The purchasing power parity theory was

put forward by Gustav Cassel.

In the word of Cassel, the rate of exchange
between two currencies must stand
essentially on the quotient of the internal
purchasing powers of these currencies.
According to the Purchasing power parity
theory, the exchange rate between one
currency and another is in equilibrium when
their domestic purchasing powers at that
rate of exchange are equivalent.

If there is change in prices (i.e., the

purchasing power of the currencies), the
new equilibrium rate of exchange can be
find out by the following formula :
ER = Er Pd/Pf
Where
ER = Equilibrium exchange rate
Er = Exchange rate in the reference period
Pd = Domestic price index
Pf = Foreign countrys price index

Because the exchange rates only reflects

when goods are traded. Also, currencies are
traded for purposes other than trade in
goods and services, e.g., to buy capital
assets.
Also, different interest rates, speculation or
interventions by central banks can influence
the foreign-exchange market.

Differences in living standards between

nations because PPP takes into account the
relative cost of living and the inflation rates
of the countries,

For example, a TV set that sells for 750 Canadian

Dollars [CAD] in Vancouver should cost 500 US
Dollars [USD] in Seattle when the exchange rate
between Canada and the US is 1.50 CAD/USD.
If the price of the TV in Vancouver was only 700
CAD, consumers in Seattle would prefer buying
the TV set in Vancouver due to which the US
consumers buying Canadian goods will bid up the
value of the Canadian Dollar, thus making
Canadian goods more costly to them. This
process continues until the goods have again the
same price.

PPP rate fluctuations are mostly due to

different rates of inflation in the two
economies which would result in the
difference in prices at home and abroad

The balance of payments theory, also

known as the demand and supply theory
and the General equilibrium theory of
exchange rate.
According to this theory, the foreign
exchange rate, under free market
conditions, is determined by the conditions
of demand and supply in the foreign
exchange market.

According to this theory, the price of a

currency, i.e., the exchange rate, is
determined just like the price of any
commodity is determined by the free play
of the forces of demand and supply.
The value of a currency appreciates when
a demand for it increases and depreciates
when the demand falls, in relation to its
supply in the foreign exchange market.

1. Unlike the purchasing power parity

theory, the balance of payments theory
recognises the importance of all the items in
the balance of payments, in determining the
exchange rate.
2. This demand and supply theory is in
conformity with the General theory of value
--- like the price of any commodity in a free
market, the rate of exchange is determined
by the forces of demand and supply.

3.
This theory brings the determination of
the rate of exchange within the purview of the
General equilibrium theory. That is why this
theory is also called the general equilibrium
theory of exchange rate determination.
4.
It also indicates that balance of
payments disequilibrium can be corrected by
adjustments in the exchange rate (i.e., by
devaluation or revaluation), rather than by
internal deflation or inflation.

The Interest Rate Parity states that the

interest rate difference between two
countries is equal to the percentage
difference between the forward exchange
rate and the spot exchange rate.

It plays essential role in foreign exchange

markets.
The difference between the interest rates in
any two countries is the same as the
difference between the forward and the
spot rates of their respective currencies.

Interest rate parity A currency is worth

what it can earn.

The return on a currency is the interest

rate on that currency plus the expected
rate of appreciation over a given period.

When the returns on two currencies are

equal, interest rate parity prevails.

The relationship can be seen when you follow

the two methods an investor may take to convert
foreign currency into U.S. dollars.

Option A would be to invest the foreign currency

locally at the risk-free rate for a specific time
period. Then convert the proceeds from the
investment into U.S. dollars at the maturity.

Option B would be to invest the same dollars in

the (U.S.) market for the same time period. When
no arbitrageopportunities exist, the cash flows
from both options are equal.

Rate of return in local

currency

Rate of return in foreign

currency

In equilibrium, returns on currencies will be the

same i. e. No profit will be realized
and interest rate parity
exits which can be written
(1 + rh) = F
(1 + rf)
S

If interest rate parity is violated, then an arbitrage

opportunity exists. The simplest example of this is what
would happen if the forward rate was the same as the spot
rate but the interest rates were different, then investors
would:

borrow in the currency with the lower rate

convert the cash at spot rates
enter into a forward contract to convert the cash plus the
expected interest at the same rate
invest the money at the higher rate
convert back through the forward contract
repay the principal and the interest, knowing the latter will
be less than the interest received.

