Theory of Purchasing Power Parity (PPPT)

International Finance
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Table of Contents
Purchasing Power Parity Theory (PPPT)........................................................................................2
International Fisher’s Effect (IFE) (Fisher-open)............................................................................2
Forward contract (derivative instrument)........................................................................................4
Futures contract (derivative instrument)..........................................................................................4
Options.............................................................................................................................................5
Swap (derivative instrument)...........................................................................................................6
Interest Rate Derivatives (derivative instrument)............................................................................6
Forward rate agreement (FRA) (derivative agreement)..................................................................6
Money Market Hedge......................................................................................................................6
References........................................................................................................................................8
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Theory of Purchasing Power Parity (PPPT)
As per this theory, the exchange rate between the two different currencies purely depends on
inflation rate prevailing in the two respective countries. PPPT suggests that countries having a
higher inflation rate will have less valued currency. PPPT helps in determination or calculating
estimated spot rates. As per PPPT,
FR = SR X 1 + id
1 + if
Where,
FR = Forward Rate
SR = Spot Rate
id = Rate of inflation in Domestic Country
if = Rate of inflation in Foreign Country
International Fisher’s Effect (IFE) (Fisher-open)
The theory of Fisher Effect (also known as Fisher-closed) was founded by Irving Fisher, states
the relationship between inflation and interest rates. As per this theory, the real rate of interest
equals the nominal rate of interest rate minus the expected rate of inflation.
The equation of fisher effect can be expressed as:
r = i - e
Where,
r = Real rate of interest
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i = Nominal rate of interest
e = Rate of inflation
This equation of fisher theory can be expressed using continuous compounding:
(1+i) = (1+r) (1+e)
The international Fisher effect is an improvement over the standard fisher effect theory and is
especially used in trading of foreign exchange and also to analyze the exchange rate model. This
theory considers present and risk-free rate of interest and does not consider the rate of inflation.
It uses rate of interest rather than rate of inflation to explain how the rate of exchange changes.
According to Puc and Mansaku (2016, p.249), nominal risk-free rate of interest contains a return
in real rate and anticipated inflation. IFE theory indicates that whose interest rate will be high
will have less valued currency because the high-interest rates (nominal) reflect estimated
inflation.
The equation of IFE can be denoted as:

E = variation in the rate of exchange
i1 = rate of interest of country 1
i2 = rate of interest of country 2
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