Study of PPP, IFE, IRP

Running head: STUDY OF PPP, IFE, IRP
Study of Purchasing Power Parity, International Fisher Effect Hypothesis and Interest Rate
Parity
Name of the Student:
Name of the University:
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STUDY OF PPP, IFE, IRP1
Table of Contents
Chapter 1: Introduction....................................................................................................................4
1.1 Introduction............................................................................................................................4
1.2 Background of the Study.......................................................................................................5
1.3 Problem Statement.................................................................................................................8
1.4 Aims of Study........................................................................................................................9
1.5 Objective of the Study...........................................................................................................9
1.6 Research questions...............................................................................................................10
1.7 Research Hypotheses...........................................................................................................11
1.8 Structure of the Study..........................................................................................................12
Chapter 2: Literature Review.........................................................................................................13
1.1 Introduction:........................................................................................................................13
1.2 The Theory of Purchasing Power Parity:.............................................................................13
1.2.1 Analyzing the Purchasing Power Parity:......................................................................14
1.2.2 Difficulties in Purchasing power parity:.......................................................................15
1.3 Interest Rate Parity:.............................................................................................................17
1.3.1 Overview:.....................................................................................................................17
1.3.3 Assumptions:................................................................................................................18
1.3.4 Forward contract:..........................................................................................................19
1.3.5 Spot exchange rate:.......................................................................................................19

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1.3.6 Covered interest rate parity:..........................................................................................20
1.3.7 Uncovered interest rate parity:......................................................................................21
1.4 The International Fisher Effect Hypothesis:........................................................................21
1.4.1 Limitation of the International Fisher Effect Hypothesis:............................................22
1.4.2 Analyzing the International Fisher Effect Hypothesis:................................................23
1.4.3 Derivation of International Fisher Effect Hypothesis and relation to interest rate parity:
...............................................................................................................................................24
1.5 Empirical Study:..................................................................................................................25
1.6 Conclusion:..........................................................................................................................26
Chapter 3: Research Methodology................................................................................................28
3.1 Introduction..........................................................................................................................28
3.2 Development of three models of exchange rate..................................................................28
3.2.1 Purchasing power parity...............................................................................................28
3.2.2 International Fisher Effect............................................................................................29
3.2.3 Interest Rate Parity.......................................................................................................31
3.3 Data collection process........................................................................................................32
3.3.1 Secondary data collection.....................................................................................................33
3.3.2 Sample size...................................................................................................................34
3.4 Data analysis........................................................................................................................34
Chapter 4: Data Analysis and Discussion......................................................................................38

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4.1 Introduction..........................................................................................................................38
4.2 Testing accuracy of exchange rate with actual spot exchange rate.....................................38
4.2.1 Purchasing Power Parity...................................................................................................38
4.2.2 International Fisher Effect................................................................................................40
4.2.3 Interest Rate Parity...........................................................................................................42
4.3 Correlation between actual exchange rate and model exchange rate..................................43
4.3.1 Purchasing Power Parity...............................................................................................44
4.3.2 International Fisher Effect............................................................................................46
4.3.3 Interest Rate Parity.......................................................................................................48
4.4 Testing PPP, IFE and IRP exchange rate in the long run........................................................49
4.4.1 PPP exchange rate in the long run................................................................................50
4.4.2 IFE exchange rate in the long run.................................................................................52
4.4.3 IRP exchange rate in the long run.................................................................................55
Chapter 5: Conclusion...................................................................................................................59
5.1 Conclusion...........................................................................................................................59
5.2 Recommendation.................................................................................................................61
5.3 Limitation of the research....................................................................................................61
Reference.......................................................................................................................................62

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Chapter 1: Introduction
1.1 Introduction
Exchange Rate states the price of a currency in terms of another currency and is also
expressed as a number of units in the domestic currency that needs to be exchanged for a unit of
a foreign currency. It is important to determine that is we need to fluently determine the change
in the exchange rate with the help of different variables that shows the influences in the exchange
rate. Factors that were taken into consideration for the purpose of analysis will be interest rate
parity, international fisher effect and purchasing power parity. The theory that we have taken into
consideration are non-independent from one another on the contrary the theories are closely
correlated. The present paper has the objective of finding the correlation between the Great
Britain Pound with the Euro and US Dollar exchange rate. It is crucial to note that the movement
in the exchange rate is unstable and the changing variable will be taken into analysis with the
help of the weekly data of the exchange rate applicable (Della Corte, Ramadorai and Sarno
2016).
Exchanges Rates prevailing in various country is dependent on several factors and the
same can be explained with the help of the various factors that explain the movement in the
same. Correlation between the exchange rate pairs have been the most controversial and
interesting topic in the area of international finance and economics. Various theoretical models
and assumptions were built in order to explain the same. Various researches were done
extensively for the topic correlation between the Great Britain Pound with the Euro and US
Dollar. There are different assumptions and factors that were taken into account for explaining
the correlation between the currency exchange rates (Alagidede and Ibrahim 2017). The
assumptions in the theoretical models in the form of open-economy macroeconomic factors may

