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International Parity
Demand/Supply
of currency- Equilibrium, Factors
affecting exchange rate, Parity Theories
and their Interrelationship
Int
ernationalfinanc
ialManagement
MBA2012, August 2013Mohanamani
7/27/2019 International Parity Session- V
2/23
Int
ernationalfinanc
ialManagement
MBA2012, Sep 2013Mohanamani
Exchange Rate Determination
The exchange rate is the price of onecountrys currency in terms of
anothercountrys currency1.Demand for CurrencyA countrys currency is in demand when foreigners buy the goodsand services exported by that country
When they desire to buy financial assets denominated in that
currency
2.Supply of currencyA countrys currency is supplied in the course of paying for that
countrys importsThrough receipts in the current account through export and
remittances
Inflows in the capital account through FDI, Portfolio investment and
ECBs
Bank deposits made by foreigners including NRIs
7/27/2019 International Parity Session- V
3/23
Int
ernationalfinanc
ialManagement
MBA2012, Sep 2013Mohanamani
Exchange Rate Determination
Demand and Supply of Currency
Supply
Demand
Supply and demand for foreign currency
E
xchangeRate
7/27/2019 International Parity Session- V
4/23
Int
ernationalfinanc
ialManagement
MBA2012, Sep 2013Mohanamani
Factors Affecting Exchange Rate
Inflation RatesThe Economic growth Rates
Interest rates
Political factors
Social Factors
Government Controls
7/27/2019 International Parity Session- V
5/23
Int
ernationalfinanc
ialManagement
MBA2012, Sep 2013Mohanamani
BoP Theory of Exchange rates
A statement of receipts and payments of foreignexchange based on the concept of double entry
book keeping
Represents the demand for and supply of foreign
currenciesAssumption is made a perfect foreign exchange
market and perfect international market for goods
and services
Limitation BoP itself is a function of the exchange
rate and cannot explain the determination of the
exchange rate
7/27/2019 International Parity Session- V
6/23
Int
ernationalfinanc
ialManagement
MBA2012, Sep 2013Mohanamani
The Purchasing Power Parity Theory
Developed by a Swedish Economist Gutsav CassellDescribes the relationship between average price level in a
country and its exchange rates
The home currency price of a commodity in different
countries, when converted into a common currency at thespot exchange rate , is the same in all countries across the
world
A unit of home currency should have
the same purchasing power in allcountries
7/27/2019 International Parity Session- V
7/23
Internationalfinanc
ialManagement
MBA2012, Sep 2013Mohanamani
The Purchasing Power Parity Theory -
The Law of One PriceIf a commodity or product can be sold in two different
markets, its price should be the same in both markets
Assumptions:
There are no transportation costsThere are no transaction costs
There are no tariffs
There are no restrictions on the movement of products
There is free flow of information
There is no product differentiation
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Internationalfinanc
ialManagement
MBA2012, Sep 2013Mohanamani
Forms of PPP
The absolute formThe law of one price states that if a commodity or
product can be sold in two different markets, its price in
terms of a common currency should be the same in both
the marketsIf the prices measured in a common currency are not
the same, traders will engage in arbitraging to earn a
profit until the price in different countries measured in a
common currency equalizes
7/27/2019 International Parity Session- V
9/23
Internationalfinanc
ialManagement
MBA2012, Sep 2013Mohanamani
Forms of PPP
The Relative FormThe percentage change in the exchange rate
between the domestic currency and the foreign
currency should equal the percentage change in
the ratio of price indices in the two countries.
7/27/2019 International Parity Session- V
10/23
Internationalfinanc
ialManagement
MBA2012, Sep 2013Mohanamani
Forms of PPP
The Expectation FormIt involves the exchange rate and inflation rates
being expressed in terms
It states that the expected percentage change in
exchange rate equals the expected inflation
differential in the two countries assuming the
market participants are risk neutral and the
markets are perfect
7/27/2019 International Parity Session- V
11/23
Internationalfinanc
ialManagement
MBA2012, Sep 2013Mohanamani
Departures from PPP
It is free trade which can equalize prices in acommon currency across the countries
Non-traded items , highly perishable commodities
and hospitality services may cause departures from
PPPLimitations of price indices as a measure of price-
level changes- different countries may use different
basket of goods and services in the construction of
the price indexThere are many other factors other than prices of
goods and services which influence exchange rates
PPP holds only in the long run
7/27/2019 International Parity Session- V
12/23
Internationalfinanc
ialManagement
MBA2012, Sep 2013Mohanamani
The real exchange rate
It is the nominal exchange rate adjusted for inflationdifferential between the two countries.
