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Forecasting Exchange Rates

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Forward exchange rate is the rate at which a currency will be exchanged at a future predetermined date. For instance the forward exchange rate may be stated as US$ 1.6200/UK£ or  UK£ 0.6173/US$, which means that the United Kingdom pound will exchange for 1.6200 US dollars at a certain future predetermined date or the US dollar will exchange for 0.6173 United Kingdom pounds . In this case, if a contract entered into when the current spot exchange rate is different form the above forward rate, the exchange rate which will apply during payment is the forward exchange rate and not the spot exchange rate.

A theory of Interest rate parity and purchasing power parity

Interest rate parity (IRP) is a theory whereby the interest rate differential between two trading states is equal to the differential between spot exchange rate and the forward exchange rate. On the other hand, purchasing power parity (PPP) is a theory that tries to estimate the adjustment that needs to be made on the exchange rate between two trading countries in order to achieve the same economic purchasing power between the two countries.

Firstly, under the purchasing power parity, assuming a spot exchange rate of US$ 1.6200/UK£ which is also equal to UK£ 0.6173/US$. This implies that a basket of goods worth UK£ 100 in the United Kingdom sell for UK£ 100 X 1.6200 = US$ 162 in the United State and vice versa (i.e. goods worth US$ 162 in the United States sell for UK£ 100 in the United Kingdom). Now assuming annual inflation in United King is 4.2 % and that for the United States is 3 %, then the same basket of goods will then sell at 1.042 X UK£ 100 = UK£ 104.2 in the United Kingdom and 1.03 X US$ 162 = US$ 166.86 in the United States. These relative prices imply that within one year, a basket of goods worth UK£ 104.2 in the United Kingdom will be worth US$ 166.86 in the United States. So the exchange rate in one year will change to UK£ 104.2/ US$ 166.86 i.e. UK£ 0.6245/ US$ or US$ 1.6013/ UK£. In other words United Kingdom pound will depreciate from UK£ 0.6173/US$ to UK£ 0.6245/ US$ while the United States dollar appreciates from US$ 1.6200/UK£ to US$ 1.6013/ UK£. From the above computations and assuming that the interest rate parity and purchasing power parity hold, the British ponds one year forward will be  US$ 1.6013/ UK£.

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But under Interest rate parity, the theory require that the difference in interest rates between two countries equal the percentage difference between the forward exchange rate and the spot exchange rate i.e., (0.78- 1.58) = (forward rate- 1.62). Therefore the forward exchange rate will be -0.8+ 1.62 = 0.82. Meaning the forward exchange rate will fall to US$ 0.82/UK£. Under purchasing power parity, the theory states that the exchange rate should be equal to the ratio of the cost of goods of a similar basket in the two different countries. i.e. if goods worth US$ 1.6200 in the United States cost UK£ 0.6173 in the United Kingdom, then the ratio of  the two costs should be equal to the exchange rate as had been calculated earlier (Rosenberg, 2003).

Secondly, under the purchasing power parity, the above British Pounds forward exchange rate forecast imply depreciation of the United Kingdom pound from US$ 1.6200/UK£ to US$ 1.6013/ UK£. i.e.  {(US$ 1.6013/UK£) - (US$ 1.6200/ UK£)} {US$ 1.6200/UK£} X 100% = -1.152 %. The negative implies depreciation of the British pound which is by a magnitude of 1.152%. This also implies an appreciation of the United States dollar from UK£ 0.6173/US$ to UK£ 0.6245/ US$. As illustrated by the following graph, it is evident that increase in the inflation of a country causes depreciation of the local currency in relation to the foreign currencies. From the diagram, assuming an original inflation rate r0, then thespot exchange rate will be e0. However if the inflation rate rises to r1, then the exchange rate will increase to e2 therefore causing depreciation of the local currency in relation with the foreign currencies..

