Hi John, I just wanted to confirm if I’m getting it right.
Purchasing power parity means that the reduction in the purchasing power of a particular currency will lead to the currency buying less of another currency.
It also means that the change in price of an item due to inflation in one country’s currency, will not affect the price of the same item in another country’s currency.
In first illustration if we assume no inflation in US, the price in US will remain $150, reducing the exchange rate to $1.47 per pound.
According to this, the inflation in one country, should not affect the price of its goods (exports) in another country, but practically if a country has higher inflation, its exports will become relatively expensive, why is that so?

I will use your example (inflation at 2% in the UK and 0% inflation in the US) and your arithmetic is correct in the the exchange rate will be $1.47 to the pound (so the pound has weakened – one pound buys fewer dollar, and therefore one dollar will buy more pounds).

The Pound price of UK exports will indeed increase. However, because the pound has weakened, it will mean that when the US importer convert dollars to pay for them, the final dollar cost to the US importer will remain the same.

Obviously in real life, lots of other factors will affect the exchange rate – inflation is just one of the factors – and also the change in the exchange rate is unlikely to be instant (and depends more on expectations of future inflation).

(In future, it is better to ask this sort of question in the F9 Ask the Tutor Forum. I always see questions in the forum, but I do not always see comments on lectures.)

In real life, there are lots of interest rate, such as: short-term and long-term loan interest rate, and interest rate of deposit with many different terms. They usually change due to market. they don’t stay constant.

Related to formulae of Interest rate Parity, which interest rate can we apply to calculate the exchange rate while real Interest rate don’t fix, and is the formulae right while the interest rate always fluctuate?

Could you please help me to understand these problem.

The interest rates used are the interest rates being quoted ‘today’ (the day the forward rate is being quoted) for fixed interest depositing or borrowing for the period in question (i.e. three month interest for 3 month forward rates etc..).

It has the same effect as money market hedging as is explained in the lecture on money market hedging.

In the exam it is not a problem anyway because you are only given one set of interest rates.

Hi John
can i say S2=S0 * {(1+Hc)/(1+Hb)}2 ? and similarly raise the power to 4 if you want the exchange rate in 4 years time assuming that inflation rate stays constant.

Dear Sir, I am doing the specimen questions and I am confused as to why the purchasing power parity could not have been used to forecast the 6 month forward exchange rate. The question : The home currency of ACB Co., is the dollar and it trades with a foreign Co. whose currency is the Dinar. ……….. Home Foreign country…………………..Interest…………………3%………………7%………………………………….
……………………………..Inflation…………………2%………………5%……………………………………………….The answer given is …20.39 (interest rate parity) which I understand, but why wasn’t the Purchasing Power Parity used?

Forward rates are never determined by purchasing power parity.
They are determined by interest rates (and in real life give the same result as money market hedging because the bank is using the interest rates to determine the forward rate).

Forward rates are not predictions/guesses/ forecasts.

Only if we are forecasting what will happen to the spot rate in the future might we use PPP.

Thank you…got it….forward rate using the spot rate and interest rates of both countries and future spot rate using spot rate and inflation rates of both countries!! Thank you!!

The Fisher Effect is not directly related to exchange rates.

It relates interest rates to inflation rates and its relevance in the exam (occasionally) is when dealing with inflation in NPV calculations. It is dealt with in those lectures.

I might have missed it on the video, but did you say you were going to explain why the interest rate parity formula starts with F0, as opposed to F1, like with the purchasing power formula? My curiosity is getting the better of me!

It is more of a Paper P4 thing (both papers use the same formula sheet), but the reason is that when the banks quote forward rates (covered in the chapter/lectures on foreign exchange risk) they do not just ‘guess’ a rate but they calculate it based on the interest rates.

So….Fo is the forward rate that they quote now.

(If forward rates do not mean much to you then read my answer again when you have covered foreign exchange risk management ๐ )

Thanks for explaining that for me. I’m working through your lectures bit by bit, so I’m sure when I’ve covered foreign exchange risk I’ll understand your answer more fully!

@annchen, It is impossible to forecast future exchange rates, whatever factors you try and take into account.

Inflation and interest rates are two factors that can be measured and at least give an indication. How would you go about trying to measure other factors?
Anyway there is not exactly very much to learn since the formulae are given on the formula sheet ๐

Mahrukh says

Hi John, I just wanted to confirm if I’m getting it right.

Purchasing power parity means that the reduction in the purchasing power of a particular currency will lead to the currency buying less of another currency.

It also means that the change in price of an item due to inflation in one country’s currency, will not affect the price of the same item in another country’s currency.

In first illustration if we assume no inflation in US, the price in US will remain $150, reducing the exchange rate to $1.47 per pound.

According to this, the inflation in one country, should not affect the price of its goods (exports) in another country, but practically if a country has higher inflation, its exports will become relatively expensive, why is that so?

John Moffat says

I will use your example (inflation at 2% in the UK and 0% inflation in the US) and your arithmetic is correct in the the exchange rate will be $1.47 to the pound (so the pound has weakened – one pound buys fewer dollar, and therefore one dollar will buy more pounds).

The Pound price of UK exports will indeed increase. However, because the pound has weakened, it will mean that when the US importer convert dollars to pay for them, the final dollar cost to the US importer will remain the same.

Obviously in real life, lots of other factors will affect the exchange rate – inflation is just one of the factors – and also the change in the exchange rate is unlikely to be instant (and depends more on expectations of future inflation).

(In future, it is better to ask this sort of question in the F9 Ask the Tutor Forum. I always see questions in the forum, but I do not always see comments on lectures.)

