Exchange rates determinants: an overview
Forex market is the largest financial market in terms of size. This is so irrespective of the fact that
it is fully over the counter market. By far the largest market for currencies is the interbank market,
which trades spot and forward contracts. The market can be termed as efficient with enough
breadth, depth and resilience.
The basic theories underlying the exchange rates –
1. Law of One Price: In competitive markets free of transportation costs barriers to trade,
identical products sold in different countries must sell at the same price
when the prices are expressed in terms of their same currency.
Purchasing power parity: As inflation forces prices higher in one country but not another
country, the exchange rate will change to reflect the change in relative
purchasing power of the two currencies.
2. Interest rate effects: If capital is allowed to flow freely, the exchange rates stabilize at a point
where equality of interest is established.
The Fisher Effect: the nominal interest rate (r) in a country is determined by the real interest rate
R and the inflation rate i as follows:
(1 + r) = (1 + R)(1 + i)
International Fisher Effect: the spot rate should change in an equal amount but in the opposite
direction to the difference in interest rates between two countries.
S1 - S2
----------- x 100 = i2 – i1
Where: S1 = spot rate using indirect quotes at beginning of the period;
S2 = spot rate using indirect quotes at the end of the period;
i = respective nominal interest rates for country 1 and 2.
Though the above principles attempt to explain the movement of exchange rates, the
assumptions behind these two theories [free flow of capital] are seldom seen and thus these
theories can’t be applied directly.
The dual forces of demand and supply determine exchange rates. Various factors affect these,
which in turn affect the exchange rates:
The business environment: Positive indica