Exchange Rates

B B Chakrabarti
Professor of Finance

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 INTERNATIONAL MONETARY SYSTEM
• Current international monetary system is a hybrid system.
• Major currencies float on managed basis.
• Some currencies use freely-floating method.
• Others move in and out of various types of pegged exchange
rate relationships.
• Pegging is a method of stabilizing a country's currency by
fixing its exchange rate to that of another country. Most
countries peg their exchange rates to USD.
• Visit: [Link]

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 INTERNATIONAL MONETARY SYSTEM
• Free Float: US, Canada, Brazil, Japan, UK, Australia
• Managed Float: India, Russia, Singapore, Thailand
• Exchange arrangement with no separate legal tender: Euro
zone
• Use of foreign currency: Zimbabwe, Ecuador
• Different types of pegs:
- Against a single currency: Bhutan, Nepal, UAE
- Crawling peg (currency adjusted periodically in small
amounts at a fixed preannounced rate or in response to
changes in selective quantitative indicators): Iran
• Currency Board arrangement (implicit legislative commitment
to exchange HC for a specified FC at a fixed exchange rate):
Hong Kong (USD)

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 ARBITRAGE AND THE LAW OF ONE PRICE
 Law of One Price:
- Identical goods sell for the same price worldwide.
 If the prices after exchange-rate adjustment were not equal, arbitrage for
the goods worldwide ensures that eventually they will.
 Five Parity Conditions result from these arbitrage activities

1. Purchasing Power Parity (PPP)

2. The Fisher Effect (FE)
3. The International Fisher Effect (IFE)
4. Interest Rate Parity (IRP)
5. Unbiased Forward Rate (UFR)

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 PURCHASING POWER PARITY (PPP)
 The Theory of Purchasing Power Parity states that spot
exchange rates between currencies will change to the
differential in inflation rates between countries.

 Absolute Purchasing Power Parity: Price levels adjusted for

exchange rates should be equal between countries.
 One unit of currency has same purchasing power globally.

 Relative Purchasing Power Parity states that the exchange

rate of one currency against another will adjust to reflect
changes in the price levels of the two countries

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 PURCHASING POWER PARITY
In mathematical terms:

et

ih 1  
t

e0 1  i f 
t

where et = future spot rate

e0 = spot rate
ih = home inflation
if = foreign inflation
t = the time period

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 PURCHASING POWER PARITY
• If purchasing power parity is expected to hold, then the best
prediction for the one-period spot rate should be

et  e0
1  ih  t

1  i  f
t

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 PURCHASING POWER PARITY
• A more simplified but less precise relationship is

e1  e0
 ih  i f
e0

that is, the percentage change should be approximately equal

to the inflation rate differential.

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 PURCHASING POWER PARITY
• PPP states that the currency with the higher inflation
rate is expected to depreciate relative to the currency
with the lower rate of inflation.
• Ex. Swiss Franc is selling in NY at spot $1.1024. The expected
inflation rates over the next 1 month in US and Switzerland
are 3% and 2% respectively. What is the expected exchange
rate for CHF after 1 month?
Soln.: et = 1.1024*(1+0.03/12)/(1+0.02/12) = $ 1.1033 / CHF

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 PURCHASING POWER PARITY
 Real Exchange Rates: the quoted or nominal rate adjusted for
a country’s inflation rate is:
(1  i f ) t

e '
 et
(1  ih )
t t

 If exchange rates adjust to inflation differential, PPP states that

real exchange rates stay the same.
 Ex. Over the last 1 year, USD exchange rate moved from Rs.
55.40 to 62.35. If during that period US and India inflation
rates were 2% and 8% respectively, what was the real
exchange rate?
Ans. REER = 62.35*1.02/1.08 = Rs. 58.89 / USD
This means that INR depreciated by (58.89-55.40)/55.40 =
6.30% in real terms. So, exports became more competitive and
imports more costly.
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 FISHER EFFECT (FE)
 Fischer Effect states that nominal interest rates (r) are a
function of the real interest rate (a) and a premium (i) for
inflation expectations.
r = a + i + a*i
 Real Rates of Interest should tend toward equality
everywhere through arbitrage. With no government
interference nominal rates vary by inflation differential.
rh - rf = ih - if
 According to the Fisher Effect: countries with higher inflation
rates have higher interest rates.
 Due to capital market integration globally, interest rate
differentials are eroding.
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 INTERNATIONAL FISHER EFFECT
• IFE states that the spot rate adjusts to the
interest rate differential between two
countries.
• IFE = PPP + FE

et (1  rh ) t

e0 (1  r f ) t

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 INTERNATIONAL FISHER EFFECT
 Simplified IFE equation (if rf is relatively small):

e1  e0
rh  rf 
e0

 Implications of IFE: Currency with the lower interest rate is

expected to appreciate relative to the one with a higher
rate.

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 INTEREST RATE PARITY THEORY
 IRP states that the forward rate (F) differs from the spot rate (S)
at equilibrium by an amount equal to the interest differential (rh
- rf) between two countries.

F

1  rh 

S 1  r  f

or, (F - S)/S = (rh - rf) if rf is small.

 Summary: IRP states that higher interest rates on a currency are

offset by forward discounts and lower interest rates are offset
by forward premiums

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 INTEREST RATE PARITY THEORY
• Covered Interest Arbitrage means that Funds will move to a
country with a more attractive rate.
• Conditions required: interest rate differential does not equal
the forward premium or discount.
• Ex. Suppose: Interest rates in London on GBP deposits and in
NY on USD deposits are 4% and 2% [Link] spot and
1-year forward rates in NY are
$ 1.6040 and $ 1.6018 respectively. Is there any covered
interest arbitrage?
Ans. Forward discount = (1.6018-1.6040)/1.6040 = -0.14%
Covered yield on GBP deposits = 4-0.14 = 3.86%
Funds will flow from NY to London to earn more.
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 INTEREST RATE PARITY THEORY
• Actions for covered interest arbitrage (with $ 1 mn.):

Time Actions Cash Flow

0 Borrow $1 mn. in NY at 2% + $ 1,000,0000

0 Convert USD to GBP at $ 1.6040 -$ 1,000,000

+ £ 623,441.40
0 Inv. £ amount in London at 4% - £ 623,441.40

0 Short forward £ 648379.06

(623,441.40*1.04) at $ 1.6018
1 Collect inv. in London £ 648,379.06

1 Deliver £ 648,379.06 ag. SF +$ 1,038,573.57

1 Repay $ 1,000,000 in NY - $ 1,020,000

Net Arbitrage Profit + $ 18,573.57

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 FORWARD AND THE FUTURE SPOT RATE

• The Unbiased Forward rate (UFR) states that, if

the forward rate (ft ) is unbiased, then it should reflect the
expected future spot rate (et)
• Stated as ft = et
• or, (f1 - e0)/ e0 = (e1 - e0 )/ e0

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 Parity Relationships

FE
Difference in Interest Difference in Inflation
Rates Rates
IFE

PPP
IRP

Difference between Expected Change in

Spot and Forward Spot rates
UFR
Rates

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 CURRENCY FORECASTING
• Forecasting Models created to forecast exchange
rates in addition to parity conditions.

• Two types of forecast:

1. Market-based
2. Model-based

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 CURRENCY FORECASTING
 Market based forecasts derived from market indicators.
- The current forward rate contains implicit information about
exchange rate changes for one year.
- Interest rate differentials may be used to predict exchange rates
beyond one year.
 Model based forecasts include fundamental and technical
analysis.
- Fundamental relies on key macroeconomic variables and
policies which most like affect exchange rates.
- Technical relies on use of historical volume and price data.
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