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  1. john correct me if am wrong
    we can calculate Forward Rates using interpolation of interest rates (if interest rate are given for today)
    if expected interest rates of two countries for next three months are given then we an use interest rate parity Right?

  2. 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.)

  3. 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

  7. 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.

  10. 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.

    • 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 馃檪 )

      • 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 馃檪

      • @johnmoffat,
        monte carlo simmulation? anyway nothing approachable at f9 馃檪
        will attempt p4 due to your lectures, i really enjoyed them!

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