Theories About Foreign Exchange

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1. Introduction

Professor Adrian Buckley states that the test of a good theory concerns the strength with which it can stand up in the real world. A number of theories about foreign exchange have emerged over the years with diverse definitions and assumptions. The five important theories that are widely recognised and used in the contemporary environment are detailed below.

  • Purchasing Power Parity (PPP)
  • Interest Rate Parity Theory (IRPT)
  • Fisher Effect
  • International Fisher Effect (IFE)
  • Expectations Theory (EP)

This report discusses various aspects of these theories with special regard to their strength in standing up in the real world environment.

2. Purchasing Power Parity Theory (PPP)

The PPP theory was developed by Gustav Cassel in 1920. Power Parity Purchasing is fundamentally based on the one price law and states that identical services or goods should have only one price in identical efficient markets (Craig, 2005). PPP is important to foreign exchange markets and is a driving force behind currency movements in such markets. It confirms the relationship between exchange rates of different countries and the prices at which products and services are sold in such countries. Forex purchasing power parity can also be described as the equilibrium that exists between currencies when their purchasing powers are the same in the concerned countries (Craig, 2005).

The Purchasing Power Parity Theory states that if spot exchange rates of 2 nations commence from an equilibrium point, the variation in the rate of inflation of these nations will certainly have an influential impact on the long term currency values of these nations. Ricardo states that determination of foreign exchange rates between two currencies will require the ratio of the values of these two currencies to equal the ratios of the respective CPI (Consumer Price Index) of these nations (Hakkio, 1992). It can also be implied that the Forex rate of two countries plays a decisive factor in maintenance of equilibrium of the purchasing power of these countries. Real exchange rates consequently move around steady equilibrium levels. The PPP theory assumes that exporters and importers act on the basis of cross country price differences and bring about alterations in spot exchange rates (Choong, et al, 2006).

The PPP theory is based on the assumption that foreign exchange rates exist in equilibrium and will increase or decrease with change in prices of different countries. The theory is not used in predicting foreign exchange rates, and governments do not by and large let market mechanisms influence their exchange rates (Hakkio, 1992). The PPP theory however has a number of weaknesses. It does not for all practical purposes take account of the influence of non tradable goods in the calculation of Forex rates because the absence of such goods from international trade is bound to have a significant impact on the Forex rate (Choong, et al, 2006).

The PPP theory does not take account of the relevance of transaction or transportation costs in the determination of Forex rates. Whilst the prices in importing states are by and large higher than those in exporting countries, the situation is also influenced by the costs that are likely to be incurred on transportation, insurance and transactions. Other issues like incomes and cultures also determine the Forex rates (Choong, et al, 2006). It is also possible that whilst the PPPs of particular countries may be decreasing, their balance of payments might be increasing, with consequent effect on Forex rates. The PPP influence is also affected by factors like the impact of IS-LM curves, the need to take account of wholesale, retail and consumer prices, and other barriers like prices and quotas (Craig, 2005).

It however remains a fact that whilst the application of the PPP theory is constrained by many barriers, it remains the best possible way of forecasting exchange rates between countries in the long term (Craig, 2005). Whilst empirical studies do reveal considerable and drawn out short-run deviations from relative PPP, when measured with the use of real effective exchange, relative PPP holds remarkably well in the long run (Craig, 2005).

2. Interest Rate Parity Theory

The IRPT, whilst akin to PPP, approaches the issue from another perspective and focuses on the interest rate of a country, a force that influences the movement of capital from a country with a lower interest rate to a country with a higher one (Harvey, 2006). The phenomenon, known as Interest Rate Arbitrage, implies that existences of differences in exchange rates are likely to lead to the emergence of capital flows to countries with higher interest rates and to the consequent increase in demands for such currencies (Harvey, 2006).

Movement of capital flows on account of differences in interest rates are however subject to risks that can arise on account of exchange rate fluctuations. To provide an example the movement of capital from one country to another, for example the UK and Japan, should under this theory move from one country to another on the base of their interest rates. If Japan has an interest rate of 9 % and UK, of 7 %, capital flows should move from the UK to Japan to take advantage of the 3 % difference between such interest rates (Bekaert & Hodrick, 2008). Individuals desirous of investing in Japan will cash their UK bonds convert their money from GBP to Yen and invest in Japanese bonds. They will however have to convert their again from Yen to GBP after completion of their transactions. Such processes could be hazardous because of the tendency of the currency being sold to fall in comparison to the currency being bought (Bekaert & Hodrick, 2008). It could happen that the fall in the value of the Yen at the time of completion of transaction could outweigh the benefits obtained from arbitrage in interest rates and reduce or eliminate the benefits from such transactions (Harvey, 2006).

