SUB: MULTINATIONAL FINANCIAL

MANAGEMENT
ASSIGNMENT 2
Topic: Testing the Exchange Rate Determination
Exchange Rate Determination Chosen: INFLATION

Submitted By:
Stuti Nautiyal
Nishanth Kolipaka
Anvesh Muhar
 INTRODUCTION

The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-
counter (OTC) market for the trading of currencies. This market determines foreign exchange
rates for every currency. It includes all aspects of buying, selling and exchanging currencies at
current or determined prices
No country today is rich enough to have a free gold standard, not even the U.S.A.
All countries have now paper currencies and these paper currencies of the various countries are not
convertible into gold or other valuable things. Therefore, these days various countries have paper
currency standards. The exchange situation is difficult in such cases. In such circumstances the ratio
of exchange between the two currencies is determined by their respective purchasing powers.
No country today is rich enough to have a free gold standard, not even the U.S.A.
All countries have now paper currencies and these paper currencies of the various countries are not
convertible into gold or other valuable things. Therefore, these days various countries have paper
currency standards. The exchange situation is difficult in such cases. In such circumstances the ratio
of exchange between the two currencies is determined by their respective purchasing powers.

The purchasing power parity (PPP) relationship becomes a theory of exchange rate determination by
introducing assumptions about the behavior of importers and exporters in response to changes in
the relative costs of national market baskets. Recall the story of the law of one price, when the price
of a good differed between two countries’ markets and there was an incentive for profit-seeking
individuals to buy the good in the low price market and resell it in the high price market. Similarly, if
a market basket containing many different goods and services costs more in one market than
another, we should likewise expect profit-seeking individuals to buy the relatively cheaper goods in
the low-cost market and resell them in the higher-priced market.
Thus while the value of the unit of one currency in terms of another currency is determined at any
particular time by the market conditions of demand and supply, in the long run the exchange rate is
determined by the relative values of the two currencies as indicated by their respective purchasing
powers over goods and services.
In other words, the rate of exchange tends to rest at the point which expresses equality between the
respective purchasing powers of the two currencies. This point is called the purchasing power parity.
Thus, under a system of autonomous paper standards the external value of a currency is said to
depend ultimately on the domestic purchasing power of that currency relative to that of another
currency. In other words, exchange rates, under such a system, tend to be determined by the
relative purchasing power parities of different currencies in different countries.

The purchasing power parity theory compares the general price levels in two countries without
making any provision for distinction being drawn between the price level of domestic goods and that
of the internationally traded goods. The prices of internationally-traded goods will tend to be the
same in all countries (transport costs are, of course omitted). Domestic prices on the other hand, will
be different in the two countries, even between two areas of the same country.
The purchasing power parity theory assumes that there is a direct link between the purchasing
power of currencies and the rate of exchange. But in fact there is no direct relation between the
two. Exchange rate can be influenced by many other considerations such as tariffs, speculation and
capital movements.
 Exchange rate Determinants

