The main economic theories found in the foreign exchange deal with parity conditions. A parity condition is an economic explanation of the price at which two currencies should be exchanged, based on factors such as inflation and interest rates. The economic theories suggest that when the parity condition does not hold, an arbitrage opportunity exists for market participants. However, arbitrage opportunities, as in many other markets, are quickly discovered and eliminated before even giving the Indivizual investor an opportunity to capitalize on them. Other theories are based on economic factors such as trade, capital flows and the way a country runs its operations. We review each of them briefly below.
Major Theories: Purchasing Power Parity
Purchasing Power Parity (PPP) is the economic theory that price levels between two countries should be equivalent to one another after exchange-rate adjustment. The basis of this theory is the law of one price, where the cost of an identical good should be the same around the world. Based on the theory, if there is a large difference in price between two countries for the same product after exchange rate adjustment, an arbitrage opportunity is created, because the product can be obtained from the country that sells it for the lowest price.
The relative version of PPP is as follows:
Where 'e' represents the rate of change in the exchange rate and 'π1' and 'π2'represent the rates of inflation for country 1 and country 2, respectively.
For example, if the inflation rate for country XYZ is 10% and the inflation for country ABC is 5%, then ABC's currency should appreciate 4.76% against that of XYZ.
Interest Rate Parity
The concept of Interest Rate Parity (IRP) is similar to PPP, in that it suggests that for there to be no arbitrage opportunities, two assets in two different countries should have similar interest rates, as long as the risk for each is the same. The basis for this parity is also the law of one price, in that the purchase of one investment asset in one country should yield the same return as the exact same asset in another country; otherwise exchange rates would have to adjust to make up for the difference.
The formula for determining IRP can be found by:
Where 'F' represents the forward exchange rate; 'S' represents the spot exchange rate; 'i1' represents the interest rate in country 1; and 'i2' represents the interest rate in country 2.
International Fisher Effect
The International Fisher Effect (IFE) theory suggests that the exchange rate between two countries should change by an amount similar to the difference between their nominal interest rates. If the nominal rate in one country is lower than another, the currency of the country with the lower nominal rate should appreciate against the higher rate country by the same amount.
The formula for IFE is as follows:
Where 'e' represents the rate of change in the exchange rate and 'i1' and 'i2'represent the rates of inflation for country 1 and country 2, respectively.
Balance of Payments Theory
A country's balance of payments is comprised of two segments - the current account and the capital account - which measure the inflows and outflows of goods and capital for a country. The balance of payments theory looks at the current account, which is the account dealing with trade of tangible goods, to get an idea of exchange-rate directions.
If a country is running a large current account surplus or deficit, it is a sign that a country's exchange rate is out of equilibrium. To bring the current account back into equilibrium, the exchange rate will need to adjust over time. If a country is running a large deficit (more imports than exports), the domestic currency will depreciate. On the other hand, a surplus would lead to currency appreciation.
The balance of payments identity is found by:
Where BCA represents the current account balance; BKA represents the capital account balance; and BRA represents the reserves account balance.
Real Interest Rate Differentiation Model
The Real Interest Rate Differential Model simply suggests that countries with higher real interest rates will see their currencies appreciate against countries with lower interest rates. The reason for this is that investors around the world will move their money to countries with higher real rates to earn higher returns, which bids up the price of the higher real rate currency.
Asset Market Model
The Asset Market Model looks at the inflow of money into a country by foreign investors for the purpose of purchasing assets such as stocks, bonds and other financial instruments. If a country is seeing large inflows by foreign investors, the price of its currency is expected to increase, as the domestic currency needs to be purchased by these foreign investors.