### Syllabus E2b)

b) Evaluate, for a given hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure:

i) The use of the forward exchange market and the creation of a money market hedge

### Purchasing Power Parity (PPP theory)

**Why do exchange rates fluctuate?**

“The law of one price”

#### Illustration

Item costs $1,000

$2:€ (base)

However inflation in US is 5% and Europe is 3%

**According to law of one price what is the predicted exchange rate in 1 year?**

**Solution**So next year - Item in US costs $1,050 and in Europe €515

“The law of one price” = $1,050 = €515So, forward exchange rate = 1,050 / 515 = $2.039:€1

PPPT “High inflation leads to depreciation of currency”

**Another way of calculating this is as follows:****Exchange rate now (counter) x (1+ Inf (counter) / 1 + inf (base))**2 x 1.05 / 1.03 = 2.039

#### Limitations

Future inflation is an estimate

Market is ruled by speculative not trade transactions

Governments often intervene

### Interest Rate Parity (IRP theory)

**Why do exchange rates fluctuate?**

An investor will get the same amount of money back no matter where he deposits his money

#### Illustration

US Interest rate = 10%

European Interest rate = 8%

Exchange rate = $2:€

Investor has $1,000 to invest for 1 year

**What is the future exchange rate as predicted by IRPT?**

**Solution**In US he will receive $1,100 in one years time

In Europe he will receive €540

Forward rate will therefore be 1,100 / 540 = $2.037:€IRPT “High interest rates leads to depreciation of currency”

**Another way of calculating this is as follows:****Exchange rate now x (1+ Int (counter) / 1 + int (base))**2 x 1.10 / 1.08 = 2.037

#### Limitations

Government intervention

Controls on currency trading