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THEORIES OF FOREIGN EXCHANGE RATE MOVEMENT

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 THEORIES OF FOREIGN EXCHANGE RATE MOVEMENT
Written by: Ayantika Dey; Email: [email protected]

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Exchange rate fluctuations have an effect on an MNC's valuation because they influence the
amount of cash inflows from selling or a subsidiary, as well as the amount of cash outflows needed
to compensate for imports. The value of one currency in terms of another currency is calculated
by an exchange rate. Exchange rates will fluctuate dramatically as economic conditions change.
The term "depreciation" is used to describe a decrease in the value of a currency. Depreciation is
the term used to describe a decrease in the value of a currency. When the British pound falls in
value over the US dollar, that means the dollar is strengthening against the pound. Appreciation is
the term used to describe the rise in the value of a currency. When the spot values of a foreign
currency at two different points of time are measured, the spot rate at the more recent date is
devalued. When comparing the spot rates of a foreign currency at two different points in time, the
spot rate at the more recent date is denoted as S, and the spot rate at the earlier date is denoted as
St-1. The following formula is used to calculate the percentage change in the value of a foreign
currency:

Percentage change in foreign currency value= [Index cp – Index pp / Index pp] X 100

where IndexCP is the index for the current period and IndexPP is the index for the previous
period in the same base reference period.

A positive percentage difference means the foreign exchange has risen, while a negative
percentage change means it has depreciated. Over the course of a 24-hour period, the value of
certain currencies has fluctuated by as much as 5%.

Many international currencies appreciate against the dollar on certain days, albeit to varying
degrees. Many currencies depreciate against the dollar on other days, but to varying degrees.
There are days where some currencies appreciate and others depreciate against the dollar; the
media refers to this as “the dollar being mixed in trading.
PURCHASING POWER PARITY THEORY:

PPP is an economic philosophy that contrasts the currencies of various nations using a "basket
of goods" strategy, not to be confused with the CARES Act's Paycheck Protection Program.
This definition states that two currencies are in equilibrium (or at par) when a basket of
commodities is priced the same in both countries after exchange rates are taken into account.

Purchasing power parity (PPP) is a common macroeconomic metric that compares the
currencies of various countries using a "basket of goods" approach.

Economists may measure economic productivity and living standards between countries using
purchasing power parity (PPP).

To represent PPP, some countries change their gross domestic product (GDP) estimates.

Calculating Purchasing Power Parity:

S=P1/P2

Here, S= Exchange rate of currency 1 to currency 2

P1= Cost of good X in currency 1

P2= Cost of good X in currency 2

Comparing the Purchasing Power Parity in Different Countries

A broad variety of goods and services must be weighed in order to allow fair price comparisons
across countries. However, owing to the large volume of data that must be obtained and the
difficulty of the calculations that must be made, this one-to-one calculation is impossible to
obtain. The University of Pennsylvania has created a tool to aid in this comparison. The
International Comparison Program (ICP) was established in 1968 by the University of
Pennsylvania and the United Nations to aid in this comparison.
 For this scheme, the ICP's PPPs are based on a global price survey that measures the prices of
hundreds of different products and services. International macroeconomists may use the
software to forecast global production and development.

The World Bank publishes a study every few years that compares the competitiveness and
prosperity of different countries in PPP and US dollars. 3 Weights based on PPP metrics are
used by both the International Monetary Fund (IMF) and the Organization for Economic
Cooperation and Development (OECD) to make estimates and policy recommendations.

Economic policy, he suggested, may have an immediate short-term effect on capital markets.
PPP is often used by some forex traders to identify currencies that are potentially overvalued
or undervalued. Investors who own foreign company shares or bonds will use the survey's PPP
estimates to estimate the effect of exchange rate volatility on a country's economy, and
therefore on their investment.

The Relationship Between Purchasing Power Parity and Gross Domestic Product

Gross domestic product (GDP) is a term used in modern macroeconomics to describe the
overall monetary value of goods and services generated within a region. The numerical value
of nominal GDP is calculated in actual, absolute terms. The nominal gross domestic product
is adjusted for inflation to produce real GDP. Any accounting, on the other hand, goes still
deeper, correcting GDP for the PPP benefit. This change aims to turn nominal GDP into an
amount that can be conveniently compared across countries with different currencies.

GRAPHICAL ANALYSIS OF PURCHASING POWER PARITY:

Choose two countries (for example, the United States and a foreign country) and equate the
difference in their inflation rates to the percentage change in the foreign currency's value over
several time intervals to test the PPP hypothesis. We might use a graph to map each point
reflecting the inflation difference and percentage shift in the exchange rate over each time
cycle, and then see how these points exactly match the PPP line as drawn in the graph. If the
points deviate greatly from the PPP axis, the inflation difference is not influencing the
percentage change in the foreign currency in the way that PPP theory implies. Several
international countries may be compared to the home country over a span of time as an alternate
 test. Each foreign country would have a different rate of inflation than its home country, which
can be compared to the shift in the exchange rate over the period of concern. As a result, for
each foreign country studied, a point can be plotted on a graph. If the points deviate
substantially from the PPP axis, the exchange rates aren't reacting to inflation differentials in
the way that PPP theory predicts. Any country for which inflation data is available can be used
to test the PPP hypothesis.

