This lesson examines the core theories used to explain and forecast exchange rate movements.

2.1. Interest Rate Parity (IRP)

Interest Rate Parity (IRP) is a theory that links exchange rates to interest rate differentials. It suggests that the forward exchange rate should be in equilibrium with the spot rate and the interest rate differential between two countries . The formula for calculating the theoretical forward rate is:

F₀ = S₀ × [(1 + i_c) / (1 + i_b)]

Where:

• F₀ = Forward rate

• S₀ = Current spot rate

• i_c = Interest rate in country c

• i_b = Interest rate in country b

This theory is fundamental for pricing forward contracts and understanding the relationship between spot and forward markets .

2.2. Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) is a theory that suggests exchange rates will adjust to equalise the cost of a basket of goods between countries . In its simplest form, absolute PPP states that the exchange rate should be equal to the ratio of the price levels in two countries. Relative PPP predicts that the change in the exchange rate over time will be equal to the inflation differential between the two countries. It can be used to forecast future spot rates.

2.3. The Fisher Effect

The Fisher Effect describes the relationship between nominal interest rates, real interest rates, and expected inflation . The formula is:

(1 + nominal rate) = (1 + real interest rate) × (1 + inflation rate)

This theory is used alongside IRP and PPP to understand the complex drivers of exchange rates and interest rates.