INTEREST RATE PARITY (IRP):
IRP theory attempts to quantify interest rate – exchange rate relationship.
It says the interest rate differential between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate.
• Interest rate parity states that relative interest rates determine the relativity between the forward exchange rate and the spot exchange rate
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Implication:
A country’s currency will tend to appreciate (depreciate) relative to another currency if its interest rate is lower (higher) than the interest rate on the other currency.
PURCHASING POWER PARITY (PPP):
PPP theory attempts to quantify inflation – exchange rate relationship.
When a country’s inflation rate rises relative to that of another country, decreased exports and increased imports depress the high-inflation country’s currency.
• The theory states that changes in exchange rates are influenced by the purchasing power of one currency vis-à-vis another.
• The idea implies that the exchange rate adjusts to keep purchasing power constant among currencies (if not arbitrage would occur).
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In mathematical terms:
Where, et = future spot rate
e0 = spot rate
ih = home inflation
if = foreign inflation
t = the time period
Forward Exchange Rate of £ against $ in t years time:
£t = S0 [(1+R$) / (1+R£)]t
Current Exchange Rate between £ and $ is given as £1 = $1.70.
The annual interest rates in UK = 3%
The annual interest rates in USA = I%
1 year Forward Rate
£ = $1.7 x (1+0.01) / (1+0.03) = $1.67
3 years Forward Rate
£ = $1.7 x (1+0.01) / (1+0.03)3 = $ 1.60
6 months Forward rate
£ = $1.7 x (1+0.01) / (1+0.03).5 = $1.68
As per the above calculations, it is clearly visible that in short term dollar will appreciate, and pound will depreciate. However, compare with spot rate it looks like in long term importer will be gainer and...