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 )

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

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

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 )

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

annchen says

@johnmoffat,

monte carlo simmulation? anyway nothing approachable at f9

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

John Moffat says

@annchen, Thank you

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

whateverwinnie says

Love the new lectures. The audio is much better.