Companies involved in international trade are exposed to foreign exchange risk, and since they are sensitive to rate fluctuations, some will try to estimate the timing of the fluctuations or forecast rates themselves.
This exercise is quite complex, because it is virtually impossible to correctly forecast the movements of foreign exchange rates over short-, medium- or long-term periods. But two general theories of foreign exchange rate behaviour are useful in forecasting long-run foreign exchange movements: purchasing power parity and interest rate parity.
1. Purchasing power parity (PPP)
Defined by the Swedish economist G. Cassel in 1918, purchasing power parity (PPP) states that the exchange rate between the domestic currency and any foreign currency will adjust to reflect differences in the inflation rates between them. This means that there is a relationship between inflation rate differentials in two countries and the movements in the foreign exchange rates of these countries’ currencies in the markets.
According to this theory, if, for example, the U.S. inflation rate is higher than the Canadian inflation rate, then the purchasing power of Americans will erode compared to that of Canadians, and the value of the U.S. dollar against the Canadian dollar will be adjusted in the markets to balance the purchasing power of the two currencies.
Theoretically, the adjustment will equal the difference in the two countries’ inflation rates. For example, if inflation is running at six percent in the United States and at three percent in Canada, the Canadian dollar should gain three percent in value against the U.S. dollar.
PPP is based on the notion that high domestic inflation rates will ultimately make exports more expensive to foreigners, make investments more expensive to foreigners and make tourism to that country more expensive to foreigners.
This will cause a drop in demand for a country’s exports, its investments and in tourism, and cause the currency exchange rate to adjust (fall) as the demand for that country’s currency drops.
Exchange rates will continue to adjust, driving the price of the domestic currency downward by as much as it takes to equal the difference in inflation rates. As a result, so the theory holds, a product that costs double what it used to in terms of the domestic currency will still cost as much as it used to in the foreign currency, since a unit of that currency can now buy twice as much of the devalued domestic currency.
However, many factors affect short-term exchange rates in addition to differential inflation rates. Thus, PPP is not a particularly good predictor of short-term exchange rate movements. It does, however, do a fairly good job of predicting general exchange rate changes over the longer term. PPP is based on complicated assumptions.
In the short term, it appears that expectations, interest rate fluctuations and movements of capital have a greater influence on rates than inflation rate differentials do. As a result, many studies have failed to establish the reliability of this theory, and it should therefore only be used in conjunction with other methods, not alone.
2. Interest rate parity (IRP)
Another general theory for forecasting foreign exchange rates is the theory of interest rate parity (IRP) which establishes a direct relationship between the interest rate differential of two countries and the evolution of their foreign exchange rates over time.
IRP theory holds that differences in interest rates between two countries will cause the currency with the higher interest rate to drop in value relative to the lower interest rate currency. The theory holds that this devaluation will occur until the real interest rates in the two countries are equal.
Using this theory, if interest rates were eight percent per annum in one country and only six percent per annum in another country, we would expect the currency in the country with the highest interest rates to fall two percent against the currency of the other country.
If the theory was perfect, an investor depositing funds in a foreign country where interest rates are higher would not profit from this transaction. The movements in foreign exchange rates between the two countries would approximately level the return on investments as time passed.
The IRP theory is based on the notion that high interest rates are driven by high inflation rates (see the PPP above), so a comparatively high interest rate would signal a comparatively high level of inflation.
Therefore, the idea is that investors cannot secure long-term real increases in yield simply by investing in investments with similar risk in another currency. If they could, everyone would shift to the higher yield investments, thereby increasing the supply of the high yield currency to the point where the interest rates would equalize.
Again, as with PPP, IRP does not accurately predict short-term exchange rate changes. However, it is useful in predicting exchange rate changes for high interest rate currencies over the long-term.