Theories of exchange rate

The PPP theory

The Purchasing Power Parity theory was put forwarded by Gustav Cassel, a Swedish economist, through his article Abnormal Deviations in International exchange , published in Economic Journal, December 1918. The theory states that the rate of exchange between any two currencies is determined by their purchasing power The purchasing power of a currency is equivalent to the amount of goods and services that can be purchased with one unit of that currency

Ex:

if in USA 1$ = 1kg Apple in India Rs 60= 1kg Apple then the exchange rate will be 1$ = Rs 60

Ex: if a commodity costs Rs90 - in India 2$ - in USA Then the exchange rate will be 1$ = Rs 45

Assumptions
Law of one price Free role of arbitrageurs Unrestricted movement of goods or financial assets

Law of one price

The law of one price states that the price of a commodity shall be the same in two markets, else arbitrage opportunity opens up. Ex: suppose the cost of Apple laptop in India- Rs 40,000 in USA -1000$ (1$=Rs40) If 1$=Rs44 So, in India cost of laptop is Rs 40000 instead of Rs44,000. People will buy from India sell it in USA. This price is known as cross border arbitrage

Formula: (considering US$) Law of One Price = US$ price of a commodity X the exchange rate= Rupee price of the
commodity

Ex: suppose a cricket bat costs AUD32.00 in Canberra's/AUD=Rs29.50 As per the law of one price, the Indian price for the same quality bat= 32$XRs29.50=Rs.944 Suppose the cost of the cricket bat in India is Rs885. So, the arbitrageur will buy in India at Rs.885(Rs885/29.50=30AU$) and sell at 32$. Profit=2 $

The PPP Theory has two versions 1. Absolute version 2. Relative version 1. Absolute version: It states that the price of identical basket of goods in one economy should be equal to the other basket of goods in other economy. In other words the ratio between the domestic price index and foreign price index is the exchange rate in case of the Absolute version of the PPP theory Formula: Eo=Ph/Pf Where, Eo= current exchange rate Ph= price index/price level in the home country Pf= price index/price level in the foreign country Where, Price level means one has to weight the price of each commodity by its share in the total consumption basket in the country.

Example: Explain on the basis of the following data: whether a) Law of one price holds good b) Absolute version of PPP theory holds good USA India
Goods Rice Wheat Unit 4 20 US$ Price/Unit 1 2 Goods Rice Wheat Unit 20 10 Rs. Price/Unit 40 80

Exchange rate Rs.40/US$

a) Law of One Price = US$ price of a commodity X the exchange rate= Rupee price of the Commodity For Rice: 1$ X 40 = Rs. 40 For Wheat: 2$ X 40 = Rs. 80 So, the law of one price holds good b) Goods Unit US$ Value(Unit
Price/Unit Rice Wheat Total 4 20 1 2 * Price) 4 40 44

Weight Value/Total Consumption 0.0909 0.9091 1

Price level in USA =1$ X 0.0909 + 2$ X 0.9091 = $ 1.9091

Goods

Unit

Rs. Price/Unit

Value(Unit* Price)

Weight Value/Total Consumptio n 0.5 0.5 1

Rice Wheat Total

20 10

40 80

800 800 1600

Price level in India = Rs.40X 0.5 + Rs.80 X 0.5 = Rs.60 Eo = Ph/Pf = Rs.60/1.9091 = Rs.31.43/US$ ( Given exchage rate Rs.40/US$) So, the absolute version of PPP theory does not hold good as the weight of the two commodities in total consumption basket in the two countries is different.

Limitation: The Absolute version holds good if the same commodities are included in the same proportion in the domestic market and the world market basket. If it is not, PPP theory will not hold good despite the law of one price holding good. This theory does not cover the non-traded goods and services where transaction cost is significant

Relative version
According to this version of the PPP Theory, one of the factors leading to change in exchange rates between currencies is inflation in the respective countries. Higher inflation currency rate depreciates Lower inflation currency rate appreciates It states that a change in exchange rate that would retain the original level of relative price of tradable to non tradable goods in the economy, would establish an equilibrium exchange rate. It also states that percentage change in exchange rate should equal the percentage change in the ratio of price indices prevailing in them. Symbolically, et/ eo -1= (1+Ih/1+If )t- 1

Where, e o =Spot exchange rate e t = spot exchange rate after period t et/ eo -1= percentage change in exchange rate ( Exchange rate differential) I h= rate of inflation in home country I f= rate of inflation in foreign country (1+Ih/1+If )t- 1= percentage change in the ratio of price indices ( inflation rate differential) So, it can be said that, e t= e o (1+Ih/1+If)t

Q1. the inflation rate in India & USA is expected to be 9.5% and 4% respectively. The current exchange rate is Rs.42/US$, what should be the exchange rate after one year? Predict that PPP theory hold good in the above problem. Q2.The current exchange rate isRs.43.35/US$. Inflation rate in India & USA are expected to be 7% and 3% respectively over the next 2 years. What would be the dollar rupee exchange rate after 2 years?

