Numerous Netherlands should have the same price as

Numerous entities are interested in being able to forecast the exchange rates. In order to diminish the risks and maximize returns an exchange rate forecast is needed in the decision making process. There are several methods of predicting exchange rates which is why is very difficult to generate a high-quality forecast. However, the four most common methods for forecasting exchange rates are Purchasing Power Parity (PPP), International Fisher Effect, Interest Rate Parity and Expectation Theory. 

 

The Absolute Purchasing Power Parity (PPP) predicting approach states that the exchange rate is determined by the price levels in two different countries. This law claims that a pen in the Netherlands should have the same price as a pen in the United States (U.S.) after taking into consideration exchange rates and omitting transaction and delivery costs. For instance, if a pen in the Netherlands costs 1 euro and a pen in the U.S. costs 2,5 dollars then the exchange rate (implied PPP rate) USD/EUR should be 0,4 (2,5 dollars=1 euro; 1/2.5=0,4). If there is a difference between the actual spot rate (actual exchange rate) and the implied PPP rate this means that either the spot rate is overvalued (PPPspot rate). The implied PPP rate is calculated by dividing the price of the domestic currency by the price of the foreign currency. For example, USD/EUR= (P in Holland)/ (P in the U.S.) Using PPPs is the appraisal to using market exchange rates. The actual procuring power of any currency is the amount of that currency desired to buy a quantified unit of a good or a basket of common goods and services. PPP is calculated in each country based on the cost of living and inflation rates. PPP eventually means matching the purchasing power of two different currencies by considering the variances in inflation rates and cost of living. The most famous example of the Purchasing Power Parity theorem is the Big Mac Index. As a yearly test of PPP, The Economist has monitored the price of the Big Mac burger in various countries since 1986. The Big Mac index indicates that, in theory, fluctuations in exchange rates between currencies should influence the price the customers pay for one Big Mac in a certain country. For example, if the price of a Big Mac in the U.S. is 5,04 dollars and in the Netherlands is 6,35 euros then the implied PPP rate USD/EUR=6,35/5.04=1,26. By using this index is very easy to see if a specific currency is undervalued or overvalued. Assuming that the actual spot rate USD/EUR is 0,81 then the USD is undervalued by 55,5% (%undervalued= (1,26-0,81)/0,81=55,5% ) So, 1 USD should be 1,26 but in reality is just 0,81. 

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The Relative Purchasing Power Parity states that the changes in the exchange rates are caused by the inflation rate. Inflation decreases the actual purchasing power of a nation’s currency. For instance, if the expected inflation in the U.S. is 4% and in Holland is 2% then EUR/USD will appreciate by =/-2%. The formula used to calculate the expected spot rate is:

Expected Spot Rate=

For example: The Actual Spot Rate USD/EUR equals to 0,8, the expected inflation in the U.S. is 4% and in Holland is 2% then the Expected Spot Rate USD/EUR=0,8*1,02/1,04=0,78 so USD depreciated by =/- 2%. 

 

The second methods used to forecast the foreign exchange rates is the International Fisher Effect (IFE) theory which asserts that an estimated change in the current exchange rate between any two currencies is relatively equal to the difference between the two countries’ nominal interest rates for that period. In other words, two identical investments in two different countries should have the same return. So, if the interest rate in the US is 5% and in Holland is 3% then EUR should appreciate approximately 2% compared to USD. The reasoning for the IFE is that a country with a greater interest rate will likewise tend to have a higher inflation rate. This higher inflation rate should cause the currency in the country with the high-interest rate to depreciate alongside a country with lower interest rates. In the case mentioned above, the USD will tend to depreciate in comparison to EUR. The IFE theory is based on the examination of interest rates linked with present and future riskless investments, such as treasury bills, and is used in forecasting currency fluctuations. This is in contrast to the relative PPP methods which focuses only on the inflation rates in the prediction of exchange rate movement, instead, the IFE methods combine both the interest rate and the expected inflation rate. The formula used to calculate the expected spot rate is:

Expected Spot Rate=

For example, the Actual Spot Rate USD/EUR equals to 1,5, the interest rate in the US is 7% and in Holland is 5% then the Expected Spot Rate USD/EUR=1,5*1,05/1,07=1,47 so USD depreciated by =/- 2%.  

 

The third method used in the prediction of exchange rates is the Interest Rate Parity (IRP) technique in which the interest rate variance between two countries is equal to the difference between the forward exchange rate and the spot exchange rate.

IRP states that spot and forward market are in equilibrium if an investment in a country has the same result as an identical investment in a different country.  Covered Interest Rate theory affirms that exchange rate forward premiums (discounts) counterbalance interest rate discrepancies between two countries. In other words, covered interest rate theory holds that interest rate differences between two states are counterweight by the spot/forward currency premiums as then investors could earn an arbitrage profit. Uncovered Interest Rate theory attests that predictable appreciation or depreciation of a currency is counterbalanced by lower respectively higher interest. 

 

The last method used in forecasting the future exchange rates is the Expectation Theory which states that long-term interest rates grasp a prediction for short-term interest rates in the forthcoming. The theory assumes that an investor gets the same amount of interest by investing in a one-year bond today and progressing the investment into a different one-year bond after one year as paralleled to acquiring a two-year bond today. 

It affirms that yields at higher maturities, match exactly to future realized rates, and are made up from the yields on shorter maturities. Particularly, purchasing a ten-year bond is identical to acquiring two five year bonds one after another. In this case, this investment is as safe in a ten-year as in a five-year bond.

6. REER of CAD over the period of March 2017 to August 2017

The real effective exchange rate (REER) is the weighted average of a country’s currency comparative to an index or basket of other key currencies, attuned for the consequences of inflation. The weights are decided by correlating the relative trade balance of a country’s currency alongside each country within the index. This conversation rate is used to determine the country’s currency values in comparison to the other main currencies, such as the U.S. dollar or euro. 

Let’s analyze the fluctuations of the Canadian dollar on the foreign exchange market for the period March 2017-August 2017. In the first three months, the Canadian dollar slightly depreciated against euro and US dollar but starting from June the Canadian dollar has strengthened its position on the foreign exchange market.

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