ACCA FM Syllabus G. Risk Management - Predicting Exchange Rates - Notes ^{2 / 4}

Why do exchange rates fluctuate?

“The law of one price”

Illustration

Item costs $1,000
$2:€ (base)
However inflation in US is 5% and Europe is 3%

According to law of one price what is the predicted exchange rate in 1 year?

• Solution

  So next year - Item in US costs $1,050 and in Europe €515
  “The law of one price” = $1,050 = €515

  So, forward exchange rate = 1,050 / 515 = $2.039:€1

• Another way of calculating this is as follows:

  Exchange rate now (counter) x (1+ Inf (counter) / 1 + inf (base))

  2 x 1.05 / 1.03 = 2.039

Limitations

1. Future inflation is an estimate

2. Market is ruled by speculative not trade transactions

3. Governments often intervene

Why do exchange rates fluctuate? 
An investor will get the same amount of money back no matter where he deposits his money

Illustration

US Interest rate = 10%
European Interest rate = 8%
Exchange rate = $2:€

Investor has $1,000 to invest for 1 year

What is the future exchange rate as predicted by IRPT?

• Solution

  In US he will receive $1,100 in one years time
  In Europe he will receive €540
  Forward rate will therefore be 1,100 / 540 = $2.037:€

• Another way of calculating this is as follows:

  Exchange rate now x (1+ Int (counter) / 1 + int (base))

  2 x 1.10 / 1.08 = 2.037

Limitations

1. Government intervention

2. Controls on currency trading