When an accounting student studying international finance, Purchasing Power Parity and Interest Rate Parity are easily got confused and mixed up. These two formula shows two key variables affecting exchange rate. We are here to briefly explain their differences and applications.
Here two terminologies you have to know before discussing PPP and IRP –
Spot exchange rate: is the rate at which you exchange one currency for another. Generally, it means the exchange taking place NOW;
Forward exchange rate: is the exchange rate available today that is guaranteed for an exchange of currencies that takes place in the future.
Purchasing Power Parity
Definition: Purchasing power parity (PPP) is an economic theory that states that the exchange rate between two currencies is equal to the ratio of the currencies' respective purchasing power.
Formula
S1 = Expected spot rate in period 1
S0 = Current spot rate
hc = Expected inflation rate in country c
hb = Expected inflation rate in country b
Indication
PPP formula indicates that a country with relatively higher expected inflation will be suffered from currency depreciation against another country with lower expected inflation in long run.
Applications
With strong economic theory support, PPP is a widely accepted tool in forecasting an exchange rate movement between two currencies in long run.
Interest Rate Parity
Definition: Interest rate parity is a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Interest rate parity plays an essential role in foreign exchange markets, connecting interest rates, spot exchange rates and foreign exchange rates.
Formula
F0 = Forward rate (quoted now)
S0 = Current spot rate
ic = Interest rate in country c
ib = Interest rate in country b
Indication
IRP formula indicates that a country (e.g. Country C) quoted forward rate will be at premium if its interest rate is lower than another country (e.g. Country B). In other words, fewer amount of Country C currency can exchange the same amount of Country B currency under the forward rate than spot rate.
Applications
IRP is generally applied in forward rate quotation.
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