Big Mac Index: The Big Mac index is a survey created by The Economist magazine in 1986 to
measure purchasing power parity (PPP) between nations, using the price of a McDonald's Big Mac as
the benchmark.
Purchasing power parity is an economic theory which states that exchange rates over time should
move in the direction of equality across national borders in the price charged for an identical basket
of goods. In this case, the basket of goods is a Big Mac.
According to PPP theory, any change in the exchange rate between nations should be reflected in a
change in the price of a basket of goods.
One of the key insights of the Big Mac Index is that a basket of goods in one country can rarely be
precisely duplicated in another country. For example, an American basket of groceries and a
Japanese basket of groceries are likely to contain very different products. A Big Mac, though, is
always a Big Mac, allowing for slight local differences in ingredients.
How the Big Mac Index Works:
The Big Mac Index is calculated by dividing the price of a Big Mac in one country by the price of a Big
Mac in another country in their respective local currencies to arrive at an exchange rate. This
exchange rate is then compared to the official exchange rate between the two currencies to
determine if either currency is undervalued or overvalued according to the PPP theory.
For example, suppose that a Big Mac in the U.S. costs one U.S. dollar and one in the eurozone costs
two euros. The Big Mac Index valuation for EUR/USD would be 2.0, or two divided by one, which
could then be compared to the EUR/USD exchange rate. If the EUR/USD exchange rate was 1.5,
investors might predict that the euro is undervalued by 0.5 euros per U.S. dollar.
There are also many variants of the Big Mac Index that may be useful for investors. For instance, UBS
Wealth Management expanded the index to factor in the number of hours that an average worker
must work to earn enough to buy a Big Mac. Other groups created separate indexes for everything
from Apple iPods to Starbucks coffees to Ikea Billy bookshelves.
The Consumer Price Index (CPI) - a key measure of inflation - seeks to include all kinds of goods. But,
some economists believe that certain goods could provide a more accurate indicator since the CPI
can be skewed by certain categories or manipulated by some governments. Of course, there is a
similar drawback to using the Big Mac Index: It only includes a single item and lacks the
diversification seen in other economic indicators that factor in many different products and services.

Starbucks Index : The Starbucks Index measurement of PPP is a theory that goods in one
country will cost the same in another country, once the exchange rate is applied. According to this
theory, two currencies are at par when a market basket of goods is valued the same in both
countries. PPP rates are determined by comparing the prices of identical items in different countries.
This comparison is often difficult, however, due to differences in product quality, consumer attitudes
and economic conditions in each country.

Relative purchase power parity considers the difference between two countries’ rates of inflation in
driving changes in the exchange rate between the two countries over time. RPPP expands on the
idea of purchase power parity, and complements the theory of absolute purchase power parity.
Interest rate parity : Interest rate parity is the fundamental equation that governs the
relationship between interest rates and currency exchange rates. The basic premise of interest rate
parity is that hedged returns from investing in different currencies should be the same, regardless of
the level of their interest rates.
There are two versions of interest rate parity:

1. Covered Interest Rate Parity

2. Uncovered Interest Rate Parity
Forward exchange rates for currencies are exchange rates at a future point in time, as opposed
to spot exchange rates, which are current rates. An understanding of forward rates is
fundamental to interest rate parity, especially as it pertains to arbitrage (the simultaneous
purchase and sale of an asset in order to profit from a difference in the price).
3. Forward rates are available from banks and currency dealers for periods ranging from less
than a week to as far out as five years and beyond. As with spot currency quotations,
forwards are quoted with a bid-ask spread.
4. The difference between the forward rate and spot rate is known as swap points. If this
difference (forward rate minus spot rate) is positive, it is known as a forward premium; a
negative difference is termed a forward discount.
5. A currency with lower interest rates will trade at a forward premium in relation to a currency
with a higher interest rate. For example, the U.S. dollar typically trades at a forward
premium against the Canadian dollar; conversely, the Canadian dollar trades at a forward
discount versus the U.S. dollar.
Interest rate parity is the fundamental equation that governs the relationship between interest
rates and currency exchange rates. The basic premise of interest rate parity is that hedged
returns from investing in different currencies should be the same, regardless of the level of their
interest rates.
If one country offers a higher risk-free rate of return in one currency than that of another, the
country that offers the higher risk-free rate of return will be exchanged at a more expensive future
price than the current spot price. In other words, the interest rate parity presents an idea that there
is no arbitrage in the foreign exchange markets. Investors cannot lock in the current exchange rate in
one currency for a lower price and then purchase another currency from a country offering a higher
interest rate.

