FOREIGN EXCHANGE AND RISK

MANAGEMENT-2 Determinants of Exchange

Rate

BBA 4 YEARS
8TH SEMESTER

HAILEY COLLEGE OF BANKING AND

FINANCE,
UNIVERSITY OF THE PUNJAB LAHORE

SLIDES PREPARED BY: DR JAMIL AHMAD KHAN AIBP,

ASSOCIATE OF CHARTER BANKER UK

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 EXCHANGE RATE THEORIES
 INTRODUCTION:
 These are also known as Determinants of Exchange
Rate
 For determining the par values of different currencies,
some of the theories are as unde;

 1-The Purchasing Power Parity Theory

 2-Mint Parutt Theory
 3-The Balance of Payment Theory
 4-Interest Rate Parity Theory
 5-Fishers Effect’s Theory
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 1-The Purchasing Power Parity Theory
It was propounded by Professor Gustav Cassel of
Sweden in 1920
The Theory explains the relationship between
inflation and exchange rate.
The basic theme of this theory is to determine the
exchange rate between two currencies by
equating purchasing power of inconvertible paper
currencies prevailing in the two respective
countries.

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The Value of one country’s currency is calculated
in terms of other country’s currency on the basis
of purchasing power of the respective currency.
The purchasing power of currency can be known
by the quantity of money required to purchase a
commodity.

So, according to the PPP theory, the rate

determined by knowing the amount of currency
required to buy a common commodity in the two
countries

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Example:
-Take two countries for instance Pakistan and
USA
-Common commodity is 10 gram of gold
-Now, if the price of 10 gram of gold in Pakistan is
Rs 150000 and in USA the price of 10 gram gold
is $ 530 then exchange rate will be;
Rs 150000/530=Rs 283.0189
-Thus,1$= Rs 283.0189
It means 283.0189 Pakistani rupees equal to one
USD

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- If due to inflation, exchange rate varies from rare
of PPP then increase or decrease brought in
demand of gold automatically will set the
exchange rate as per PPP theory or
We can say that Arbitrage process will set the
exchange rate as per PPP theory

There are Two Forms of Purchasing Power

Theory:
1-Absolute Purchasing Power Parity
2-Relative Purchasing Power Parity

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1Absolute Purchasing Power Parity
The absolute PPP theory postulates that the
equilibrium exchange rate between currencies of
two countries is equal to the ratio of the price
levels in the two nations.

2-Relative Purchasing Power Parity

The relative form of PPP theory is an alternative
version which postulates that the change in the
exchange rate over a period of time should be
proportion to the relative change in the price
levels in the two nations over the same time
period
7
 Criticism on Purchasing Power Parity
Theory
-Prices of all commodities never move uniformly.
Prices of some connodites rise or fall much more
than the others.
-No such direct and precise link between the
two; exchange rate and purchasing power of
currencies. Many other factors apart from
purchasing power of currencies such as tariff,
speculations, capital flows etc which significantly
affect the rate of exchange.

8
-Many goods which may enter in domestic trade,
may not figure in international trade.
-Internationally traded goods also may not have
the same prices in all the markets because of
difference in transport costs.

-It unrealistically assume that exchange rate to be

a passive variable.The theory assume that the
changes in the price levels could bring about
changes in exchange rate and not vice versa,
that the changes in exchange rate cannot affect
the domestic

9
price levels of the currencies concerned. It is not
correct.
-It fails to take into consideration any items in the
balance of payment other than mercantile trade. It
means the Purchasing Power Parity Theory
applies at the best only at Current Account
transactions, neglecting Capital Account
completely.

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Interest Rate Parity Theory
 The interest Rate Parity Theory governs the
relationship between exchange rate and interes
rates of two countries.
 This theory states that the difference between

the forward and spot exchange rates is

equivalent to the difference in interest rates
between the two countries.
 interes rate parity is notion of no arbitrage in the

foreign exchange markets(simultaneous

purchase and sale of an asset to earn profit from
a difference in the price)

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Investors cannot seek to make profit from the
difference between interest rates using foreign
exchange as an asset or a way to invest

That is why it is also known as asset approach to

foreign exchange determination.
Forward premium or forward discount will play a
major role

The Theory stresses on the fact that the size of

forward premium or discount on foreign currency
is equal to;

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Interest Rate Parity Theory
 the difference between the forward and spot
interest rates of the countries in comparison
 For example : Consider an investor of USA

having 1000 Euro with following information to

invest in domestic or international market;
 -ROI domestic market is 3%
 -ROI international market 5%
 -Forward Rate=1.201176
 -Spot rate=1.2245
 -Thus there are two options for the investor;

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Interest Rate Parity Theory
 1- Option Fist; The investor may invest in
domestic market(in USA)
 Then let take the spot exchange rate be