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However, under the interest rate parity, the percentage depreciation in the United Kingdom pound is much bigger i.e from US$ 1.6200/UK to US$ 0.82/UK£. This deduces appreciation of the dollar which also translates to depreciation of the United Kingdom pound. This can be computed as (US$ 0.82/UK£.- from US$ 1.6200/UK) divided by US$ 1.6200/UK X 100% = 49.38%. From the fore going computations it is evident that the forecasting of forward exchange rate under the two conditions is totally different.

Thirdly the forward rate would be an unbiased estimate of the future spot rate in one year. Under the purchasing power parity case, after one year from the current spot rate of US$ 1.6200/UK the spot rate will change to US$ 1.6013/ UK£ and there wont be much depreciation from this rate. In the same case under Interest rate parity the exchange rate should be much lower .e (-0.8+1.62)= 0.82 i.e US$ 0.82/UK£. This shows that the US dollar will appreciate from US$ 1.6200/UK to US$ 0.82/UK£ .However, if the above state does not hold, then the above will deviate due to reasons other than inflation and interest. This includes political factors in which the peace of a country is destabilized and therefore not providing an enabling environment in which international trade can thrive. A good example is countries that are war ravaged e.g. Afghanistan, Zimbabwe, Libya, Sudan etc where the price of the US dollar in relation to the local currency is exorbitantly high to an extent that locals prefer to trade using the US dollar instead of their local currency which is highly susceptible to the international foreign currency fluctuations caused by political instability.

Factor of exports and imports 

Another factor include exports and imports of a country, where of a country imports less than it exports e.g. developed countries, then their currency won’t be depreciate easily since they buy less from other countries (Rosenberg, 2003). On the other hand, where a country imports more than it exports i.e. developing countries, then their currency might be more exposed to foreign currency fluctuations since they buy more from foreign countries. Therefore, countries that have high inflation which are majorly the net importers are more susceptible to currency depreciation as opposed to countries that have low inflation which are majorly the net exporters.

The estimates under purchasing power parity tend to differ much from the estimates under interest rate parity. From the foregoing computations, the purchasing power parity shows that the United Kingdom pound will depreciate from US$ 1.6200/UK£ to US$ 1.6013/ UK£ giving a percentage in depreciation of 1.152 % while the interest rate parity shows a worse depreciation of the United Kingdom pound of  49.38% computed as (US$ 1.6200/UK - US$ 0.82/UK£) divided by US$ 1.6200. The two theories are only similar because they use sport exchange rate in forecasting the forward exchange rate. Otherwise, they differ to a great extent as evidenced by the percentage depreciation in the United Kingdom arrived at under the two different theories.

Purchasing power parity tends to show a smaller change between the spot exchange rate and the forward exchange rate as opposed the interest power parity which shows a greater percentage change between the spot exchange rate and the forward exchange rate. The two also differ because with purchasing power parity theory inflation as a factor is considered as opposed to interest rate parity where inflation rate is not considered. In the same vein, for interest rate parity, interest rate as a factor affecting exchange rate is considered as opposed to purchasing power parity which does not take it into consideration when computing the forward exchange rate.

Conclusion

The assumptions made under the two theories are that if transportation costs and other transaction cost are not present, competitive markets will adjust the exchange rates to a level where the price of identical goods in two different countries is equal. For example, an electronic machine that costs US$ 1600 in United States should cost UK£ 1000 in the United Kingdom if the exchange rate is US$ 1.6000/UK£. If the electronic machine was only US$ 1200 in the United States, the Britons would prefer importing the machine from United States than buying locally since it would be much cheaper provided other transaction costs are assumed not to surpass that the foreign cost when the total cost is aggregated.

Therefore as a finance manager for a multinational company, the issue of forward exchange rates is paramount to making financial decisions since such a company is often faced with foreign exchange fluctuations which pose a foreign exchange risk to the company. It is therefore one of the hedging strategies that financial managers spearheading managerial decisions for multinational companies use I cushioning the company against financial losses posed by depreciation and appreciation of currency exchange.

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