It is a measure of change in the relative purchasing
power of the two currencies concerned
A change in the real exchange rate reflects the change
in the purchasing power of one currency relative toanother
A real appreciation of domestic currency makes the
countrys exports more expensive
A depreciation of home currency relative to foreign
currency enables the home currency to be competitive inthe international market and realize increased exports
7/27/2019 International Parity Session- V
13/23
Internationalfinanc
ialManagement
MBA2012, Sep 2013Mohanamani
The real effective exchange rate
An overall measure of movement of the home currency
against the countrys major trading partners currencies is
of great significance.
It is a weighted average rate that is calculated by
weighing the exchange rates between the home currency
and other major currencies
As trade weights are used in the computation, the
effective exchange rate is also called trade-weighted
exchange rateThe exchange rate can be 1.nominal effective exchange
rate 2.real effective exchange rate
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Internationalfinanc
ialManagement
MBA2012, Sep 2013Mohanamani
Interest Rate Parity
In an efficient market with no transaction costs,
the currency of one country with the highest
interest rate should be at a forward discount in
terms of the currency of the country with a lower
interest rate
The spread between the spot rate and forward
rate is influenced by the interest rate differential
between the two countries.
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InternationalfinancialManagement
MBA2012, Sep 2013Mohanamani
Fisher Effect
Is the relationship between the nominal interestrate, the real interest rate and the expected rate of
inflation in a country
The expected rate of inflation is the difference
between the nominal rate of interest and the realrate of interest
1+nominal rate of interest = (1+real rate of
return)(1+expected rate of inflation)
Nominal rate of return = Real rate of return +
expected rate of inflation
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InternationalfinancialManagement
MBA2012, Sep 2013Mohanamani
Fisher Effect(+)
(+)(-)
(-)
Parity line
Interest rate
differential (%)
Inflation
differential (%)
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InternationalfinancialManagement
MBA2012, Sep 2013Mohanamani
The international Fisher relation
The nominal interest rate differential reflects theexpected change in the spot rate
A rise in the inflation rate in a country will be
associated with a rise in the interest rate in thecountry and a fall in the countrys currency value
It implies that the expected return on domestic
investment should be equal to the expected return
on foreign investment
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18/23
InternationalfinancialManagement
MBA2012, Sep 2013Mohanamani
Interrelationship of parity conditions(+)
(+)(-)
(-)
Parity line
Expected change
in spot rate (%)
Interest
differential (%)
7/27/2019 International Parity Session- V
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InternationalfinancialManagement
MBA2012, Sep 2013Mohanamani
Interrelationship of parity conditions
Ft / So
E(St)/ So(1+kh)t /(1+kf)t
(1+ih)t/(1+if)t
IRP FRP
PPP
IFR
7/27/2019 International Parity Session- V
20/23
InternationalfinancialManagement
MBA2012, Sep 2013Mohanamani
Exchange Rate Forecasting
It is used in making hedging decisions, investmentdecisions and financing decisions
The forward rate is generally used as an
unbiased estimate of the future spot rate
But forward rates are available only for short
maturities and their forecasting horizon ins limited
to one year
There are two approaches used in forecasting
Technical Analysis and Fundamental Analysis
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InternationalfinancialManagement
MBA2012, Sep 2013Mohanamani
Exchange Rate Forecasting
Monetary Model
It attempts to predict a proportional relationship
between nominal exchange rates and relative
supplies of money between nations
Monetary model suggests that the exchange rate is
determined by three independent variables:
-Relative money supply
-Relative interest rates
-Relative national output
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InternationalfinancialManagement
MBA2012, Sep 2013Mohanamani
Exchange Rate Forecasting The
Asset Market Model
An asset price consists of a fundamental value
plus a term that reflects expectations of future
changes in the asset price
The foreign exchange is viewed as a financial
asset and its price is determined by the demand
and supply for the stock of foreign exchange
As expectations changes rates also change
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InternationalfinancialManagement
MBA2012 Sep 2013Mohanamani
Exchange Rate Forecasting The
Portfolio Balance ModelIt is based on the premise that people divide their
total wealth between domestic and foreign currency,
domestic and foreign bonds, depending on their
expected return and riskThree assets are involved in this model
-money(M)
-domestic bonds denominated in the home
currency(B)-Foreign currency bonds(FB)