Ans1.

e t= e o (1+Ih/1+If)t
e t= 42(1+0.095)/(1+0.04) = 44.22 Exchange rate differential= (e t/e o)-1 = (44.22/42)-1 = 0.0528 Inflation rate differential = (1+I h/1+I f)-1 = (1+0.095)/(1+0.04)-1 = 0.0528 So, PPP theory theory holds good.

Ans.2 e t= e o (1+Ih/1+If)t One way: =43.35[(1+0.07)2/(1+0.03)2] =46.77 Another way: =43.35(1+0.07)/(1+0.03) = 45.033(after one year) = 45.033(1+0.07)/(1+0.03) = 46.77(after second year)

Limitations: If the difference of inflation rate between the two countries is small, its effect on competitiveness may be offset by other factors, such as balance of payments, development in real income, interest rate differential, etc. as a result, comparison of inflation rates may not explain changes in exchange rates. The theory is not applicable from the long run perspective.

Interest Rate Parity Theory

The interest rates prevailing in two countries affect the exchange rate between the currencies of those countries. For example, the interest rates ruling in India and in USA will drive the exchange rate between $ and Rupee. The IRP theory tries to explain how the exchange rate in the forward market is determined. The forward exchange rate may be at a premium or a discount to the spot exchange rate. How is the forward rate differential determined. The IRP theory postulates that the forward rate differential in the exchange rate of two currencies would equal the interest rate differential between the two countries. In an efficient market, if the interest rates in two countries are different, the exchange rates between the two countries will move in such a way as to bring about PARITY in interest rates, offsetting the apparent interest rate differentials, thereby denying any arbitrage opportunity.

Mathematically the relationship can be expressed as,

(F/S)-1=[(1+rh)t/(1+rf)t]-1 Where, F= forward exchange rate for a specified future period S= spot exchange rate rh= nominal interest rate on a security with a maturity equal to that of the forward exchange rate and denominated in the domestic currency rf= nominal interest rate on a security with a maturity equal to that of the forward exchange rate and denominated in the foreign currency (F/S)-1= forward rate differential [(1+rh)t/(1+rf)t]-1= interest rate differential The above equation also helps in determining the forward exchange rate, (F/S)-1=[(1+rh)t/(1+rf)t]-1 (F/S)= [(1+rh)t/(1+rf)t] F = S X [( 1+rh)t/(1+rf)t]

Example: let us consider a situation where the interest rates in India and the USA are, respectively, 10% and 6% and the dollar-rupee spot exchange rate is Rs.42.50/US$. Calculate the 90 day forward exchange rate Interest rate differential Forward rate differential

Ans: a)F = S X [( 1+rh)t/(1+rf)t] = 42.50(1+(0.10/4))/(1+(0.06/4)) = 42.50(1.025/1.015) = 42.50 X 1.01 = Rs. 42.9250 b) forward rate differential =(F/S)-1 =(42.9250/42.50)-1 = 0.01 or 1% c) interest rate differential = [(1+rh)t/(1+rf)t]-1 = [(1+(0.10/4))/(1+(0.06/4))-1 = (1.025/1.015)-1 = 1.01-1 = 0.01 or 1%

If there is no parity between the forward rate differential and interest rate differential opportunities for arbitrage will arise. Arbitrageurs will move funds from one country to another for taking advantage of the disparity. In an efficient market, with free flow of capital and negligible transaction cost, continuous arbitrage will soon restore parity between the forward rate differential and interest rate differential. This type of arbitrage is known as COVERED INTEREST ARBITRAGE.

EX: Let us assume that the interest rates in India and the USA are 12% and 4%, respectively, and the dollar-rupee exchange rates are Rs.42.50/US$(Spot rate) and Rs.43.00/US$ (90 day forward rate. Calculate the forward rate differential and the interest rate differential

 forward rate differential =(F/S)-1 =(43.00-42.50)/42.50 = 0.01176 or 1.176% interest rate differential = [(1+rh)t/(1+rf)t]-1 = [(1+(0.12/4))/(1+(0.04/4))-1 = (1.03/1.01)-1 = 0.0198 or 1.98% Here, there is a disparity and the interest rate differential is higher than the forward rate differential. And so, funds will move from USA to India to take advantage of the higher interest rate in India. The arbitrage process will take place.