Investors often solve such problems by the use of swap contracts, which allow investors to sell their currency in advance at the time of the commencement of the transaction (Bekaert & Hodrick, 2008). Investors can use the Covered Interest Rate Arbitrage process to protect themselves from interest rate fluctuations (Harvey, 2006). The use of Covered Interest Arbitrage, enables the obtaining of the equilibrium relationship between Forex and interest rate, illustrated as under;

If A = forward exchange rate

B = spot exchange rate

C = foreign interest rate

D = domestic interest rate

The equilibrium relationship between Forex and interest rate can be represented is
A = B (1+C)


The differences in interest rates between two countries tend to be low or insignificant because when such differences equal or exceed investors transfer funds to the state with higher rates of interest (Harvey, 2006). Such transfers increase the liquidity for the concerned currency and result in downward forces on the interest rate until the different in interest rates between two nations becomes equal to forward exchange premium rates (Bekaert & Hodrick, 2008).

If F = forward exchange premium rate, it can be implied that (A-F = C) in extreme cases,

Several instances can however occur when relationships between interest rates of two states may not be in line with the tenets of Interest Rate Parity Theory. The real world in the first case does not have perfect capital mobility (Harvey, 2006). The obtaining of benefits from interest rate arbitrage transactions requires investors to conduct at least two such transactions, both of which are exposed to exchange rate fluctuation risks (Bekaert & Hodrick, 2008). Interest rate parity has evidenced little proof of working in the recent past. Currencies with higher interest rates often rise because of the efforts of central bankers to slow down booming economies by hik­ing rates, which have little to do with riskless arbitrage (Bekaert & Hodrick, 2008).

3. Fisher Effect (IFE)

Irving Fisher, an American economist, contributed significantly to theories on money, inflation and interest rates in the first half of the 20th century (Jensen, 2009).

Fisher stated that the nominal interest rates in individual countries could be broken into two parts, the real rate and the expected inflation rate. Fisher advanced the theory of a one-to-one association between inflation and rates of interest in a global environment of faultless foresight, where real interest rates would not be related to the expected inflation rate and would be determined by real economic factors like productivity of capital and time preference of savers/investors (Jensen, 2009).

This is a significant prediction of the Fisher Effect because alterations in the real rate will not result in complete adjustment in nominal rates in answer to anticipated inflation if real rates of interest rates are related to expected inflation rates (Bekaert & Hodrick, 2008). The Fisher Hypothesis provides a simple relationship between three variables, i.e. nominal and real interest rates and expected inflation rates, illustrated as under:

If a = nominal interest rate

b = real interest rate

c = expected rate of inflation

Then the relationship between these variables is “a = b + c”

These relationships are illustrated in the chart provided below:


Country A

Country B

Nominal Interest Rate



Real Interest Rate



Expected Inflation Rate



It is important to first differentiate between the rates that can be seen in the markets in order to realise the association of inflation /deflation and interest rates.This rate is typically termed the nominal or market interest rate (Streissler, 2002).The change in price levels change during inflation results in shrinkage of the principal loan amount.Inflation thus has an effect that is similar to a negative interest rate.If the rate of inflation over the year, on a one year loan that is annually compounded at 7 percent, is 3 percent, then the real interest rate is 4 percent, i.e. the nominal interest rate less 3 percent (Bekaert & Hodrick, 2008).If the prices were to instead fall by 4 percent over a year (i.e. deflation rate of 4 percent), then the real interest rate would climb to 10 percent because the nominal rate of interest of 6 percent would be enhanced by the rate of deflation of 2 percent (Bekaert & Hodrick, 2008).Deflation enhances the real value of principal and works like an additional rate interest that accrues to the lender.Both of these are true by definition Strauss & Terrell, 1995).The real rate of interest represents the nominal (or market interest rate) adjusted for changes in price levels.The nominal interest rate will be greater than its counterpart, adjusted for price levels, the real interest rate, during inflationary period.It will however be lower than real interest rates during deflationary periods (Jensen, 2009).