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lead to the various results and the inclusion of the same in the correlation test would be the key
source of analysis that we will be undertaking (Hook and Boon 2017). The legitimacy of the
various assumptions that would be made in the context of research would be linked with the time
scale we are considering in the long run where exchange rates are perfectly flexible. The
purchasing power parity (PPP) hypothesis, interest rate parity and international fisher effect can
be said as one of the most controversial topics in terms of explanation of the movement of the
currency exchange rate (Asteriou, Masatci and Pılbeam 2016). Testing the correlation between
the various pairs of exchange rate can be well defined with the help of regression analysis where
weekly data of the GBP, Euro and US Dollar would be collected for a trend period of 10 years.
The trend period that would be taken into consideration would be from 2010-2019. Relevant
changes in the trend of the exchange rate would be taken into consideration. The changes in the
exchange rate can be explained with the help of the several macro-economic factors that can
explain the variability in these factors.
1.2 Background of the Study
Several causes can that explain the differences between the offer and demand of a certain
currency, that shows the changes in the price, in the exchange rate, amongst them the main
causes of changes are the international commerce, arbitrage and speculation. The behaviour of
the investors is a key function of two major factors the price of the products and services offered
and the prevailing momentary interest rate in the economy (Aftab, Syed and Katper 2017). The
reason behind the purchase or selling of various products and services lies in the difference of
their price. The evolution of the capital invested in one or another country is the result of
different retribution of those capitals. The series of theories that will be undertaken correlate the
exchange rate with the inflation rate and interest rate (Barunik, Krehlik and Vacha 2016).

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The economist Irvying Fisher introduced Fisher Effect or the Fisher Hypothesis in the
year 1930 in his work “Theory of Interest” that reflected the relationship between the nominal
interest rate and inflation rate in such a manner that the expected inflation rate in the economy is
absorbed with the prevailing nominal interest rate. In the long-run it was stated that the each one
of them leads to onset of one or other. The hypothesis assumes that the real interest rate remains
constant in the long-run that would be leading to the onset of one or more relationship between
both the series. The hypothesis shows that the real interest rate remains constant when
considered in the long-run period that is not affected by the changes in the expected inflation
rate. The preceding theory states that the domestic fisher effect shows a generalized version of
the fisher effect that would be stating that the interest rate on a worldwide basis are equal due to
arbitration process (Ortiz and Monge 2015). In this case, it will be assumed that the investors
consider both the internal and foreign instrument as a perfect substitute for consideration. The
key assumption that is made in the application of this theory is that the markets are efficient and
the available capital is fully mobile, there would be an equalisation of real interest rate among
the various country that should be prevailing.
The other theory that explains the movement in the exchange rate is the theory of
Purchasing Power Parity, which was introduced by David Ricardo (Jo, H., Dixon et al., 2016).
The theory states the starting point as the Law of One Price stating that under the condition
where free competition exist in the market, absence of transportation cost and trade barriers, all
identical goods must be having one price in any given country. The Purchasing Power parity is
the extension of the stated law of one price where a basket of goods or commodities is taken into
consideration while evaluating the change in the exchange rate rather than considering a single
commodity (Lothian 2016). The theory states that the exchange rate between the two countries

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equals the relationship between the price levels of these two countries. The PPP can be described
in both the forms absolute and relative, the earlier approach is considered to be quite restrictive.
The same is valid when the financial markets are considered to be efficient and the given basket
of goods is identical that does not occur due to the market imperfections or the applicable
transaction costs, product differentiation and trade restriction internationally. The relative PPP
states that the prices and the exchange rate maintains a constant ratio in the purchasing power of
the domestic currency when compared with other pegged currency (Adam and Ofori 2017).
Thus, the theory states that the country or economy with the higher inflation should raise the
currency exchange rate in respect to the other, recognizing or indicating the loss of value in the
currency rate i.e., in other terms depreciation of the currency. Thus, the variation in the exchange
rate would be solely dependent on the difference between the inflation rates. So the PPP predicts
that the foreign price index; a raise in the domestic price level of the commodity would reduce
the purchasing power of the internal currency in the domestic economy. Thus, the given
exchange rate should be reflecting the reduction in the purchasing power parity that would be
ultimately resulting in the depreciation of the internal currency (Bahmani-Oskooee et al., 2016).
The interest rate parity is the another theory that would be explaining the behaviour or the
movement of the exchange rate with the help of the forward exchange rate with the prevailing
interest rate in the economy offered in two different economies. The two versions that would be
explaining the movement is the covered interest rate parity and uncovered interest rate parity. On
the one hand, the existing relationship states about the expected spot exchange rate expected in
the future for a specified period between the two currencies is stated as covered interest rate
parity (Shim et al., 2016). The theory clearly explaining the relationship/correlation between the
variability in the spot or forward exchange rate. On the other hand, the uncovered interest rate