Step 1- borrow 1000 US$ in the USA for a three month period at the interest rate prevailing there, namely,4%. Step 2- convert the US dollars in to Rupees at the spot exchange rate(Rs.42.50) to get Rs42,500. Step 3- invest Rs. 42,500 for a three month period in India at the interest rate prevailing in India, namely 12%. Step 4- buy US dollars in the forward market at the 90 day forward exchange rate of Rs.43.00/USD so as to convert the rupee investment into dollars after three months.

After three months, the arbitrage process will be completed through the following steps: Liquidate the rupee investment to get Rs 43,775(Rs.42,500+1275 interest) Buy US dollars as per the forward contract and thus convert Rs.43,775 in US dollars at Rs.43/US$ and receive US $ 1018. Repay the US loan with interest by paying US$ 1010($1000+$10 interest) The arbitrage profit amounts to $8.

The arbitrage will continue, and has the following impact on the interest rates and the exchange rates. Borrowing more in the USA will raise the interest rate there. Investing larger funds in India will lower the interest rate in India. Consequently, the interest rate differential will narrow. Selling dollars at the spot rate will lower the spot exchange rate. Buying dollars in the forward market at the forward rate will raise the forward exchange rate. As a result the forward rate differential will widen If this will continue after some time forward rate differential will equal to interest rate differential & there will be no scope for arbitrage

Q. Rf in Japan is 6%p.a., while that in India is 3% p.a. spot Rupee Yen is 0.4002 and the twelve month Yen rate is 0.388874. you wish to invest Rs.100000 in risk free investments for one year. Will you invest the sum of Rs.100000 in India or convert it into Yen and invest in Japan Data same as above except that you have 100000 yen. Would you invest in India or in Japan?

 Step-1 invest Rs.100000 in India for one year at 3%. Principal and interest at the end of one year would be Rs.103000(Rs.100000 X 103/100) Step-2 alternatively convert Rs.100000 in to yen today. The relevant rate is the spot rate for yen, namely 0.4002 per yen. For Rs.100000 you will get 100000/0.4002=249875 Yen Step-3 Invest these funds( yen 249875) for one year at 6%. Principal and interest at the end of one year would be Yen 264868(249875 X 106/100) Step-4 To eliminate exchange rate risk, you can sell yen forward. The relevant rate will be one year forward rate, namely, Rs0.388874 per yen. This is yen 264868 can be converted in to 264868X 0.388874=Rs 103000 this is the same, as the figure arrived at, in step 1.

You have 100000 yen. Step 1- invest 100000 Yen in Japan for one year at 6%. Principal and interest at the end of one year would be (100000 X 106/100) 106000 Yen. Step 2- alternatively convert 100000 yen into Rs today. The relevant rate is the spot rate, namely, Rs 0.4002 per Yen. For 100000 yen you will get (100000yen X 0.4002)Rs.40020 Invest these funds (Rs40020) for one year at 3%. Principal and interest at the end of one year would be Rs 41220.60 this money is to be converted back to yen. To eliminate exchange rate risk, you can buy forward. The relevant rate will be one year forward rate namely 0.388874. Rs.41220.60/0.388874=106000. This is the same as the figure arrived at in step1.

 forward rate differential =(F/S)-1 (0.388874/0.4002)-1 = -0.02832 interest rate differential = [(1+rh)t/(1+rf)t]-1 [(1+0.03)/(1+0.06)]-1 = - 0.02832 As the forward rate differential and interest rate differential are same by satisfying the IRP theory there is no scope for arbitrage in the above mentioned problem.

Q.Interest rate in India & USA is respectively 6% & 5%p.a. spot exchange rate at present is Rs.42.32/US$. Because of higher interest rate in India the arbitrageur are tempted to make investment in Rupees market, but by the time there investment matures the Rupees value depreciated to Rs.45.20/USD. Show the procedure of uncovered interest rate arbitrage.

 Take a loan of 100000$ from USA @5%p.a Convert 100000$ into Indian Rupees at the spot exchange rate Rs42.32/US$ and get Rs.4232000 Invest Rs4232000 in India @6%p.a for 1 year. After 1 year in India the liquidate amount will be (4232000 X 106/100) 4485920 Convert Rs4485920 @ spot exchange rate after one year @45.20/US$ Rs.4485920/45.20=99246 $ Repay the loan amount (100000$ X 105/100)i.e. 105000$ Hence you suffer a loss of (105000$-99246$) 5754$

 Under this type of situations, arbitrageurs will take back their investment out of Rupee market for fear of lower return in terms of US$. This is a situation of Uncovered Interest Arbitrage.