The nominal interest rate and real interest rate must diverge when price levels are change, both during inflation and deflation.The nominal rate will equal the real rate only when price levels are stable (Bekaert & Hodrick, 2008).

4. International Fisher Effect (IFE)

The International Fisher Effect Theory, also known as the “Fisher Open”, represents an international finance hypothesis that states that difference in nominal interest rates between two nations determine the movement of nominal exchange rates between their currencies; the currency value of the country with lower nominal interest rates increases in such circumstances (Eun, S. C., & Resnick, G. B., 2003). Also known as the rationale of Uncovered Interest Parity, the IFE is perceived to be a combination of the Fisher Effect and the relative interpretation of the PPP model. The Fisher Effect hypothesises that real interest rates across nations tend to equalise on account of arbitrage possibilities. If the real interest rates across countries are equal, differences in nominal interest rates must come about on account of differences in expected inflation rates (Eun, S. C., & Resnick, G. B., 2003).

The PPP theory hypothesises that inflation differentials across nations are likely to be offset by exchange rate changes. The IFE holds forth that spot exchange rate alterations between two nations will be equal to disparities in their nominal interest rates (Bekaert & Hodrick, 2008). The increase in inflation of country A compared to country B will lead to depreciation of the currency of country A compared to that of country B. In such circumstances the nominal interest rate of country A will increase in comparison to nominal interest rate of country B (Bekaert & Hodrick, 2008). Such adjustment of exchange rate on account of differentials in nominal interest rates between nations can occur on account of various reasons like (a) capital flows across international money markets, (b) actions between the goods and money markets, (c) cross border investment activities, and (d) changes in trade patterns in markets for goods and services (Dimand, 2003). Speculators would in such instances transfer their capital from low interest rate to high interest rate states. Such capital movements would result in movements in foreign exchange rates, which would be likely to compensate differentials in nominal interest rates (Bekaert & Hodrick, 2008).

The IFE leads to the conclusion that differentials in nominal interest rates can act as predictors for alterations in future spot exchange rates. It must however also be considered that purchase of foreign assets, whilst being return bearing investments are also foreign currency investments, where returns depend upon appreciation or depreciation of Forex rates (Eun, S. C., & Resnick, G. B., 2003). The IFE postulates that returns on foreign investment will be offset by exchange rate alterations, leading investors to purchase foreign assets that will by and large earn returns similar to domestic asset investments (Dimand, 2003).

It should be considered that huge interest rate changes, as seen in the past, do not occur in the contemporary environment. Modern day central bankers focus on inflation targets and determine interest rates on the basis of expected inflation rates (Bekaert & Hodrick, 2008). The Fisher models may thus not be practical for implementation in daily currency trades, but their utility rests in their illustration of expected relationships between interest, inflation and exchange rates (Bekaert & Hodrick, 2008).

5. Expectations Theory (EP)

The Expectations Theory postulates that strong economies, where future interest rates are expected to rise on account of increased borrowings from various sectors, individuals and organisations are likely to result in rising yield curbs (Blanchard, 2009). Conversely weakening economies where reduction in consumer and business borrowing is likely to lead to decreasing interest rates are indicators of falling yield curbs. Such behaviour in yield curbs is essentially caused by investor behaviour, which changes in accordance to perceptions about interest rates of short and long term bonds (Blanchard, 2009). Expectations about declining interest rates in the near future result in investors selling their short term bonds and transferring their monies to long term bonds, which consequently results in falling of prices of short term bonds and increase prices of long term bonds (Mishkin, 2003). Considering that yields and bond prices move in opposite directions, yields go up when short term bond prices drop and fall when long term bond prices rise. The yield curb thus tends to move in a negative direction with increase in shorter yields and decrease in long term yields (Reddick, 2004).

The available empirical evidence however suggests that the use of the expectations theory often results in over statement of future rates of interest for short term bonds (Blanchard, 2009). Such over estimation could occur on account of the higher risk premiums that are associated with the holding of long term debt securities, whose yield is likely to be more uncertain because of the possibility of changes in interest rates (Reddick, 2004). Whilst empirical evidence on testing of expectations theory has given different results in different countries, it continues to be a fundamental component of financial theory and has significant implications for the prediction of future movements in rates of interest, interpretation of monetary policy and building of macroeconomic models (Blanchard, 2009).