If domestic interest rates are less than

foreign interest rates, you will invest in
foreign country at higher interest rates.

Domestic investors can benefit by investing

in the foreign market

The Investor Hedge Argument

MNC shareholders can hedge against exchange

rate fluctuations on their own.

The investors may not have complete information
on corporate exposure. They may not have the
capabilities to correctly insulate their individual
exposure too.

Currency Diversification Argument

An MNC that is well diversified should not be

affected by exchange rate movements because of

offsetting effects.

Stakeholder Diversification Argument

Well diversified stakeholders will be somewhat

insulated against losses experienced by an MNC

due to exchange rate risk.
MNCs may be affected in the same way because
of exchange rate risk.

Response from MNCs

Many MNCs have attempted to stabilize
their earnings with hedging strategies,
which confirms the view that exchange rate
risk is relevant.

Although exchange rates cannot be

forecasted with perfect accuracy, firms can
at least measure their exposure to
exchange rate fluctuations.
Exposure to exchange rate fluctuations
comes in three forms:

Transaction exposure
Economic exposure
Translation exposure

The degree to which the value of future

cash transactions can be affected by
exchange rate fluctuations is referred to as
transaction exposure.
To measure transaction exposure:

project the net amount of inflows or outflows in

each foreign currency, and

determine the overall risk of exposure to those
currencies.

MNCs can usually anticipate foreign cash

flows for an upcoming short-term period
with reasonable accuracy.
After the consolidated net currency flows for
the entire MNC has been determined, each
net flow is converted into either a point
estimate or a range of a chosen currency,
so as to standardize the exposure
assessment for each currency.

An MNCs overall exposure can be assessed

by considering each currency position
together with the currencys variability and
the correlations among the currencies.
The standard deviation statistic on historical
data serves as one measure of currency
variability. Note that currency variability
levels may change over time.

The exposure of the MNCs consolidated

financial statements to exchange rate
fluctuations is known as translation
exposure.
In particular, subsidiary earnings translated
into the reporting currency on the
consolidated income statement are subject
to changing exchange rates.

Does Translation Exposure Matter?

Cash Flow Perspective - Translating financial
statements for consolidated reporting
purposes does not by itself affect an MNCs
cash flows.
However, a weak foreign currency today
may result in a forecast of a weak exchange
rate at the time subsidiary earnings are
actually remitted.

An MNCs degree of translation exposure is

dependent on:
the proportion of its business conducted by its

foreign subsidiaries,
the locations of its foreign subsidiaries, and
the accounting method that it uses.

Does Translation Exposure Matter?

Stock Price Perspective - Since an MNCs

translation exposure affects its
consolidated earnings and many
investors tend to use earnings when
valuing firms, the MNCs valuation may
be affected.

In general, translation exposure is relevant

because
some MNC subsidiaries may want to remit their

earnings to their parents now,

the prevailing exchange rates may be used to
forecast the expected cash flows that will result
from future remittances, and
consolidated earnings are used by many investors
to value MNCs.

An MNCs degree of translation exposure is

dependent on:
the proportion of its business conducted by its

foreign subsidiaries,
the locations of its foreign subsidiaries, and
the accounting method that it uses.

Economic exposure refers to the degree to

which a firms present value of future cash
flows can be influenced by exchange rate
fluctuations.
Cash flows that do not require conversion of
currencies do not reflect transaction
exposure. Yet, these cash flows may also
be influenced significantly by exchange rate
movements.

Even purely domestic firms may be affected

by economic exposure if there is foreign
competition within the local markets.
MNCs are likely to be much more exposed
to exchange rate fluctuations. The impact
varies across MNCs according to their
individual operating characteristics and net
currency positions.

One measure of economic exposure

involves classifying the firms cash flows
into income statement items, and then
reviewing how the earnings forecast in the
income statement changes in response to
alternative exchange rate scenarios.
In general, firms with more foreign costs
than revenues will be unfavorably affected
by stronger foreign currencies.

Another method of assessing a firms

economic exposure involves applying
regression analysis to historical cash flow
and exchange rate data.