Inflation Rate: The rate of inflation in a country can have a major impact on the value of the
country's currency and the rates of foreign exchange it has with the currencies of other nations.
However, inflation is just one factor among many that combine to influence a country's exchange
rate.
Inflation is more likely to have a significant negative effect, rather than a significant positive effect,
on a currency's value and foreign exchange rate. A very low rate of inflation does not guarantee a
favorable exchange rate for a country, but an extremely high inflation rate is very likely to impact the
country's exchange rates with other nations negatively.
The ultimate determination of the value and exchange rate of a nation's currency is the perceived
desirability of holding that nation's currency. That perception is influenced by a host of economic
factors, such as the stability of a nation's government and economy. Investors' first consideration in
regard to currency, before whatever profits they may realize, is the safety of holding cash assets in
the currency. If a country is perceived as politically or economically unstable or if there is any
significant possibility of a sudden devaluation or other change in the value of the country's currency,
investors tend to shy away from the currency and are reluctant to hold it for significant periods or in
large amounts.
monetary approach : The monetary approach happens to be one of the oldest approaches to
determine the exchange rate. It is also use as a yardstick to compare the other approaches to
determine exchange rate. The monetary model assumes a simple demand for money curve. The
purchasing power parity or the law of one price holds true. The monetary model also assumes a
vertical aggregate supply curve. A vertical aggregate supply curve does not imply constancy in the
output but a flexible price.

BoP approach : it is also referred to as demand-supply theory of exchange. The theory stresses
that the rate exchange basically relates to the position of balance of payments of the country
concerned. A favourable balance of payments leads to an appreciation in the external value of the
currency of the country. Unfavourable balance of payments causes a depreciation of the external
value.
The balance of payments theory of exchange rate holds that the price of foreign money in terms of
domestic money is determined by the free forces of demand and supply in the foreign exchange
market. It follows that the external value of a country’s currency will depend upon the demand for
and supply of the currency.

The theory states that the forces of demand and supply are determined by various items in the
balance of payments of a country. According to the theory, a deficit in the balance of payments leads
of a fall or depreciation in the rate of exchange, while a surplus in the balance of payments
strengthens the exchange reserves, causing an appreciation in the price of home currency in terms
of foreign currency.

A deficit balance of payments of a country implies that demand for foreign exchange exceeds its
supply. As a result, the price of foreign money in terms of domestic currency must rise, i.e., the
exchange rate of domestic currency must fall.

On the other hand, a surplus in the balance of payments of a country implies a greater demand for
home currency in a foreign country than the available supply. As a result, the price of home currency
in terms of foreign money rises, i.e., the rate of exchange improves.
Movements and volatility of USD, EUR, GBP, INR, YEN, RMB, RUB. in the past
5 years

