Cross rates

• Impact of Inflation: It is
normally the inflation rate
differential between two
countries that influences
the exchange rate between
their currencies.
• In fact, this theory is based on the theory of one price in which the
• domestic price of any commodity equals its foreign price quoted in
the same currency.
• To explain it, if the exchange rate is Rs. 2/US $, the price of a
particular commodity must be US $50 in the United State of America
if it is Rs. 100 in India.
• In other words,
• US $ price of a commodity * price of US $
• =Rupee price of the commodity
Arbitrage opportunity
The exchange rate adjustment resulting from inflation may be explained further.
If the Indian commodity turns costlier, its export will fall. At the same time, its import from the
United States of America will expand as the import gets cheaper.
Higher import will raise the demand for the US dollar raising, in turn, its value vis-á-vis rupee.
However, this version of the theory, which is known as the absolute version, holds good if the
same commodities are included in the same proportion in the domestic market basket and
the world market basket.
Since it is normally not so, the theory faces a serious limitation.
Moreover, it does not cover non-traded goods and services, where the transaction
cost is significant.
• Relative PPP theory
Real interest rate
Impracticality
• Not applicable to real life
• Extraneous factors like interest, govt interference will affect.
• If no domestic substitute is available then even if import price is high
it will be imported. Eg crude oil in India
2) Interest rate
Fischer effect
Real interest rate applies to all investments-domestic and foreign.
Investor will look for a positive differential
This leads to arbitrage opportunity which cant continue for long and
real interest rates will finally become equal
In real life due to government restrictions and economic policies in
different countries real interest rate differs
International Fischer effect(combination of
interest and inflation)
• There is also Fisher’s open proposition, known as the International
Fisher Effect or the generalised version of the Fisher effect. It is a
combination of the conditions of the PPP theory and Fisher’s closed
proposition. It may be recalled that the PPP theory suggests that
exchange rate is determined by the inflation rate differentials, while
the latter states that the nominal interest rate is higher in a country
with a higher inflation rate. Combining these two propositions, the
International Fisher effect states that the interest rate differential
shall equal the inflation rate differential. In the form of an equation, it
can written as
• The rationale behind this proposition is that an investor likes to hold
assets denominated in currencies expected to depreciate only when
the interest rate on those assets is high enough to compensate the
loss on account of depreciating exchange rate.
• As a corollary, an investor holds assets denominated in currencies
expected to appreciate even at a lower rate of interest because the
expected capital gain on account of exchange rate appreciation will
make up the loss on yield on account of low interest.
• Bandwagon Effect: When a speculator being dominant in the market
• expects a drop in the value of a particular currency, he begins selling it
forward. The other speculators follow the lead. As a result, the
currency tends to depreciate despite favourable impact of inflation
and interest rate. This factor played a crucial role in the depreciation
of rupee during the closing months of 1997.
EXCHANGE RATE DETERMINATION
IN FORWARD MARKET
• Forward exchange rate is normally not equal to the spot rate. The size
of forward premium or discount depends mainly on the current
expectation of the future events.
• Such expectations determine the trend of the future spot rate towards
appreciation or depreciation and, there by, determine the forward rate
that is equal to, or close to, the future spot rate.
• Suppose, the dollar is expected to depreciate, those holding the dollar will
start selling it forward. These actions will help depress the forward rate of
the dollar. On the contrary, when the dollar is expected to appreciate, the
holders will buy it forward and the forward rate will improve
• IRP theory states that equilibrium is achieved when the forward rate
differential is approximately equal to the interest rate differential.
• The determination of exchange rate in a forward market finds an important
place in the theory of Interest Rate Parity (IRP). The IRP theory states that
equilibrium is achieved when the forward rate differential is approximately
equal to the interest rate differential.
• In other words, the forward rate differs from the spot rate by an amount that
represents the interest rate differential.
• In this process, the currency of a country with a lower interest rate should be
at a forward premium in relation to the currency of a country with a higher
interest rate.
Covered interest rate
• If forward rate differential is not equal to interest rate differential, covered
• interest arbitrage will begin and it will continue till the two differentials
• become equal. In other words, a positive interest rate differential in a
• country is offset by annualised forward discount. Negative interest rate
• differential is offset by annualised forward premium. Finally, the two
differentials
• will be equal. In fact, this is the point where forward rate is determined
• If interest rate differential is more than forward rate differential,
covered interest arbitrage manifests in borrowing in
• a country with low interest rate and investing in a country with high
• interest rate so as to reduce the interest rate differential.
