Amity Business School
International Financial and Forex Management
EXCHANGE RATE DETERMINATION
➢ The exchange rate between two currencies in a floating rate regime is determined by the interplay of
demand & supply forces.
➢ The demand for foreign currency comes from individuals & firms who have to make payments in
foreign currency mostly on account of imports of goods & services and purchase of securities.
➢ The supply of foreign exchange results from the receipts of foreign currency normally on account of
exports or sale of financial securities.
Factors Determining the Spot Exchange Rate
The rate of exchange in the market is the outcome of the combined effect of multiple of factors constantly at play. The
Economic factors are better guides in the long run.
Factors
Balance of Economic &
Monetary Factors Market Factors
Payment Political Factors
Inflation, Interest National Income, Psychological
Rate, Money Resource Factors,
Supply, Capital Discovery, Speculation,
Movements Political Factors Technical Factors
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Theories on Exchange Rate Determination
PURCHASE POWER PARITY THEORY
This theory holds that the exchange rate between two
currencies is determined by the relative purchasing Purchasing power parity (PPP) is a theory which states
power as reflected in the price levels expressed in that exchange rates between currencies are in equilibrium
domestic currencies in the two countries concerned. when their purchasing power is same in each of the two
countries
Changes in the exchange rates are explained by
relative changes in the purchasing power of the
currencies caused by inflation in the respective
countries
This means that the exchange rate between two
countries should equal the ratio of the two countries'
price level of a fixed basket of goods and services.
When a country's domestic price level is increasing
(i.e., a country experiences inflation), that country's
exchange rate must depreciated
PURCHASE POWER PARITY THEORY
This theory is enunciated by prof. Gustav Cassel. According to him ,the Rate of Exchange between
two countries on inconvertible paper currency standard is determined by the purchasing power parity
of there currency.
Therefore, the theory suggests that at any given time, the rate of exchange between two currencies is
determined by there purchasing power
i.e., if e is the exchange rate and Pa & Pb are the purchasing power of two currencies, a & b then as an
equation it can be
e = Pa/Pb
A country experiencing high rate of inflation will experience a corresponding depreciation of its
currency, while a country with low inflation rate will experience an appreciation in the value of its
currency.
Absolute Version of PPP
The absolute version is based on the Law of one price. This law states that under Free Market conditions with
the absence of transportation costs, tariffs and other frictions of Free trade, the price for identical goods should
be the same at any market when measured in a common currency.
The law of one price relates to a single product, PPP theory does not confine to a Single products. Instead of
single commodity, we consider a basket comprising a variety of products.
𝑃𝑑
Symbolically PPP absolute version can be stated as 𝐸 =
𝑃𝑓
CPI Basket in USA = $1250
CPI Basket in India = ₹90,000
The exchange Rate between USA & India is ₹90,000/$1250 = ₹72.00 as per the Absolute version of PPP
If inflation of one country causes a temporary deviation from the equilibrium , arbitrageurs will
begin operating and as a result, equilibrium will be restored through changes in exchange rate.
Thus, if the Indian commodity turns costlier ,its export will fall. At the same time, the import
price being cheaper ,its import from the foreign will expand. Higher imports will raise the
demand for foreign currency in turn raising its value vis-à-vis the rupee.
This version of PPP theory is the Absolute version , it hold good only when the same
commodities are included in the domestic market basket &world market basket.
RELATIVE VERSION OF PPP THEORY
The Relative version states that the exchange rate between currencies of any two countries should be
a constant multiple of the general price indices prevailing in them. Therefore, it indicate that
percentage change in exchange rate should be equal to the percentage change in the ratio of price
indices in the two countries. e.g., if the current exchange rate is ₹ 70.92/US$ and the rate of inflation
is 7% in India & 4% in USA then the exchange rate will be
(1+.07)/(1+.04)* 70.92 = ₹ 72.97
Therefore, the purchasing power parity is never constant but keeps on changing according to the change in the
price level of the two countries.
In short period the rate of exchange between the two countries can be either more or less than the
purchasing power parity. But in the long period the rate of exchange between the two countries is
determined by the purchasing power parity.
Two Types of Exchange Rate
1. Nominal Exchange Rate
2. Real Exchange Rate
Nominal Exchange Rate is a bilateral exchange rate, and it represent the ratio between the value of two
currencies at a particular point of time
𝑃
Real Exchange rate is the price adjusted nominal exchange rate and it is represented as: E =
𝑃∗
P = Price Index of Domestic Country
P* Price Index of Foreign Country
Note : In floating exchange rate Regime, the nominal exchange rate moves automatically with
a change in the price. But in fixed rate regime it does not happens as the rate is administered.
Therefore, there is a gap between the Real and the Nominal Rate.
