International Finance and Accounting Handbook

The Purchasing Power Parity (PPP) theorem can be stated in different ways, but
the most common representation links the changes in exchange rates to those in rel-
ative price indices in two countries:

The relationship is derived from the basic idea that, in the absence of trade restric-
tions, changes in the exchange rate mirror changes in the relative price levels in the
two countries. Therefore, under conditions of free trade, prices of similar commodi-
ties cannot differ between two countries by more than the transfer cost, because ar-
bitrageurs will take advantage of such situations until price differences are elimi-
nated. This “Law of One Price” leads logically to the idea that what is true of one
commodity should be true of the economy as a whole—the price level in two coun-
tries should be linked through the exchange rate—and hence to the notion that ex-
change rate changes are tied to inflation rate differences.
The International Fisher Effect (IFE) states that the interest rate differential will
exist only if the exchange rate is expected to change in such a way that the advantage
of the higher interest rate is offset by the loss on the foreign exchange transaction.
The IFE can be written as follows:

In practical terms, the IFE implies that while an investor in a low-interest country can
convert his funds into the currency of the high-interest country and get paid a higher

Expected rate of change of the exchange rate
Interest rate differential

Rate of change of exchange rate
Difference in inflation rates

6.3 ECONOMIC EXPOSURE, PURCHASING POWER PARITY 6 • 7

Exhibit 6.1. Key Parity Relationship of International Finance that Affect Corporate Ex-
change Risk Exposure.

THE FOREIGN EXCHANGE DIAMOND

RELATIVE

INFLATION

RATES

FORWARD

EXCHANGE

RATE

SPOT

EXCHANGE

RATE

RELATIVE

INTEREST

RATES

Purchasing power

parity:inflation

differential offset by

exchange rate

change

Fisher effect:

interest rate equals

real rate plus

expected inflation

rate

International

Fisher effect:

interest rate

differential equals

expected exchange

rate change

Unbiased forward

rate theory:

for ward rate differs

from spot rate by a

percentage equal to

expected exchange

rate change

Interest rate parity:

for ward rate differs

from spot rate by a

percentage equal to

interest rate

differential