The aspect of foreign exchange rate is captured by international finance and international economics. It is an important phenomenon in analyzing the level of international relations in foreign exchange. As important microeconomic variable, foreign exchange helps to gesture the portfolio with which a country’s balance of payment would be in relation to the others. A broad array of effects of exchange rates to the international community is evident. (Ronald, 1999, p.
78) It is not a subject of influence to financial markets only but influential towards multinational companies that are involved in the international trade where the costs and revenues is billed in terms of foreign currencies. The fundamental concept of exchange rates is built on a two broad financial benchmark, both the floating and fixed exchange rates. (Ephraim, Dilip, 2004, p. 87) Both the systems have various economic implications upon different global states. Consequently, another aspect of reality held within floating exchange rates consequently comes in.
Economically, such floating exchange rates volatility is the core factor that has hitherto shaped the global phenomena towards economic growth, employment, inflation and also investment. (Beate, 1998, p. 35) Economically there has been a continued disparity between what should be the fundamental exchange rate system that could promise favorable macroeconomic variable. However, at the discretional different capacities, different economist have stood to argue differently on the fundamentality of both the two systems of exchange rates in regard to what they have for the global economies.
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(Robert, 1994, p. 98) This is in their views that, the disparity held in different global economies which could be subject to low or high economic growth and development calls for a difference in exchange rate approach that adequately answers the question of the most adequate exchange rate to use. (Frank, Philip, 1989, p. 65) Though the exchange rate school of thought would rationally necessitate a complex academic study, this paper would be a review of a partial capacity of the fundamental theories determining exchange rates.
Basically, an explanation towards exploring the movement of exchange rates have run into centuries but have failed to bring a consensus agreement of a basic approach. Consequently, various theories explaining these phenomena have been brought out. (Risto, 2003, p. 53) Purchasing Power Parity Perhaps significantly, the Purchasing Power Parity (PPP) theory holds an important part in this area. Its organization was sometimes in the 16th Century in Spain. Various economists have echoed it emphasize in the international finance portfolio.
It is a basic instrument/theory of evaluating the under and over valuations in exchange rate. It has it basics on ‘law of one price’ where the price is taken as a competitive and integrated product and as having the assumption of neutrality in the market risks. (Lavan, Peter, 2002, p. 78) Its basement is on the flow theory of exchange rates with an assertion that currency demand is used for paying exports white currency supplied is used for paying imports. However, the theory has lacked a clear-cut description despite having its development across many Centuries. (Barry, 1993, p. 43)
Assumption Assuming ‘p’ is the price of a commodity at home country and ‘q’ is the price of the same commodity in the foreign country without any trade friction assigned for the commodity in the two countries, their prices should ultimately be equal. This is to imply the p=eq. where ‘e’ stands for exchange rate. Elsewhere when different prices depict an equalized price across different countries, the state of the PPP is now absolutely prevailing. Therefore, when p=e=standard price of a commodity in one country say X then q is the equivalent standard price in another country say Z.
According to the theory however, when perfectly homogenous goods do not possess any price parity at any time, this does not necessitate market failures. However, this would be due to the inability in shifting the cost of the commodities at instantaneous regimes across different countries. For the theory to hold however, the market of operation across the international portfolio should be perfectly elastic with sufficiently adequate information about the states of exchange within the trading partners.
(Samuel, 1979, p. 102) This is a basically important phenomenon in avoiding market asymmetries. However, deviations in the PPP may usually develop either via’ transitory versions’ or even in a ‘structural form’. Structural changes arise from deviation in exchange trends within the PPP. (Paul, 1962, p. 27) This may be characteristically from changes in differentials that existed in productivity growth between countries. (Jacob, Thomas, 1978, 61) This would consequently lead to a change in real exchange rates.
As a basic assumption in the model, when the productivity rate of one country (domestic) rises, its home currency appreciates relatively to the rate of growth when compared to the foreign currency. This could be due to factors like growth in labour force, change in consumer tastes, adequate commercial policies and technological development. (Steve, 2003, p. 61) Consequently, factors such as factor endowment, real income and changing levels of productivity leads to PPP systematic departures.
Elsewhere, transitory deviations usually occur from economic disturbances, which seldom lead to adjusted preferential prices of services and goods. Both the two modes of deviations lead to purchasing power disparity hence the purchasing power disparity theory. (Meher, 1993, p. 46) Modern Asset View (1) It is ideally import to internalize on the modern asset view as an exchange rate theory. This operates in the asset market unlike the commodity market held in PPP. Accordingly, a constant price exists for assets within the international portfolio as long as there is no price friction.
This implies that when there is no price friction within the international market investment securities will depict equality in rate of returns. Therefore, the international cost of financial investment would be equal. This would thus provide a mobility in the perfect capital flow as well as perfect substitutability of capital. (Maria, et al, 1997, p. 87) This view exists in different phenomenological approaches which include the Covered Interest Rate Parity (CIRP), the Uncovered Interest Rate Parity (UCIRP) and the Fisher open hypothesis.
Under the covered interest rate parity, there basically exists no difference in making borrowing or lending for assets in one country to the other. Any consequence of advantage would that imply market interest would move towards a parity situation. Arbitrage in the interest rate implies that there would be various opportunities for unexploited profits. Basically, CIRP has its application in forward rates pricing model. This is a tool for avoiding the consequences of the uncertainty that may be brought out by both market and political risks, which may leads to an influx in the price of investment capital costs.
(Ronald, 1993, p. 45) The UCIRP model could be influential in creating forward linkages in the exchange rates. This model seeks to capture the risks involved in the changing cost of capital due to the new information within the international portfolio. The Fisher open hypothesis is built on the conception that asset cost in real rates of interest would be substantially equal across different countries. Here, real interest rate would be the difference between nominal interest rate and the expected inflationary rate. ( Peter, 2000, 109)
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