% % %
change change change
Period Start Date USD/EUR in EUR USD/CAD in CAD USD/INR in INR
01-05-2019 0.893557 0.39 1.34504 0.54 69.71039 0.38
01-04-2019 0.890049 0.58 1.33785 0.12 69.44698 -0.06
01-03-2019 0.884935 0.46 1.336268 1.23 69.48948 -2.28
01-02-2019 0.880906 0.6 1.320073 -0.81 71.10948 0.93
01-01-2019 0.875636 -0.37 1.330884 -0.99 70.45624 -0.07
01-12-2018 0.878886 -0.09 1.344137 1.9 70.50329 -1.49
01-11-2018 0.879681 1.09 1.31907 1.36 71.56652 -2.6
01-10-2018 0.870199 1.39 1.301401 -0.11 73.47916 2.09
01-09-2018 0.858311 -0.96 1.302846 -0.09 71.97315 3.69
01-08-2018 0.866657 1.32 1.304064 -0.67 69.41459 1.32
01-07-2018 0.855378 -0.12 1.312888 0.12 68.51224 1.25
01-06-2018 0.856373 1.26 1.311293 1.91 67.66559 0.33
01-05-2018 0.845698 3.82 1.286674 0.99 67.44135 2.88
01-04-2018 0.814613 0.46 1.274004 -1.41 65.55481 0.92
01-03-2018 0.8109 0.17 1.292168 2.86 64.95965 0.9
01-02-2018 0.8095 -1.29 1.25627 1.02 64.37977 1.38
01-01-2018 0.820117 -2.89 1.243555 -2.51 63.50488 -0.92
01-12-2017 0.844485 -0.85 1.275538 0 64.09709 -1.16
01-11-2017 0.851715 0.11 1.275576 1.31 64.84652 -0.39
01-10-2017 0.850791 1.4 1.259118 2.45 65.09922 1.08
01-09-2017 0.839075 -0.85 1.229045 -2.49 64.4062 0.78
01-08-2017 0.846258 -2.46 1.260439 -0.8 63.90638 -0.73
01-07-2017 0.867574 -2.58 1.270557 -4.6 64.37478 0.03
01-06-2017 0.890557 -1.54 1.331829 -2.04 64.3537 0.03
01-05-2017 0.904492 -3.14 1.359587 1.25 64.33162 -0.21
01-04-2017 0.933843 -0.15 1.34275 0.32 64.46851 -1.99
01-03-2017 0.9352 -0.42 1.338405 2.23 65.77816 -1.68
01-02-2017 0.939131 -0.19 1.309197 -0.95 66.90023 -1.61
01-01-2017 0.940956 -0.82 1.321801 -0.98 67.9969 0.43
01-12-2016 0.948735 2.43 1.334877 -0.79 67.70468 0.24
01-11-2016 0.926184 2.23 1.345569 1.6 67.54407 1.41
01-10-2016 0.905969 1.54 1.324353 1.15 66.60535 -0.15
01-09-2016 0.892232 -0.03 1.309253 0.75 66.70672 -0.22
01-08-2016 0.892494 -1.21 1.299452 -0.26 66.85213 -0.3
01-07-2016 0.903406 1.56 1.302786 1.03 67.05181 -0.24
01-06-2016 0.889567 0.54 1.289453 -0.33 67.21465 0.51
01-05-2016 0.884807 0.35 1.293774 0.81 66.87245 0.73
01-04-2016 0.881764 -1.89 1.283351 -2.96 66.38784 -0.7
01-03-2016 0.898718 -0.2 1.322538 -4.12 66.85331 -1.93
 01-02-2016 0.900528 -2.14 1.379336 -2.72 68.16943 1.51
01-01-2016 0.920251 0.28 1.417871 3.43 67.15541 1.18
01-12-2015 0.917675 -1.49 1.370887 3.25 66.37176 0.53
01-11-2015 0.931584 4.56 1.32775 1.64 66.02101 1.71
01-10-2015 0.890931 0.13 1.30635 -1.5 64.91305 -1.89
01-09-2015 0.889803 -0.94 1.326294 0.92 66.16197 1.81
01-08-2015 0.898244 -1.12 1.31426 2.44 64.98648 2.45
01-07-2015 0.908434 1.94 1.28295 3.88 63.43306 -0.44
01-06-2015 0.891144 -0.51 1.235044 1.42 63.71166 0.1
01-05-2015 0.895705 -3.21 1.217725 -1.46 63.6483 1.76
01-04-2015 0.9254 0.18 1.235734 -2.03 62.54622 0.17
01-03-2015 0.923695 4.86 1.261286 0.81 62.43913 0.73
01-02-2015 0.880904 2.49 1.25118 3.63 61.98752 -0.21
01-01-2015 0.859497 5.81 1.207319 4.6 62.11989 -1.12
01-12-2014 0.812279 1.33 1.154175 1.96 62.82576 2.09
01-11-2014 0.801611 1.57 1.131972 0.9 61.53861 0.47
01-10-2014 0.789239 1.77 1.121889 1.94 61.25041 0.74
01-09-2014 0.775502 3.31 1.100536 0.77 60.79841 0.05
01-08-2014 0.750665 1.66 1.092173 1.8 60.76618 1.45
01-07-2014 0.73838 0 1.072868 0 59.90002 0