Mahrukh says

Thanks ๐

khanhhoangvu says

Dear Teacher,

In real life, there are lots of interest rate, such as: short-term and long-term loan interest rate, and interest rate of deposit with many different terms. They usually change due to market. they don’t stay constant.

Related to formulae of Interest rate Parity, which interest rate can we apply to calculate the exchange rate while real Interest rate don’t fix, and is the formulae right while the interest rate always fluctuate?

Could you please help me to understand these problem.

Thank you Teacher very much

John Moffat says

The formula is correct ๐

The interest rates used are the interest rates being quoted ‘today’ (the day the forward rate is being quoted) for fixed interest depositing or borrowing for the period in question (i.e. three month interest for 3 month forward rates etc..).

It has the same effect as money market hedging as is explained in the lecture on money market hedging.

In the exam it is not a problem anyway because you are only given one set of interest rates.

khanhhoangvu says

Tks Teacher very much

John Moffat says

You are welcome ๐

Md. Abdullah Hel Kafi (Rashed) says

Short and effective, Thanks a lot. Before exam, it may be more effective for whose have a little time to prepare.

John Moffat says

Thank you.

(although if you watch our lectures, in order, then they are a complete course and cover everything need to be able to pass Paper F9 well.)

nikki says

Thanks Mr. M! I like your way for knowing the difference between b & c in the formula. It’s stuck in my head now ๐

John Moffat says

You are welcome ๐

shahz20 says

Hi John

can i say S2=S0 * {(1+Hc)/(1+Hb)}2 ? and similarly raise the power to 4 if you want the exchange rate in 4 years time assuming that inflation rate stays constant.

shahz20 says

i got the answer ๐ sorry to ask halfway through lecture

claudia1 says

Dear Sir, I am doing the specimen questions and I am confused as to why the purchasing power parity could not have been used to forecast the 6 month forward exchange rate. The question : The home currency of ACB Co., is the dollar and it trades with a foreign Co. whose currency is the Dinar. ……….. Home Foreign country…………………..Interest…………………3%………………7%………………………………….

……………………………..Inflation…………………2%………………5%……………………………………………….The answer given is …20.39 (interest rate parity) which I understand, but why wasn’t the Purchasing Power Parity used?

John Moffat says

Forward rates are never determined by purchasing power parity.

They are determined by interest rates (and in real life give the same result as money market hedging because the bank is using the interest rates to determine the forward rate).

Forward rates are not predictions/guesses/ forecasts.

Only if we are forecasting what will happen to the spot rate in the future might we use PPP.

claudia1 says

Thank you…got it….forward rate using the spot rate and interest rates of both countries and future spot rate using spot rate and inflation rates of both countries!! Thank you!!

John Moffat says

Thats correct ๐

arman90fy says

Dear John,

i am afraid, u didnt talk about the fisher effect topic, do we need the formula or not necessary?

John Moffat says

The Fisher Effect is not directly related to exchange rates.

It relates interest rates to inflation rates and its relevance in the exam (occasionally) is when dealing with inflation in NPV calculations. It is dealt with in those lectures.

arman90fy says

okey. thank you sir..

kezekiah says

how can i download the lectures

John Moffat says

Lectures are not downloadable – it is the only way that we can keep this website free of charge.

neilsolaris says

I might have missed it on the video, but did you say you were going to explain why the interest rate parity formula starts with F0, as opposed to F1, like with the purchasing power formula? My curiosity is getting the better of me!

Thanks for your help.

John Moffat says

It is more of a Paper P4 thing (both papers use the same formula sheet), but the reason is that when the banks quote forward rates (covered in the chapter/lectures on foreign exchange risk) they do not just ‘guess’ a rate but they calculate it based on the interest rates.

So….Fo is the forward rate that they quote now.

(If forward rates do not mean much to you then read my answer again when you have covered foreign exchange risk management ๐ )

neilsolaris says

Thanks for explaining that for me. I’m working through your lectures bit by bit, so I’m sure when I’ve covered foreign exchange risk I’ll understand your answer more fully!

annchen says

I don’t understand, if the model is so unreliable, because it does not take a lot of factors into consideration, why are we supposed to learn it?

John Moffat says

@annchen, It is impossible to forecast future exchange rates, whatever factors you try and take into account.

Inflation and interest rates are two factors that can be measured and at least give an indication. How would you go about trying to measure other factors?

Anyway there is not exactly very much to learn since the formulae are given on the formula sheet ๐

annchen says

@johnmoffat,

monte carlo simmulation? anyway nothing approachable at f9 ๐

will attempt p4 due to your lectures, i really enjoyed them!

John Moffat says

@annchen, Thank you ๐

With regard to simulation, the most he is ever likely to ask at F9 is what he asked in question 1 of June 2010.

ai1989 says

smashing keep updating.

DLS says

Awesome… Just Loved it, using these lectures to revise some F9 Stuff for P4 Prep.

jaykhawaja says

tried thousands of times but not working…

admin says

@jaykhawaja, Please visit the support page: http://opentuition.com/support/

aasmaa says

it desnt open..

ykacca says

its not working here??? please guide me regarding it …

barbara2012 says

I amusing Kaplan text book but this topic isnt mentioned withing the book…

Why?

Thanks

B

barbara2012 says

@barbara2012, yes it is mentioned from page 322 onwards

funlover says

great stuff.By the way, the question he has discussed is actually on page number 180.

regina1979 says

great simple explanation ๐

whateverwinnie says

Love the new lectures. The audio is much better. ๐