Difference between Covered Interest Arbitrage & Uncovered Interest Arbitrage

Covered interest arbitrage Here the arbitrageur takes the advantage of forward market Here the decision is made upon the forward rate Here the forex risk is eliminated Uncovered interest Arbitrage Here the arbitrageur does not take the advantage of forward market Here the decision behind profit making depends upon the expectation about the future spot rate Incapable to eliminate the forex risk

Fisher Effect theory

The Fisher effect deals with the phenomenon of varying interest rates in different countries. Interest is essentially the reward for waiting. Assuming that there is an international mobility of funds or facility for free flow of funds across nations, the interest rates in different countries would be the same. Or else, arbitrage in the form of international capital flows will begin and continue till parity is established between the interest rates across countries.

 Interest is an accretion or addition to the investment or wealth of the investor, but the value of this accretion may be eroded if there is inflation during the period of investment. Ex: if the interest rate is 8% for one year period and the rate of inflation during the same period is also 8%, there is no net increase in the wealth of the investor. Thus the value of interest gets eroded to the extent of inflation in the economy. Fisher makes a distinction between the two rates of interest, namely the real interest rate and the nominal interest rate.

 The real interest rate is the rate of interest required by the investor as reward for waiting. When there is inflation, the value of interest would erode. The interest rate, therefore, needs to be adjusted upwards to compensate for the erosion in value on account of inflation. Such adjusted interest rate is known as the nominal interest rate. In other words, nominal interest rate is the required real rate of return on investment plus the expected rate of inflation. Countries experiencing higher inflation rate would have higher nominal interest rates and vice versa. Thus, the varying interest rates in different countries are due to the inflation rate differential between the countries.

 So we can say that the relationship between the interest rate & inflation rate is known as the fisher effect. Mathematically, 1+r = (1+a) (1+i) or r = (1+a) (1+i) -1 Where, r = Nominal interest rate a = required real interest rate I = expected rate of inflation

Q. If Real interest rate is 5% and the inflation rate is 8%, what would be the nominal interest rate? r = (1+a) (1+i) -1 = (1+0.05) (1+0.08) 1 = 1.05 X 1.08 1= 0.134 0r 13.4% Q. Find the real interest rate if nominal interest rate is 10% and rate of inflation is 4% ? Q. Find the rate of inflation if nominal and real interest rates are respectively 15% and 5% ?

 The Fisher effect explains the interest rate variations across countries as the effect of inflation rate differentials between countries. So the interest rate differential between any two countries equals the inflation rate differential between these two countries. Mathematically it can be expressed as, (1+rh/1+rf) 1 = (1+ih/1+if) -1 (1+rh/1+rf) = (1+ih/1+if)

q. The inflation rates in India and the USA are expected to average 6.5% and 4% over the year, respectively. The nominal interest rate in India is 11.75%. What would be the nominal interest rate in the USA? (1+rh/1+rf) = (1+ih/1+if) (1+0.1175/1+rf) = (1+0.065/1+0.04) (1+0.1175/1+rf) =1.0240 1+rf = (1+0.1175)/ 1.0240 rf =1.09131 - 1 = 9.131%

Q. If the rate of inflation in India & USA is 7% and 4% respectively and if interest rate in USA is 6%. Find the interest rate in India.

The International Fisher Effect Theory

According to the PPP theory the exchange rate between two currencies changes to reflect the inflation rate differential between the two countries, where as the fisher effect states that the interest rate differential between two countries equals the inflation rate differential between these two countries. On considering the above two theories together, it may be concluded that the exchange rate movement equals the interest rate differential between the countries concerned. This proposition is known as Fisher s open proposition or the International

Fisher Effect theory.

 PPP Theory
exchange rate differential = inflation rate differential et/ eo -1= (1+ih/1+if )t- 1 et/ eo = (1+ih/1+if )t Fisher Effect theory (1+rh/1+rf) 1 = (1+ih/1+if) -1 (1+rh/1+rf) = (1+ih/1+if) International Fisher Effect theory et/ eo = (1+rh/1+rf)

Q1. If the interest rate in India is expected as 9.5% against the interest rate of 4% in the USA, what would be the dollar-rupee exchange rate after one year, given that the current exchange rate is 1USD=Rs42. Q2. The inflation rates in India and the USA over the year are expected to be 6.5% and 3% respectively. The current dollar-rupee exchange rate is Rs42.50/USD. The interest is likely to be 4% in the USA. What would be the expected nominal interest rate at the year end?

Sol1. et/ eo = (1+rh/1+rf) et = eo (1+rh/1+rf) = 42(1.095/1.04) = 42 X 1.0529 = 44.2218 Sol 2. et/ eo = (1+ih/1+if )t et = eo(1+ih/1+if )t = 42.50(1.065/1.03) = 42.50 X 1.034=Rs 43.9450 et/ eo = (1+rh/1+rf) 43.9450/42.50 =(1+rh/1+0.04) (1.034) X (1.04) -1 = rh rh = 1.07536-1 =0.07536 = 7.536%