Assignment 2 (Theories of Exchange Rates - PPP, IFE, IRP)
Assignment 2 (Theories of Exchange Rates - PPP, IFE, IRP)
Assignment 2 (Theories of Exchange Rates - PPP, IFE, IRP)
Management
Assignment 2
Submitted by:-
Sruthi Ramachandran
b2356
Introduction
Changes in exchange rates may affect the relative position of a country in the
international trade. The percentage change in the value of the foreign currency
is computed as follows:
Fixed Rate (gold/other precious metals and each unit of the currency
corresponds to a fixed quantity of that standard)
Floating Rate (indicates that each currency need not be compulsorily backed by
a resource. Current international market rates are determined by this rate which
majorly depends on actions of its Government/Central Bank.)
For example, the relatively high U.S. inflation causes the U.S. consumers to
increase imports from the United Kingdom and British consumers are ought to
lower their demand for U.S. goods. Such forces place upward pressure on the
British pound’s value. The shifting in consumption from the United States to the
United Kingdom will continue until the British pound’s value has appreciated to
the extent that (1) the prices paid for British goods by U.S. consumers are no
lower than the prices for comparable products made in the United States and (2)
the prices paid for U.S. goods by British consumers are not higher than the
prices for comparable products made in the United Kingdom.
Here ef is the percentage change, Ih is the interest rate on the home deposit and If
is the interest rate on foreign deposit..
Even though exchange rates deviate from the levels predicted by PPP in the
short run, their deviations are reduced over the long run.
The IRP Theory indicates the existence of a link between the nominal interest
rates in two countries and exchange rate between their currencies. It follows
certain assumptions as under:
1) The transaction costs related to conversion of a currency in to another/selling or
buying of a financial security are zero.
2) The cash flow between different countries is free and there is full mobility of
capital.
3) An investor may choose to invest in financial securities, denominated in one’s
home currency or to invest in financial securities that are denominated in
foreign currency.
Understanding forward rates is fundamental to IRP as it pertains to arbitrage.
For example, if the spot rate for 1 USD= 1.065 Canadian Dollars, the forward
rate could be computed as follows:-
1USD=1.065*[(1+3.64%)/ (1+3.15%)]= 1.0700 CAD
Here,
(1USD = forward rate, 1.065 = spot rate, 3.64% = interest rate of overseas
country and 3.15 = interest rate of domestic country.)
The difference between spot rate and forward rate is known as swap points.
Here the swap points equal to 50. If the difference is positive, it is called
forward premium; a negative difference results in a forward discount.
The international Fisher effect uses interest rates to explain why exchange rates
change over time, but it is closely related to the PPP theory because interest
rates are often highly correlated with inflation rates. If investors of all countries
require the same real return, interest rate differentials between countries may be
the result of differentials in expected inflation.
The IFE theory suggests that foreign currencies with relatively high interest
rates will depreciate because the high nominal interest rates reflect expected
inflation. The foreign investors will be adversely affected by the effects of a
relatively high U.S. inflation rate if they try to capitalize on the high U.S.
interest rates. The IFE theory can be applied to any exchange rate, even
exchange rates that involve two non-U.S. currencies. According to the IFE, the
effective return on a foreign investment should, on average be equal to the
interest rate on a local money market investment:
where r is the effective return on the foreign deposit and ih is the interest rate on
the home deposit.
We can also determine the degree by which the foreign currency must change in
order to make investments in both countries generate similar returns by the
formula:
The IFE theory contends that when ih> if , ef will be positive because the
relatively low foreign interest rate reflects relatively low inflationary
expectations in the foreign country. That is, the foreign currency will appreciate
when the foreign interest rate is lower than the home interest rate. This
appreciation will improve the foreign return to investors from the home country,
making returns on foreign securities similar to returns on home securities.