Question

IFE, IRP, and PPP. Understand the implications of the three theories, and be able to explain and mathematically work with them.

Answer 1

IFE stands for International Fisher Effect. This theory states that the changes in currency values at a particular time period, between any 2 countries is directly proportional to the difference between their nominal interest rates. Nominal interest rates is equal to the sum of real interest rates and expected inflation. According to IFE, country with higher nominal interest rate will see its currency depreciate. So IFE focuses on how the currency's spot rates will change over time.

The formula used to calculate is (1+nominal rate) = (1+real rate) * (1+inflation rate)

IRP stands for interest rate parity. It is used to predict future currency movements. This theory states that countries with lower interest rates will have lower inflation which in turn will result in the appreciation of its currency with respect to the country with higher interest rates. So IRP theory focuses on the reasons why the forward rates are different from the spot rates.

For example, if USD/GBP is trading at 1.30 today. The interest rate in US is 2% and that in UK is 1% p.a. According to IFE, the forward exchange rate of USD/GBP in 1 year would be 1.30 * (1+2%)/(1+1%) = 1.3128. We can see that USD depreciates as the interest rates in US is higher than UK.

PPP stands for purchasing power parity. This theory states how much amount will people in each country will have to pay for the "basket of goods". The different countries' currencies can be compared using this approach. The actual purchasing power of any currency is the quantity of that currency required to buy the basket of goods. The basis of this theory is the law of one price. In the absence of any transportation and other costs the amount of goods, the amount of goods which can be bought with each country's currency should be the same.

For example, a washing machine that sells for USD 500 in US should sell for GBP 384 in the UK if the exchange rate between them is 1.30 USD/GBP.