CPI Basket in USA = $1250
CPI Basket in India = ₹90,000
The exchange Rate between USA & India is ₹90,000/$1250 = ₹72.00 as per the Absolute version of PPP
Suppose the actual Exchange rate prevailing is ₹75. It means the actual exchange Rate is higher than the exchange rate as
per PPP. Which denotes the basket is cheap in India and if this happens arbitrage process will start to restore the
equilibrium position.
WHY DOES PPP THEORY NOT HOLD?
1. The rate of exchange is also influenced by some more factor i.e., interest rate, governmental interference etc beside
inflation.
2. When no domestic substitute to an import is available the material is imported even after the price is going high.
3. Nontraded items such as immovable goods (e.g., land and building etc) highly perishable commodities e.g., milk
vegetable)and hospitability services may cause departures from PPP as they cannot be moved from one country to another
to cash in on price differential between the countries.
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Question on Real & Nominal Exchange Rate
Q. The Consumer price Index in India rose from 200 to 216 over the period 1 January to 31 December and
the US Consumer price Index is moved from 100 to 105 over the same period. The exchange Rate between
the USD and INR on January 1 was INR 44, what should be the exchange rate between the Indian Rupee
and the USD on December 31?
Q. The administered exchange rate in India was ₹7.91/$ during 1981-90. The price Index in India and the
USA is rose by 67% and 26% respectively. Calculate whether there was any change in real exchange rate
during the period.
Q. If Exchange Rate at the end of the 2019-2020 is ₹65.22/$ and if the rate of inflation in India is 8% and
inflation in USA is 5% during the year 2020-2021. Calculate
i.Inflation rate differential
ii.Exchange rate at the end of 2020-2021
Q. The spot exchange rate between Indian Rupee and US dollar in 2000 was ₹55/$ when the price index
in both the countries were 100. By 2024 Rupee was Depreciated to ₹85/$ and at the same time the price
index has moved up during the period. In India it was 130 and in US it was 145. Find out the extent of
change in nominal and real exchange rate.
INTEREST RATE PARITY
Exchange Rate between the countries are influenced by the Interest Rate prevailing in the countries. In
simple Exchange rate between two countries depends upon the Interest Rate prevailing in the
respective countries
Experts have different views on how changes in interest rate influence exchange rate.
The flexible price version of Monetary Theory:
Any rise in domestic interest rate lower the demand for money in relation to the supply of money
causing depreciation in the value of domestic currency.
The Sticky Price version of Monetary Theory:
A rise in interest rate increases the supply of loan able fund which lead to greater supply of money
and depreciation of domestic currency.
The sticky BOP version: The higher rate of interest at home than in foreign country attracts capital
from abroad in lure of higher returns and in flow of foreign currency results in increase of the
supply of foreign currency, raises the value of domestic currency
Fishers Approach: He suggested that any preposition cannot be thought in isolation of inflation, as
inflation negates the returns on capital to be received. The gain in form of interest may be
cancelled out by the loss on account of inflation.
So according to Irving Fisher nominal interest is decomposed into two parts:
1. The Real Interest Rate
2. The Expected Rate of Inflation.
The relationship between the two is known as Fisher Effect
Therefore, the investor is always interested in the nominal rate of interest that covers both the
expected inflation and required real interest rate. It can be mathematically expressed as:
r = (1+a)(1+i) -1
r nominal interest rate; a real interest rate; i expected rate of inflation
Suppose required real rate of interest is 8% and inflation is 10% in India then the nominal rate of
interest will be
r = (1+.08)(1+.10) -1
r =18.8%
Therefore, US investor will be tempted to invest in India only when the nominal interest in India is
more than 18.8%
Concept check Calculation
a. If the Real Interest rate is 5% and the inflation rate is 7% what would be the nominal interest
rate
b. Calculate the Interest rate if nominal interest rate is 10% and inflation rate is 4%.
c. Calculate the rate of inflation if nominal and real rates are 15% and 5% respectively
Combine effect of inflation & interest rate:
The combine effect is given the name of International Fisher Effect or generalized version of the Fisher
Effect.
The International Fisher Effect states that the interest rate differential is equal to the inflation rate
differential i.e. ( 1+rA/1+rB) = (1+IA/1+IB)
The rationale behind this preposition is that an investor likes to hold assets denominated in currencies
expected to depreciate only when the interest rate on those assets is high enough to compensate the loss on
account of depreciating exchange rate. As corollary, an investor holds assets denominated in currencies
expected to appreciate even at a lower rate of interest because the expected capital gain on account of
exchange rate appreciation will make up the loss on yield on account of low interest rate
If the rate of inflation in India and the US is 7 percent and 4 percent respectively and if the
interest rate in the USA is 6 percent, calculate the interest rate in India.
If Interest rate in India is 9.06 percent and 6 percent in USA and the exchange rate prevailing
₹68.92/$, calculate the expected exchange rate next year.
Exchange Rate determination in Forward Market
Interest Rate Parity theory helps in determining the forward Exchange rate.
