Exchange Rate Determination Theories in Foreign Exchange- CA Final SFM

I. Interest Rate Parity Theory

As per IRPT exchange rate between currencies are directly affected by Interest Rates.

If the Interest Rate of Currency is higher than currency will be at discount in future and if the interest rate is lower, the currency will be at premium in future.

FR  =  1 +  RHS Currency Interest Rate SR       1 + LHS Currency Interest Rate

If IRPT doesn’t hold good, then there would arise arbitrage profit. It means forward rate as IRPT ≠ Actual Forward Rate then there would arise arbitrage profit.

If Actual Interest Rate of a currency is less than Interest Rate as per IRPT then borrow in that currency and invest in another currency.

If Actual Interest rate of a Currency is more than Interest rate as per IRPT than Invest in that currency and borrow in another currency.

It means,

Borrow at lower rate and invest at higher rate.

Arbitrage Process

Step I: - Borrow in Cheaper.

Step II: - Convert it into costlier currency and invest in costlier currency.

Step III: - Enter into forward convert to buy cheaper currency.

Step IV: - Covert realized in cheaper currency.

Step V: - Repay Cheaper Currency along with Interest.

Step VI: - Repay cheaper currency along with Interest.

Step VII: - Arbitrage Profit is the balance remains after payment of Loan (Investment Realized – Loan Repayment).

Here,

Cheaper Currency means that currency whose actual interest rate is less than interest rate as per TRPT and Costlier Currency means that currency whose actual Interest Rate is more than Interest Rate as per IRPT.

Purchasing Power Party Theory

As per PPPT the exchange rate between two currencies are determined by the inflation rate prevailing in those countries.

If the Inflation Rate in a country is higher than whose currency will be traded at discount.

If the Inflation Rate in a country is lower than whose currency will be traded at premium.

Expected SR (ESR) =  1+ RHS Currency’s Inflation Rate                                    SR                1+ LHS Currency’s Inflation Rate

   .

Profit or Loss is always calculated in Home Currency if Home Currency is defined otherwise profit or loss is calculated in price currency.

Calculation of Implied deferential in Interest Rate between two Countries’: -

Step I: - Calculate Discount/Premium in Commodity Currency as per given equation.

Step II: - If there is discount than interest rate will higher by such percentage than interest rate in price Currency.

Step III: - If there is premium than interest rate will be less by such percentage than interest rate in price currency.

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