The purchasing power parity theory was put forward by Gustav Cassel.In the word of Cassel, the rate of exchange between two currencies must stand essentially on the quotient of the internal purchasing powers of these currencies.According to the Purchasing power parity theory, the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent.

If there is change in prices (i.e., the purchasing power of the currencies), the new equilibrium rate of exchange can be find out by the following formula :ER = Er Pd/PfWhere

ER = Equilibrium exchange rateEr = Exchange rate in the reference periodPd = Domestic price indexPf = Foreign countrys price index

Because the exchange rates only reflects when goods are traded. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets. Also, different interest rates, speculation or interventions by central banks can influence the foreign-exchange market.

Differences in living standards between nations because PPP takes into account the relative cost of living and the inflation rates of the countries,

For example, a TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver due to which the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again the same price.

PPP rate fluctuations are mostly due to different rates of inflation in the two economies which would result in the difference in prices at home and abroad

The balance of payments theory, also known as the demand and supply theory and the General equilibrium theory of exchange rate.According to this theory, the foreign exchange rate, under free market conditions, is determined by the conditions of demand and supply in the foreign exchange market.

According to this theory, the price of a currency, i.e., the exchange rate, is determined just like the price of any commodity is determined by the free play of the forces of demand and supply. The value of a currency appreciates when a demand for it increases and depreciates when the demand falls, in relation to its supply in the foreign exchange market.

1. Unlike the purchasing power parity theory, the balance of payments theory recognises the importance of all the items in the balance of payments, in determining the exchange rate.2. This demand and supply theory is in conformity with the General theory of value --- like the price of any commodity in a free market, the rate of exchange is determined by the forces of demand and supply.

3.This theory brings the determination of the rate of exchange within the purview of the General equilibrium theory. That is why this theory is also called the general equilibrium theory of exchange rate determination.4.It also indicates that balance of payments disequilibrium can be corrected by adjustments in the exchange rate (i.e., by devaluation or revaluation), rather than by internal deflation or inflation.

The Interest Rate Parity states that the interest rate difference between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate.

It plays essential role in foreign exchange markets. The difference between the interest rates in any two countries is the same as the difference between the forward and the spot rates of their respective currencies.

Interest rate parity A currency is worth

what it can earn.

The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period.

When the returns on two currencies are equal, interest rate parity prevails.

The relationship can be seen when you follow the two methods an investor may take to convert foreign currency into U.S. dollars.

Option A would be to invest the foreign currency locally at the risk-free rate for a specific time period. Then convert the proceeds from the investment into U.S. dollars at the maturity.

Option B would be to invest the same dollars in the (U.S.) market for the same time period. When no arbitrageopportunities exist, the cash flows from both options are equal.

Rate of return in localcurrencyRate of return in foreigncurrency=

In equilibrium, returns on currencies will be the same i. e. No profit will be realized and interest rate parity exits which can be written(1 + rh) = F (1 + rf) S

If interest rate parity is violated, then an arbitrage opportunity exists. The simplest example of this is what would happen if the forward rate was the same as the spot rate but the interest rates were different, then investors would:

borrow in the currency with the lower rate convert the cash at spot rates enter into a forward contract to convert the cash plus the expected interest at the same rate invest the money at the higher rate convert back through the forward contract repay the principal and the interest, knowing the latter will be less than the interest received.

If domestic interest rates are less than foreign interest rates, you will invest in foreign country at higher interest rates.

Domestic investors can benefit by investing in the foreign market

The Investor Hedge ArgumentMNC shareholders can hedge against exchange rate fluctuations on their own.The investors may not have complete information on corporate exposure. They may not have the capabilities to correctly insulate their individual exposure too.

Currency Diversification ArgumentAn MNC that is well diversified should not be affected by exchange rate movements because of offsetting effects.

Stakeholder Diversification ArgumentWell diversified stakeholders will be somewhat insulated against losses experienced by an MNC due to exchange rate risk.MNCs may be affected in the same way because of exchange rate risk.

Response from MNCsMany MNCs have attempted to stabilize their earnings with hedging strategies, which confirms the view that exchange rate risk is relevant.

Although exchange rates cannot be forecasted with perfect accuracy, firms can at least measure their exposure to exchange rate fluctuations.Exposure to exchange rate fluctuations comes in three forms:

Transaction exposureEconomic exposureTranslation exposure

The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure.To measure transaction exposure:

project the net amount of inflows or outflows in each foreign currency, anddetermine the overall risk of exposure to those currencies.

MNCs can usually anticipate foreign cash flows for an upcoming short-term period with reasonable accuracy.After the consolidated net currency flows for the entire MNC has been determined, each net flow is converted into either a point estimate or a range of a chosen currency, so as to standardize the exposure assessment for each currency.

An MNCs overall exposure can be assessed by considering each currency position together with the currencys variability and the correlations among the currencies.The standard deviation statistic on historical data serves as one measure of currency variability. Note that currency variability levels may change over time.

The exposure of the MNCs consolidated financial statements to exchange rate fluctuations is known as translation exposure.In particular, subsidiary earnings translated into the reporting currency on the consolidated income statement are subject to changing exchange rates.

Does Translation Exposure Matter?Cash Flow Perspective - Translating financial statements for consolidated reporting purposes does not by itself affect an MNCs cash flows.However, a weak foreign currency today may result in a forecast of a weak exchange rate at the time subsidiary earnings are actually remitted.

An MNCs degree of translation exposure is dependent on:

the proportion of its business conducted by its foreign subsidiaries,the locations of its foreign subsidiaries, andthe accounting method that it uses.

Stock Price Perspective - Since an MNCs translation exposure affects its consolidated earnings and many investors tend to use earnings when valuing firms, the MNCs valuation may be affected.

Does Translation Exposure Matter?

In general, translation exposure is relevant because

some MNC subsidiaries may want to remit their earnings to their parents now,the prevailing exchange rates may be used to forecast the expected cash flows that will result from future remittances, andconsolidated earnings are used by many investors to value MNCs.

An MNCs degree of translation exposure is dependent on:

the proportion of its business conducted by its foreign subsidiaries,the locations of its foreign subsidiaries, andthe accounting method that it uses.

Economic exposure refers to the degree to which a firms present value of future cash flows can be influenced by exchange rate fluctuations.Cash flows that do not require conversion of currencies do not reflect transaction exposure. Yet, these cash flows may also be influenced significantly by exchange rate movements.

Even purely domestic firms may be affected by economic exposure if there is foreign competition within the local markets. MNCs are likely to be much more exposed to exchange rate fluctuations. The impact varies across MNCs according to their individual operating characteristics and net currency positions.

One measure of economic exposure involves classifying the firms cash flows into income statement items, and then reviewing how the earnings forecast in the income statement changes in response to alternative exchange rate scenarios.In general, firms with more foreign costs than revenues will be unfavorably affected by stronger foreign currencies.

Another method of assessing a firms economic exposure involves applying regression analysis to historical cash flow and exchange rate data.