Source: International Financial Management book by, Jeff Madura

The economic theory is often broken down into two main concepts:

1. Absolute purchasing power parity:

The absolute type of PPP is founded on the idea that if there are no foreign barriers,
customers would move their demand to lower-cost locations. It implies that when
calculated in a single currency, the prices of the same basket of goods in two different
countries should be identical. Where there is a market difference as determined by a single
currency, demand should change to get all markets closer together.

2. Relative purchasing power parity

PPP in its relative form. Market imperfections such as shipping costs, tariffs, and quotas
are taken into account in the relative form of PPP. Because of these market imperfections,
prices of the same basket of goods in various countries will not always be the same when
 calculated in a single currency, according to this edition. It does state, however, that when
calculated in a foreign currency, the rate of change in the basket prices should be relatively
comparable, as long as shipping costs and trade barriers remain constant.

INTERNATIONAL FISHER EFFECT

Along with PPP theory, the international Fisher effect (IFE) theory is another important
theory in international finance. It explains why exchange rates vary over time using interest
rate differentials rather than inflation rate differentials, but it is closely linked to the PPP
hypothesis because interest rates and inflation rates are also strongly correlated. The so-
called Fisher effect states that nominal risk-free interest rates have a real rate of return as
well as expected inflation. Interest rate differentials between countries may be the product
of differences in potential inflation as both investors demand the same real return.

The following is the exact relationship between the interest rate difference between two
countries and the predicted exchange rate adjustment according to the IFE. First, the real
return to borrowers in their home country who lend in money market instruments (such as
short-term bank deposits) is essentially the interest rate paid on those securities.

The real return to investors in a foreign money market security, on the other hand, is determined
not only by the foreign interest rate (if), but also by the percentage change in the value of the
foreign currency (ef) that the security is denominated in. The real or "effective" (exchange-
rate-adjusted) return on a foreign bank deposit (or other money market security) is calculated
using the formula below.

r= (1+if) (1+ef)-1

GRAPHICAL ANALYSIS OF INTERNATIONAL FISHER EFFECT

The graph depicts the set of points that support the IFE theory case. Point E, for example,
represents a scenario in which the international interest rate is three percentage points higher
interest rate benefit.
 sources: International Financial Management book by, Jeff Madura

As a result, an individual who establishes a deposit in a foreign country receives a return

comparable to what is available domestically. Point F denotes a home interest rate that is 2%
higher than the international interest rate. If borrowers from their home country open a foreign
account, they would be at a disadvantage in terms of interest rates.

However, according to IFE theory, the currency could appreciate by 2% to compensate for the
interest rate disadvantage. Point F in the graph depicts the IFE from the perspective of a global
investor. For a foreign investor, the domestic interest rate would become enticing.

However, according to IFE theory, the foreign currency will appreciate by 2%, implying that
the home country's currency, which denominates the investment instruments, will depreciate
to compensate for the interest rate advantage.

On the IFE Line, there are points. Many of the points in the graph along the so-called
international Fisher effect (IFE) line reflect exchange rate changes to compensate for the
interest rate difference. This assumes that if buyers spend at home or abroad, they would end
up with the same yield (adjusted for exchange rate fluctuations).

To be more specific, the IFE principle does not imply that this interaction would last over time.
The IFE theory states that if a company makes foreign investments on a regular basis to take
advantage of higher foreign interest rates, it would earn a yield that is sometimes higher and
sometimes lower than the domestic yield. Periodic acquisitions by a US company in an effort
 to profit from higher interest rates would, on average, provide a yield comparable to that of a
corporation making domestic deposits on a regular basis.

Below the IFE Line are the points. The higher returns from investing in international deposits
are usually reflected by points below the IFE axis. For eg, point G in the graph shows that the
international interest rate is 3% higher than the domestic interest rate. Furthermore, the foreign
exchange has appreciated by 2%. The international yield would be higher than what is possible
domestically due to the combination of a higher foreign interest rate and the appreciation of
the foreign currency.

If actual data were collected and plotted, and the vast majority of points were below the IFE
axis, it would appear that foreign bank deposits could reliably raise investment returns for
home country investors. The IFE hypothesis will be debunked by such findings.

Points that are higher than the IFE Line. Points above the IFE line normally reflect lower
returns from international deposits than those available domestically. Point H, for example,
represents a global interest rate that is 3% higher than the domestic rate. Point H, on the other
hand, shows that the foreign currency's exchange rate has depreciated by 5%, more than
cancelling out the interest rate benefit.

