

Consider Political Risk Relationship not perfect even in the long run Holds during some time frames
Differential Tax Laws Use of inflation differentials is supported Based on PPP
Due to: confounding effects + lack of Will not hold when PPP does not hold
substitutes
Exact
Equation

Approximate
Equation

Md. Uzzal Hossain, MBA 24th Batch