STANDARD DEVIATION 1.88 1.93 1.3

Inflation
rates
Countries 2014 2015 2016 2017 2018
US 1.60% 0.10% 1.30% 2.10% 2.40%
EUROPE 0.43% 0.03% 0.24% 1.54% 1.74%
JAPAN 2.80% 0.80% -0.10% 0.50% 1.00%
UK 2.40% 1.00% 1.80% 3.60% 2.48%
INDIA 5.80% 4.90% 4.50% 3.60% 3.48%
CHINA 1.99% 1.44% 2.00% 1.56% 2.10%
RUSSIA 7.82% 15.53% 7.05% 3.67% 2.88%

EURO Currency/INFLATION
19%
20.00%

15.00% 12%
10%
% CHANGE

10.00%
6%
5.00% 1.74%
1.54%
0.43%
0% 0.03% 0.24%
0.00%
01/01/2015 01/01/2016 01/01/2017 01/01/2018 01/01/2019
01/03/2015 01/03/2016 01/03/2017 01/03/2018 01/03/2019
INFLATION 1.74% 1.54% 0.24% 0.03% 0.43%
CURRENCY MOVEMENT 12% 19% 6% 10% 0%

Time Period
 JAPANESE YEN/INFLATION
1.40
1.19
1.20 1.12 1.12
1.05
1.00

0.80
% CHANGE

0.60

0.40

0.20
2.80%
0.00 0.80% -0.10% 0.50% 1.00%
0.00
01/01/2015 01/01/2016 01/01/2017 01/01/2018 01/01/2019
-0.20
01/03/2015 01/03/2016 01/03/2017 01/03/2018 01/03/2019
JAPAN 1.05 1.12 1.12 1.19 0.00
JAPAN INFLATION 1.00% 0.50% -0.10% 0.80% 2.80%

TIME PERIOD

UK Sterling/INFLATION
0.35
0.30
0.30 0.28
0.24
0.25
0.19
% CHANGE

0.20

0.15

0.10
3.60%
0.05 2.40% 1.80% 2.48%
0.00 1.00%
0.00
01/01/2015 01/01/2016 01/01/2017 01/01/2018 01/01/2019

01/03/2015 01/03/2016 01/03/2017 01/03/2018 01/03/2019

Currency Movement 0.24 0.28 0.19 0.30 0.00
Inflation 2.48% 3.60% 1.80% 1.00% 2.40%

Axis Title
 Indian INR/INFLATION
14.00% 12.54%
12.00%

% CHANGE 10.00%

8.00% 6.84% 6.74%

5.80%
6.00% 4.90% 4.50%
3.60% 3.48%
4.00%
1.62%
2.00%
0.00%
0.00%
01/01/2015 01/01/2016 01/01/2017 01/01/2018 01/01/2019

01/03/2015 01/03/2016 01/03/2017 01/03/2018 01/03/2019

INFLATION 3.48% 3.60% 4.50% 4.90% 5.80%
Currency Movements 6.74% 12.54% 1.62% 6.84% 0.00%

Time Period

Chinese Yuan/Inflation
7.00% 5.89%
5.50% 5.71%
6.00% 5.32%
5.00%
%change

4.00%
3.00% 1.99% 2.00% 2.10%
1.44% 1.56%
2.00%
1.00% 0.00%
0.00%
01/01/2015 01/01/2016 01/01/2017 01/01/2018 01/01/2019

01/03/2015 01/03/2016 01/03/2017 01/03/2018 01/03/2019

Inflation 2.10% 1.56% 2.00% 1.44% 1.99%
Currency Movement 5.71% 5.32% 5.89% 5.50% 0.00%

Time Period
 Russian Rubble/Inflation
20.00%
17.21%
18.00% 16.25%
15.53%
16.00% 14%

% Change
14.00%
12.00%
10.00% 7.82%
7.05%
8.00%
6.00% 3.67%
2.88%
4.00% 1.33%
2.00% 0.00%
0.00%
01/01/2015 01/01/2016 01/01/2017 01/01/2018 01/01/2019

01/03/2015 01/03/2016 01/03/2017 01/03/2018 01/03/2019

Inflation 2.88% 3.67% 7.05% 15.53% 7.82%
Currency Movements 14.25% 1.33% 17.21% 16.25% 0%

Time Period