• The process of covered interest arbitrage may be explained with the
• help of an example. Suppose, the spot rate is Rs. 40/US $ and three month
• forward rate is Rs. 40.28/US $ involving a forward differential of
• 2.8 per cent. Interest rate is 18 per cent in India and it is 12 per cent in the
• United States of America, involving an interest rate differential of 5.37 per
• cent. Since the two differentials are not equal, covered interest arbitrage
• will begin. The successive steps shall be as follows:
• 1.Borrowing in the United States of America, say, US $1,000 at 12 per cent
interest rate.
• 2. Converting the US dollar into rupees at spot rate to get Rs. 40,000/-.
• 3. Investing Rs. 40,000 in India at 18 per cent interest rate.
• 4. Selling the rupee 90-day forward at Rs. 40.28/US $.
• 5. After three months, liquidating Rs. 40,000 investment, which would fetch Rs.
41,800.
• 6. Selling Rs. 41,800 for US dollars at the rate of Rs. 40.28/US $ to get US $1,038.
• 7. Repaying loan in the United States of America, which amounts to US $1,030.
• Reaping profi t: US $1,038 1,030 US $8.
• So long as inequality continues between the forward rate differential and the interest
rate differential, arbitrageurs will reap profit and the process of arbitrage will go on.
• However, with this process, the differential will be wiped out because:
• 1. Borrowing in the United States of America will raise the interest rate there.
• 2. Investing in India shall increase the invested funds and, thereby,
• lower the interest rate there;
• 3. Buying rupees at spot rate will increase the spot rate of the rupee;
• 4. Selling rupees forward will depress the forward rate of the rupee.
• The first two narrow the interest rate differential, while the latter two
• widen the forward rate differential.
• Since differentrates prevail on bank deposits, loans, treasury bills, and so on, short term interest rate cannot
be specific and the chosen rate can hardly be the definitive rate of the formula.
• Again, the marginal interest rate applicable to the borrowers and lenders differs from the average interest
• rate in view of the fact that the interest rate changes with successive amount of borrowing.
• Yet again, the investment in foreign assets is more risky than that in domestic assets. If greater diversifi
cation is applied to foreign investment in order to lower the risk element, diminishing return may apply; and
as a result, arbitrageurs may not respond to interest rate differential as expected by the IRP theorem.
Moreover, there are cases when interest rate parity is disturbed owing to the play of extraordinary forces.
This leads to speculation. It is basically the marke t expectation of future spot rates that influences the
forward rate. If market expectations are strong enough, they can push forward rates beyond the
• point that interest rate parity would dictate. Last but not least, the proponents of the modern theory feel
that it is not only the role of the arbitrageurs but of all participants in the foreign exchange market, such as
the
• traders and hedgers and speculators that influences the forward
exchange rate. Since the action of the three different participants may
not be similar in a given situation of the exchange rate, there is every
possibility of the forward exchange rate differing from the no-profi t
forward exchange rate, as explained by the IRP theorem
Exchange rate theories
• Balance of Payments Theory
• 1. Higher inflation rate differential at home → greater import and lower
export →
• greater demand for foreign currency → depreciation of domestic currency
• 2. Greater real income at home → greater import → depreciation of
domestic currency
• 3. Greater interest rate at home → infl ow of foreign capital → greater
supply of
• foreign currency → appreciation of domestic currency
• • Monetary Approach Flexible Price Version
• 1. Increase in money supply → higher price level → depreciation of
domestic currency
• 2. Money supply being less than real domestic output → excess
demand for money
• balances → lower domestic prices → appreciation of domestic
currency
• 3. Rise in interest rate → lower demand for money → domestic
currency depreciates
• Monetary Approach Sticky Price Version
• 1. Increase in money supply → depreciation of domestic currency
• 2. Increase in money supply → price rise → lower real interest rate → lower infl ow of
• capital → depreciation of domestic currency
• 3. Rise in interest rate → greater infl ow of capital → appreciation of domestic currency
• 4. Rise in interest rate → increase in money supply (loanable funds) → depreciation
• of domestic currency
• • Portfolio Balance Approach
• 1. Domestic income/wealth increase → greater demand for foreign fi nancial assets →
• depreciation of domestic currency
• 2. Foreign fi nancial assets being more risky → demand for them decreases → appreciation
• of domestic currency