International Economics
Course 3 14-9-2018 Jurne Sleddens
How does the forward rate come about?
As you know, forward contracts protect you against negative effects of exchange rates, but how are
they priced?
One theoretical explanation is referred to as the interest rate parity theory or IRP
Purchasing Power Parity (PPP)
PPP theory attempts to explain the determination and changes in the spot exchange rate. Its
assumption is that there is the law of one price.
The law of one price: Expressed in the same currency, goods should cost the same anywhere. If the
law is violated, the exchange rates will change to make the law hold again.
Case
1 basket = 250 USD in USA. 1 basket = 500 CAD in Canada. USD/CAD= 2.
This means law of one price holds.
1 basket = 250 USD in USA. 1 basket = 500 CAD in Canada. USD/CAD= 3.
Law of one price doesn’t hold. Arbitrage affects exchange rates.
Exchange rate will change to make the law hold again which means it changes to USD/CAD=2.
Course 3 14-9-2018 Jurne Sleddens
How does the forward rate come about?
As you know, forward contracts protect you against negative effects of exchange rates, but how are
they priced?
One theoretical explanation is referred to as the interest rate parity theory or IRP
Purchasing Power Parity (PPP)
PPP theory attempts to explain the determination and changes in the spot exchange rate. Its
assumption is that there is the law of one price.
The law of one price: Expressed in the same currency, goods should cost the same anywhere. If the
law is violated, the exchange rates will change to make the law hold again.
Case
1 basket = 250 USD in USA. 1 basket = 500 CAD in Canada. USD/CAD= 2.
This means law of one price holds.
1 basket = 250 USD in USA. 1 basket = 500 CAD in Canada. USD/CAD= 3.
Law of one price doesn’t hold. Arbitrage affects exchange rates.
Exchange rate will change to make the law hold again which means it changes to USD/CAD=2.