IRP suggests that forward rate differentials is approximately equal to the interest rate differential
Therefore, IRP theory states that equilibrium s achieved when the forward rate differential is approximately
equal to the interest rate differential
In simple, forward rate differs from spot rate by an amount that represents the interest
rate differential.
Q. Calculate 90 days forward rate when interest rate in India & the US are 10 percent & 7 percent respectively.
The spot rate is Rs.60/US$.
Calculate 6-month forward rate if the spot rate is ₹68/$ and the interest rate in India is 6%
and interest rate in US is 3%. Calculate Interest Rate Differential and show Interest Rate
Differential is equal to Forward Rate Differential.
The Interest Rate in India and US are 8% and 6% p.a. The current Spot Rate is ₹72/$.
Calculate 3 Month forward and show does Interest Rate Parity Holds.
Note:
If Forward Rate Differential is not equal to the Interest Rate Differential, then coved
Interest Arbitrage will begin and it will continue till two differential become approximately
equal.
Covered Interest Arbitrage involves borrowing and lending in two different market and it
also involve buying spot and selling forward of the respective currencies so as to attain
parity Condition.
Cover Interest Arbitrage Process Example
Suppose the spot rate is ₹80/$
3-Month forward Rate is ₹81.50/$
Interest Rate in India is 18% and Interest Rate in US is 8%
As the Forward Rate Differential is not equal to Interest Rate Differential so
The Investor will borrow from US @8% and Invest in India @18%
Question
Find out the amount of profit out of Interest Arbitrage if Interest rate in
India and the USA is respectively 9% and 4.5% and the 6-month forward
and Spot Rate are respectively ₹82.60 & ₹83
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Forecasting Exchange Rates
Forecasting of exchange rate is used for several purposes such as:
✓ hedging of risk,
✓ earning assessment,
✓ investment decision and
✓ financing decision
Techniques of Forecasting
❖ Technical Forecasting Technique
❖ Fundamental Forecasting Technique
❖ Market Based
❖ Mixed Forecasting
Technical Forecasting
➢ Technical forecasting is based on the movement of historical rates.
Therefore, historical rates are used to estimating the future rates.
➢ The technical forecasting technique is used for short term forecasting and
the coverage is normally not very wide.
Tools used in Technical forecasting
➢ Classical Charting techniques embracing line chart, bar chart, candlestick
chart, point and figure charts
➢ Statistical techniques includes moving average system- both simple and
weighted moving average techniques are used.
➢ Mathematical techniques used are regression analysis
Fundamental forecasting
Fundamental forecasting is based on fundamental relationship between
economic variables and exchange rate. This technique of forecasting is based
on the macro economic variables and not on the historical data.
Examines economic relationships and financial data to arrive at a
forecast.
• Short term horizons: Asset Market Model (Asset Choice Model)
• Long term horizons: Parity Models
Asset Market Model or Asset Choice:
(Foreign exchange is viewed as financial asset)
Examines why one currency might be preferred over others. Variables include:
➢ Relative interest rates (current and anticipated)
➢ Political/country risk
➢ Carry trade strategies
The carry trade is a strategy in which traders borrow a currency that has a low interest rate
and use the funds to buy a different currency that is paying a higher interest rate. The
traders' goal in this strategy is to earn not only the interest rate differential between the two
currencies, but to also look for the currency they purchased to appreciate.
Essentially, trying to identify why the demand for a currency will
change.
Long Term :Parity Models
➢Through these models one attempts to calculate an “equilibrium” exchange
rate in the future.
➢Analysis built on “long standing” economic theories of exchange rate
determination.
a. Purchasing Power Parity Model
b. International Fisher Effect
Purchasing Power Parity
➢ One of the oldest exchange rate models.
➢ Assumes that exchange rates will change to offset relative prices levels between
countries.
❖Countries with relatively high rates of inflation will show currency depreciation
❖Countries with relatively low rates of inflation will experience currency
appreciation
➢ In equilibrium, the amount of depreciation (or appreciation) will be equal to the
inflation differential.
International Fisher Effect
➢ Assume that exchange rates will change in direct proportion to relative differences in
long term interest rates.
❖Assumes that long term interest rates capture the market’s expectation for
inflation.
❖Countries with relatively high rates of long-term interest rates (i.e., high inflation)
will show currency depreciation.
❖Countries with relatively low rates of long-term interest rates (i.e., low inflation)
will show currency appreciation.
➢ In equilibrium, the amount of depreciation (or appreciation) will be equal to the long-
term interest rate differential.
Market Based Forecasting
Market based forecasting is based on the expected trend in the market.
In this technique, the estimation of future rates depends on the spot and forward rates prevailing in the market
and on the expectations about the future.
Mixed Forecasting
Market based forecasting is a weighted average of technical, fundamental and market-based forecasting
technique.
Under this technique each technique is assigned a particular weight, the total weight being 1. The result of
each technique is multiplied by the assigned weight and then are summed up to reach the final forecast.