$1.2245/1Euro so we practically get in

exchange;
 Euro 1000@ $1.2245= $1224.50
 -When invested this money in domestic market

in dollars at 3% then after one year we get

interest of; $ 1224.50@3%=36.735
 So after one year we have $
36.735+1224.5=1261.235

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Interest Rate Parity Theory
 2-Option Second:
 The investor may take second option of

investing 1000 Euro in international market

then;
 Where the interest rate is 5% per year or per

annum
 So we get interest after one year as under;
 Euro 1000@5@=Euro1000*5/100=Euro 50

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Interest Rate Parity Theory
 -Let the forward exchange rate be
$1.201176/1Euro
 So we buy the forward for one year in future

exchange rate at $1.201176/1Euro

 Since we need to convert Euro 1050 back to the

domestic currency i.e. in US dollar

 Then, we can convert Euro in the US dollar

1050@$1.201175=$ 1261.235
 Thus, no arbitrage profit i.e home investment

and international investment, the return are

equal i.e $ 1261.235

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Interest Rate Parity Theory
- Thus, when there is no arbitrage, the return on
investment(ROI) is equal in both the options
regardless of the choice of investment method
 Formula For Interest Rate Parity Theory is as

under;
 F=S*(1+id)/(1+if)
 Where F denotes forward exchange rate, S

denotes Spot exchange rate,’id’ denotes interest

rate of domestiv or home currency and ‘if’
denotes interest rate of foreign currency .

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Fisher’s Effect Theory

 1-Fisher;s Effect

 The Fisher;s Effect is an Economic Theory, built

by the Economist Irving Fisher

 that describes the relationship between inflation

and interest ( both nominal and real interest)



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Fisher’s Effect Theory
 In an economy, the relationship between the
nominal interest rate, real interest rate and
inflation is known as Fisher's; Effect.
 2-Nominal interest Rate and Real Interest Rate
 Nominal Interest Rate
 It represents the financial returns that a
person receives/pays when he/she
deposits/borrows money in/from a bank etc.

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Fisher’s Effect Theory

 -A bank offers 15% interest on saving bank

deposit which is nominal interest rate

 It suggests that an individual will get an extra

15% on money that he/she has deposit in the
bank
 -
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Fisher’s Effect Theory
 -Real Interest Rate
 -The real interest rate is the inflation adjusted

nominal interest rate

 The Fisher’s Effect states that the real interest

rate is equal to the nominal interest rat minus the

expected inflation rate. i.e.
 Real Interest Rate=Nominal interest Rate- inflation

rate
 or
 Nominal Interest rate=real interest rate+inflation
rate
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Fisher’s Effect Theory
 -It states that the nominal interest rate in an
economy, is equal to sum of the real rate of
return and the inflation rate.We can express it
as;
 ( 1+i)=(1+r)(1+inflation)
 Where i=nominal interest rate and r=real interest

rate
 For Example: If the nominal interest rate on a

bank fixed dsposit is 12% and the expected rate

of inflation is 8% then;

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Fisher’s Effect Theory
 -the real rate of return is 4% or 3.70
 1+12%=(1+r)(1+8%)
 Or 1+12/100)=1+r)(1+8/100)
 Or (1+0.12)=(1+r)(1+0.08)
 Or 1.12=(1+r)(1.08) Or 1+r=1.12/1.08
 Or 1+r=1.037037 Or r=1.037037-1
 Or r=0.037037
 Or r=3.70%
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-It mean the money in the bank is growing in the
saving account is really growing at rate of 4% or
3.70%
 International Fisher’s Effect
 In the Currency Markets, the Fisher’s Effect is
called the International Fisher’s Effect(IFE) and
it is used in Forex trading and analysis

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 -The IFE is based on the assumption that real
interest rates for the securities with similar risk is
same all over the world. It describes the
relationship the ;
 that the nominal interest rates in two countries

and the spot exchange rates for their

currencies.

 The IFE says that the interest rate differential

between two countries should be equal to;
 the expected inflation rate differential
over the term of the interest rate

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International Fishera;s Effect Theory
 -It states the movement in the
 exchange rate of two currencies is proportional

to the difference in their nominal interest rates

 This equation can also be used to determine the

reqyured nominal interest rate return that will

help the investors to achieve their goals.
 -For Example: An investment in the foreign debt

of a country is concsidered risk free and offer a

yield of 2$ over one year.
 Assume that the inflation in that country is 3%

per year and bunines needs to purchase

goods that are of worth $100 today
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- Since the inflation was 3%, that goods are now
worth $103
-They invest their cash in government debt that
means they get $102 in one year.
Hence, there is a shortfall of $1.

Formula For International Fisher’s Effect

Theory is as under;

1+ia/1+ra=1+ib/1+rb where ‘a’ and ‘b’ are two

contrives with i= interest rate and r= inflation rate

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