Ifm- Hemant Sachan

PRESENTATION ON EXCHANGE RATE DETERMINATION THEORIES PRESENTED BY

HE MA NT SACHA N M0729 SEC- A

Introduction to Purchasing Power Parity (PPP) 

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Purchasing power parity (PPP) is a theory of exchange rate determination and a way to compare the average costs of goods and services between countries. The theory assumes that the actions of importers and exporters, motivated by cross country price differences, induces changes in the spot exchange rate. In another vein, PPP suggests that transactions on a country's current account, affect the value of the exchange rate on the foreign exchange market. This contrast with the interest rate parity theory which assumes that the actions of investors, whose transactions are recorded on the capital account, induces changes in the exchange rate. PPP theory is based on an extension and variation of the "law of one price" as applied to the aggregate economy. To explain the theory it is best, first, to review the idea behind the law of one price.

The Law of One Price (LoOP) 

The law of one price says that identical goods should sell for the same price in two separate markets when there are no transportation costs and no differential taxes applied in the two markets. Consider the following information about movie video tapes sold in the US and Mexican markets.

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The idea between the law of one price is that identical goods selling in an integrated market, where there are no transportation costs or differential taxes or subsidies, should sell at identical prices. If different prices prevailed then there would be profit-making opportunities by buying the good in the low price market and reselling it in the high price market. If entrepreneurs acted in this way, then the prices would converge to equality.

The purchasing power parity theory is really just the law of one price applied in the aggregate, but, with a slight twist added. If it makes sense from the law of one price that identical goods should sell for identical prices in different markets, then the law ought to hold for all identical goods sold in both markets. Conceptually this theory is sound. But this theory takes only the movement of goods, not that of capital. Above all this theory ignores the fact that a currency may be an instrument of payment by other counties. In this situation, the exchange rate may evolve in a manner that has nothing to do with the price levels of the country.

The PPP theory can be considered as an idle theory to determine exchange rates in specific situations, such as high inflation or monetary disturbances. In such situations, the response of individuals to changes in value of real and monetary assets can be expected to be strong and the exchange rate prediction by PPP theory may turn out to be realistic.

Interest rate parity 

The interest rate parity is the basic identity that relates interest rates and exchange rates. The identity is theoretical, and usually follows from assumptions imposed in economics models. There is evidence that supports as well as rejects interest rate parity.

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Interest rate parity is an arbitrage condition which says that the returns from borrowing in one currency, exchanging that currency for another currency and investing in interest-bearing instruments of the second currency, while simultaneously purchasing futures contracts to convert the currency back at the end of the investment period, should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency. If the returns are different, investors could theoretically arbitrage and make risk-free returns.

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According to interest rate parity the difference between the (risk free) interest rates paid on two currencies should be equal to the differences between the spot and forward rates. If interest rate parity is violated, then an arbitrage opportunity exists. The simplest example of this is what would happen if the forward rate was the same as the spot rate but the interest rates were different, then investors would: borrow in the currency with the lower rate convert the cash at spot rates enter into a forward contract to convert the cash plus the expected interest at the same rate invest the money at the higher rate convert back through the forward contract repay the principal and the interest, knowing the latter will be less than the interest received. Therefore, we can expect interest rate parity to apply. However, there is evidence of forward rate bias.

Covered interest rate parity   

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Assuming the arbitrage opportunity described above does not exist, then the relationship for US dollars and pounds sterling is: (1 + r£)/(1+r$) = (£/$f) / (£/$s) where r£ is the sterling interest rate (till the date of the forward), r$ is the dollar interest rate, £/$f is the forward sterling to dollar rate, £/$s is the spot sterling to dollar rate Unless interest rates are very high or the period considered is long, this is a very good approximation: r£ = r$ + f where f is the forward premium: (£/$f) / (£/$s) -1 The above relationship is derived from assuming that covered interest arbitrage opportunities should not last, and is therefore called covered interest rate parity.

Uncovered interest rate parity     

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Assuming uncovered interest arbitrage leads us to a slightly different relationship: r = r2 + E[ΔS] where E[ΔS] is the expected change is exchange rates. This is called uncovered interest rate parity. As the forward rate will be the market expectation of the change in rates, this is equivalent to covered interest rate parity - unless one is speculating on market expectations being wrong. The evidence on uncovered interest rate parity is mixed, but this paper finds evidence that it applies in the long term, although t .

FISHER EFFECT The FE theory suggests that foreign currencies with relatively high interest rates will depreciate because the high nominal interest rates reflect expected inflation. The nominal interest rate would also incorporate the default risk of an investment . FE uses interest rate rather than inflation rate differentials to explain why exchange rate change over time, but it is closely related to the PPP theory because interest rate are often highly correlated with inflation rate. According to the Fisher Effect, nominal risk-free interest rate contains a real rate of return and anticipated inflation. If investors of all countries require the same real return, interest rate differentials between countries may be the result of differentials in expected inflation.