INTEREST RATE PARITY

Interest rate parity exists as market conditions allow interest rates and exchange rates to adjust to
the point where protected interest arbitrage is no longer possible (IRP). The forward rate varies
enough from the spot rate in equilibrium to mitigate the interest rate difference between two
currencies. The following is the relationship between a foreign currency's forward premium (or
discount) and the interest rates that serve these currencies according to IRP. Consider a protected
interest arbitrage bid by a US trader. The following factors should be used to calculate an investor's
return on protected interest arbitrage:

1. The sum invested in the home currency (in this case, US dollars) (Ah). The spot rate (S) in
dollars is used to purchase foreign currency.
 2. A global deposit's rate of return (if).

3. The dollar forward rate (F) is the rate at which a foreign currency is converted back into
US dollars.

The sum of home currency issued at the conclusion of the deposit time as a result of this technique
(referred to as An) is:

An= (An/S) (1+ if)F

INTEREST RATE PARITY GRAPHICAL ANALYSIS

A graph can be used to equate the interest rate difference to the forward premium (or discount).
Using the approximation mentioned earlier and plugging in numbers, all possible points that reflect
interest rate parity are plotted on a graph. When the international interest rate is higher than the
domestic rate, the forward rate should show a discount that is roughly equal to the difference.

sources: International Financial Management book by, Jeff Madura

A premium is represented by points. When the foreign interest rate is lower than the domestic
interest rate, the forward rate may have a premium that is roughly proportional to the difference.

To decide if interest rate parity exists, the forward rate (or discount) must be compared to interest
rate quotes happening at the same time. The findings may be skewed if the forward rate and interest
rate quotes do not represent the same time of day.

It is impossible to collect quotes that represent the same point in time due to data access limitations.
It is impossible to profit from protected interest arbitrage if IRP persists. If investors stay
unprotected, they will also want to profit from high international interest rates (do not sell the
currency forward).

However, according to IFE, this approach would not generate better returns than those available
domestically since the exchange rate is projected to fall by the sum of the interest rate difference
on average.

IRP is defined by any points on the diagonal line that cuts through the junction of the axes. Because
of this, the diagonal line is known as the interest rate parity (IRP) line. Value for points along the
IPR line was covered.

COMPARISON BETWEEN PPP- IFE- and IRP THEORIES:

Theory Key Variable of Summary of Theory Type of Theory

theory

Interest Rate Forward Rate The premium (or discount) in a Interest rate
Parity (IRP) Premium or currency's forward rate versus differential
discount another currency is calculated by
the interest rate difference
between the two countries. As a
result, the yield on protected
interest arbitrage would be no
better than the return on domestic
arbitrage.
Purchasing Percentage The spot rate of one currency Inflation rate
Power Parity change in spot versus another will fluctuate in differential
(PPP) exchange rate response to the inflation rate
difference between the two
countries. As a result, consumers'
purchasing power when buying
products in their own country
would be comparable to their
purchasing power when
consuming goods from another
country.

International Percentage The spot rate of one currency Interest rate

Fisher Effect change in spot versus another will fluctuate in differential
(IFE) exchange rate response to the interest rate
difference between the two
countries. As a result, from the
standpoint of investors in the
home world, the yield on
undisclosed international money
market securities would be no
better than the return on domestic
money market securities.
 REFERENCES:

1. Fisher Effect. (n.d.). CFI. Retrieved April 25, 2021, from

https://corporatefinanceinstitute.com/resources/knowledge/economics/fisher-effect/
2. Stein, Jerome. 1980. The dynamics of spot and forward prices in an efficient foreign
exchange market with rational expectations. American Economic Review 70 (September):
565-83.
3. Saidi, Nasser H. 1980. Fluctuating exchange rates and the international transmission of
economic disturbances. Journal of Money, Credit and Banking 12 (November): 575-9 1.
4. Purchasing Power Parity. (n.d.-b). The University of British Columbia. Retrieved April 25,
2021, from https://fx.sauder.ubc.ca/PPP.html
5. Jeff Madura, 9th Edition, 2008, International financial Management.
6. Phelps, Edmund S., and Taylor, John. 1977. Stabilizing powers of monetary policy under
rational expectations. Journal of Political Economy 85 (February): 163-90.
7. Hacker, S. and Hatemi-J, A. (2004), The effect of exchange rate changes on trade balances
in the short and long run, Economics of Transition, Vol 12(4) 2004, p.777-799
8. Hacker, S. and Hatemi-J, A. (2003), Is the J-curve Effect Observable for small North
European Economies? Open economic review, 14, p.119-134
9. Gros, D. and Thygesen, N. (1998), European Monetary Integration, Second edition,
Pearson Education Limited, UK

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