Forward Rate Using Both Interest Rate Parity Theory and the Purchasing Power Parity Theory - Coursework Example

The forecast of rate using the purchasing power parity theory can also be concluded as the unbiased estimation of the forward rate.

According to the interest rate parity theory, the difference between the interest rate of two countries is equal to the differential between the forward exchange rate and the spot exchange rate of two countries. In the current global economy, interest rate parity theory plays a great part in connecting the interest rates and exchange rates of two countries. The origin of this theory can be associated with an article written by Walther Lotz in 1884 which was concerned with the Vienna forward market. In 1927, another renowned economist Keynes pointed out the fact that forward premiums are affected by the relative interest differential. There are certain assumptions that need to be considered. The securities, both domestic and foreign, are considered to be identical in terms of maturity time and risk. It is the prevailing interest rate on these securities that is utilized in the interest rate parity calculation. In addition, it is also assumed that there are no capital controls or transaction cost and market imperfections.

Purchasing power parity theory is another theory widely used in determining the forward rates of a particular currency. As per this theory, when a country’s inflation rate rises, the demand for its currency declines as its exports also declines due to the higher prices. As a corresponding impact, the importers and firms in that country start putting more emphasis on the imported goods and other items. These two factors in combination cast a downward impact on the high inflation of a country’s currency. Inflation rates do not remain constant between countries which causes international trade patterns and exchange rates to adjust accordingly. There are two forms of purchasing power parity theory. One is absolute form and the other is relative form. The rationale behind the purchasing power parity theory is that whether buying products locally or from another country, exchange rate adjustment is necessary for the relative purchasing power. Read More