This is because arbitrageurs buy currencies in one market and sell them in another market in order to take advantage of price or interest differentials prevailing at differential national markets. In efficient exchange markets, spot exchange rates are theoretically determined by the interplay of differential national rates of inflation and interest, and the forward premium or discount.Įssentially, the PPP doctrine and the interest parity theory explain why, in the long run, exchange rates move toward positions of equilibrium in which prices in different countries and their interest rates are the same. These five theories illustrate the links that exist among spot rates, interest rates, inflation rates, and forward rates. (5) the forward rate as an unbiased predictor of the future spot rate. The five major theories of exchange rate determination are (1) the theory of purchasing power parity, (2) the Fisher effect, (3) the international Fisher effect, (4) the interest rate parity theory, and The foreign-exchange market is a worldwide network of telephone and computer communications between banks. Trades in currencies take place in the foreign-exchange markets for immediate delivery (spot market) and future delivery (forward market). These flows are subject to various constraints imposed by government authorities and exchange rate fluctuations. The foreign-exchange market consists of two tiers: the interbank market, in which banks trade with each other, and the retail market, in which banks deal with their nonbank customers.Ī major problem of multinational corporations is the fact that cash flows must cross national boundaries. The primary function of the foreignexchange market is to transfer purchasing power denominated in one currency to another, thereby facilitating foreign trade and investment.
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They are determined by the forces of supply and demand under a free market system. 142 THE FOREIGN -EXCHANGE MARKET AND PARITY CONDITIONSĮxchange rates represent prices of one currency in terms of another currency.