Page 291 - DCOM507_STOCK_MARKET_OPERATIONS

Stock Market Operations

Notes ’ represent the rates
Where ‘e’ represents the rate of change in the exchange rate and ‘ ∏ 1 ’ and ∏ 2
of inflation for country 1 and country 2, respectively.

Example: If the inflation rate for country XYZ is 10% and the inflation for country ABC
is 5%, then ABC’s currency should appreciate 4.76% against that of XYZ.

XYZ – ABC 0.10 0.05 0.05
−
Expected Currency Application = = = = 4.76%
1ABC 1 0.05 1.05
+
+
Interest Rate Parity
The concept of Interest Rate Parity (IRP) is similar to PPP, in that it suggests that for there to be
no arbitrage opportunities, two assets in two different countries should have similar interest
rates, as long as the risk for each is the same. The basis for this parity is also the law of one price,
in that the purchase of one investment asset in one country should yield the same return as the
exact same asset in another country; otherwise exchange rates would have to adjust to make up
for the difference.
The formula for determining IRP can be found by:

−
(i − i ) = ⎜ ⎛ FS ⎞ ⎟ (1 i− )
1 2 ⎝ S ⎠ 2
Where ‘F’ represents the forward exchange rate; ‘S’ represents the spot exchange rate; ‘i ’ represents
1
the interest rate in country 1; and ‘i ’ represents the interest rate in country 2.
2
International Fisher Effect

The International Fisher Effect (I FE) theory suggests that the exchange rate between two countries
should change by an amount similar to the difference between their nominal interest rates. If the
nominal rate in one country is lower than another, the currency of the country with the lower
nominal rate should appreciate against the higher rate country by the same amount.
The formula for IFE is as follows:

i − i
e = 1 2
1i
+
2
Where ‘e’ represents the rate of change in the exchange rate and ‘i ’ and ‘i ’represent the rates of
1 2
inflation for country 1 and country 2, respectively.
Balance of Payments Theory

A country’s balance of payments is comprised of two segments – the current account and the
capital account – which measure the inflows and outflows of goods and capital for a country. The
balance of payments theory looks at the current account, which is the account dealing with trade
of tangible goods, to get an idea of exchange-rate directions.
If a country is running a large current account surplus or deficit, it is a sign that a country’s
exchange rate is out of equilibrium. To bring the current account back into equilibrium, the
exchange rate will need to adjust over time. If a country is running a large deficit (more imports
than exports), the domestic currency will depreciate. On the other hand, a surplus would lead to
currency appreciation.

The balance of payments identity is found by:
BCA + BKA + BRA = 0

286 LOVELY PROFESSIONAL UNIVERSITY