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Module 11 Foreign Exchange Lecture Notes

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Foreign Exchange
The determination of forex rates can be broken down into 2 calculations:
1. Purchasing Power Parity (PPP) and
2. Interest Rate Parity (IRP)
1. PPP suggests that exchange rates will be affected by the different levels of
inflation that hold in each country. For example, if the UK has 3% inflation and the
US has 1% inflation, then the UK currency will decline against the US dollar. The
price of goods will be the same in each country once you have adjusted for inflation.
The calculation is laid out in the text in section 11.2.4, but a more intuitive way of
solving these problems can be done as follows:
Take the spot forex quote, eg. $1.444/£1,
One currency is the domestic currency and one currency is the foreign
currency. The currency with the single unit in the quote is the domestic currency
(ie, £) and the currency on the left of the quote (the non single unit, ie the $) is the
foreign currency.
Label one currency domestic (DOM) (£) and one currency foreign (FORN)
($)
With the PPP you are looking for the expected spot rate at some time in the
future. This can be laid out as follows:
Expected spot = 1 + Foreign inflation rate * spot rate
1 + Domestic inflation rate
= 1 + FORN * spot
1 + DOM
In this worked example, the spot is $1.444/£1, US inflation (Foreign) is 1%,
UK inflation (Domestic) is 3%. The expected spot rate in one year’s time will
be:
Expected spot = 1.01 * 1.444
1.03
= 0.98058 * 1.444
= $1.41596/£1

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If you wanted the expected rate in six months:
Expected spot in 6 mths = (1.01)
0.5
* 1.444
(1.03)
0.5
= 1.0049876 * 1.444
1.0148892
= $1.42991/£1
So the formula becomes:
Expected spot = (1 + Foreign inflation rate)
n
* spot rate
(1 + Domestic inflation rate)
n
Using other currency pairs, eg Russian Rouble and the euro. If inflation is
11% in Russia and 2% in the euro zone, the spot exchange rate is 34.9969
roubles to the euro, what is the expected spot rate in three months time?
First, identify which currency is the foreign and which is the domestic. The
euro is the single unit in the quote so it is the domestic currency.
Second, write out our formula and drop the inflation numbers in:
Expected spot (3 mths) = 1 + foreign * spot rate
1 + domestic
= (1 + 0.11)
0.25
* 34.9969
(1 + 0.02)
0.25
= RR35.74459/1euro
The PPP is a long term determinant of exchange rates. Exchange rates do not change
quickly to move to what the PPP would predict, so we would say that PPP does not
hold in the short term, but is a much better predictor of exchange rates in the longer
term.
2. Interest Rate Parity.
This is the method for establishing forward exchange rates in the short term. It holds
that the interest rate differential between different currencies will determine the
forward exchange rate. The forward exchange rate is something that you can actually
trade. You can buy the forex forward (you cannot buy the expected spot rate at some
point in the future, ie the rate determined by the PPP). The IRP is a very powerful
relationship. The interest rates are visible, all the traders can see what the rates are, so
the forward rate can be quickly calculated. If the quoted forward is different from that

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Foreign Exchange The determination of forex rates can be broken down into 2 calculations: 1. Purchasing Power Parity (PPP) and 2. Interest Rate Parity (IRP) 1. PPP suggests that exchange rates will be affected by the different levels of inflation that hold in each country. For example, if the UK has 3% inflation and the US has 1% inflation, then the UK currency will decline against the US dollar. The price of goods will be the same in each country once you have adjusted for inflation. The calculation is laid out in the text in section 11.2.4, but a more intuitive way of solving these problems can be done as follows: • Take the spot forex quote, eg. $1.444/£1, One currency is the domestic currency and one currency is the foreign currency. The currency with the single unit in the quote is the domestic currency (ie, £) and the currency on the left of the quote (the non single unit, ie the $) is the foreign currency. • Label one currency domestic (DOM) (£) and one currency foreign (FORN) ($) • With the PPP you are looking for the expected spot rate at some time in the future. This can be laid out as follows: Expected spot = = • 1 + Foreign inflation rate 1 + Domestic inflation rate 1 + FORN 1 + DOM * spot rate * spot In this worked example, the spot is $1.444/£1, US inflation (Foreign) is 1%, UK inflation (Domestic) is 3%. The expected spot rate in one year’s time will be: Expected spot = 1.01 1.03 * 1.444 = 0.98058 * 1.444 = $1.41596/£1 • ...
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