ACCA FM Syllabus G. Risk Management - Predicting Exchange Rates - Notes 2 / 4
Purchasing Power Parity (PPP theory)
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 = €515So, 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
Future inflation is an estimate
Market is ruled by speculative not trade transactions
Governments often intervene
Interest Rate Parity (IRP theory)
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
Government intervention
Controls on currency trading