ACCA Applied Skills · Financial Management
Causes of Exchange Rate Differences and Interest Rate Fluctuations
Exchange rates move because of inflation differences (purchasing power parity), interest rate differences (interest rate parity and the international Fisher effect), and expectations. Interest rates change with inflation, risk, liquidity and the term of lending, shown by the yield curve. You solve questions by picking the right parity formula and applying it carefully.
What this chapter covers
This chapter explains why currencies trade at the rates they do and why interest rates change over time. You start with how to read exchange rate quotations, then move through the main theories: purchasing power parity, interest rate parity, the Fisher effect and the international Fisher effect. Each links two variables, such as inflation, interest rates, spot rates and forward rates.
The chapter then covers expectations theory and other causes of currency movements, such as trade flows, capital flows, government intervention and speculation. It ends with the causes of interest rate fluctuations and the shape of the yield curve, including what upward and downward slopes suggest.
It connects directly to the rest of FM. Forecast exchange rates feed into foreign investment appraisal. Forward rates and parity ideas underpin currency hedging. Interest rate theory supports cost of capital, the choice of finance and interest rate risk management. You will meet these ideas in both objective questions and constructed response questions.
The formulas are short and the calculations are mostly quick, so this chapter is a good source of reliable marks in Section A and in objective test cases. Objective questions are all or nothing, so a wrong inversion of a rate costs the full mark. The same forecasts are used later in investment appraisal and hedging questions in Section C, so errors here carry forward. Time spent getting the mechanics right pays back across the paper.
Causes of exchange rate differences and interest rate fluctuations: topics in the order to study them
- 1Exchange Rate Quotations and Spot RatesEverything else uses rates, so learn direct and indirect quotes, bid and offer, and how to invert first.
- 2Purchasing Power ParityIt is the simplest parity: it links inflation differences to spot rate changes, and it sets up the formula style used later.
- 3Interest Rate ParityIt uses the same ratio layout but with interest rates, and it gives the forward rate you need for hedging.
- 4Fisher Effect and International Fisher EffectIt splits interest rates into real and inflation parts and links this to currency moves, which pulls PPP and IRP together.
- 5Expectations Theory and Other Causes of Exchange Rate MovementsOnce the formal models are clear, you can see where they fail and what else moves currencies.
- 6Causes of Interest Rate Fluctuations and the Yield CurveIt is mainly descriptive, so it is easiest after the numerical theory is secure.
How to prepare Causes of exchange rate differences and interest rate fluctuations
Treat this chapter as a set of four ratio formulas plus a few explanations. Practise the calculations until they are automatic, then learn the reasoning for written answers.
- Practise reading quotes: identify the base currency, decide whether to multiply or divide, and check your answer is sensible.
- Write each parity formula as a ratio of (1 + rate in one currency) to (1 + rate in the other). Then check which currency sits on top.
- Do five or six short calculations for each of PPP, IRP and the international Fisher effect, using different currencies each time.
- Compare the theories side by side: what each links, what it predicts, and which data you are given in the question.
- Learn the limits of each theory in two or three points, such as market imperfections, controls and slow price adjustment, so you can write short explanations.
- Describe the yield curve shapes and the theories behind them in your own words, then practise a short written answer.
- Finish with mixed objective questions under time pressure, since a single wrong step gives zero.
Common mistakes in Causes of exchange rate differences and interest rate fluctuations
Putting the wrong currency on top in a parity formula.
Fix: Put the currency in the numerator of the quote on top. Then check the result: the higher-inflation or higher-interest currency should be weaker.
Using inflation rates where interest rates are needed, or the reverse.
Fix: Ask what is being forecast. A forward rate uses interest rates. A future spot rate under PPP uses inflation.
Ignoring the time period.
Fix: Adjust the rates to the period, or compound for several years, before you apply the ratio.
Treating the parity theories as exact predictions.
Fix: In written answers, say they are models. Mention market imperfections, controls, and prices that adjust slowly.
Using the wrong side of a bid-offer quote.
Fix: The bank always gives the customer the worse rate. With a quote of X per 1 unit of base currency, the customer buys the base currency at the higher number and sells the base currency at the lower number. Check your answer: the customer should always end up with less than the mid-rate would give.
Giving a vague explanation of the yield curve.
Fix: Link each shape to expectations about future rates, liquidity preference and risk, and say what each suggests about the economy.
Last-day revision: Causes of exchange rate differences and interest rate fluctuations
- FM quote convention: a rate of X/Y means units of X per 1 Y. Y is the base currency, the one that is 1 unit. To convert Y into X, multiply by the rate. To convert X into Y, divide by the rate.
- Spot rates are quoted bid and offer. Check which rate the bank uses for your transaction.
- PPP: future spot X/Y = spot X/Y × (1 + inflation of the currency in the numerator, X) ÷ (1 + inflation of the currency in the denominator, Y).
- The currency with the higher inflation is expected to weaken.
- IRP: forward X/Y = spot X/Y × (1 + interest rate of the numerator currency, X) ÷ (1 + interest rate of the denominator currency, Y), for the same period.
- IRP uses interest rates for the forward rate. PPP uses inflation for the future spot rate.
- Fisher effect: (1 + nominal rate) = (1 + real rate) × (1 + inflation).
- International Fisher effect: expected future spot X/Y = spot X/Y × (1 + nominal interest rate of X) ÷ (1 + nominal interest rate of Y). The currency with the higher nominal interest rate is expected to depreciate.
- Use the same time period for rates and the exchange rate forecast. Adjust annual rates for part years.
- Expectations theory: the forward rate is an unbiased predictor of the future spot rate.
- Other causes: trade flows, capital flows, government intervention, speculation and political events.
- Yield curve: an upward slope is the normal shape. An inverted curve means short-term rates exceed long-term rates.
Causes of exchange rate differences and interest rate fluctuations practice questions
- A bank quotes the spot rate for the USD/EUR pair as 1.0850 – 1.0920 (euros per 1 US dollar). A US exporter wishes to sell EUR 218,400 to the…
- The spot rate between the dollar ($) and the euro (€) is $1.2000 per €1. Annual inflation is expected to be 5% in the US and 2% in the euroz…
- Under the liquidity preference theory of the term structure of interest rates, why does the yield curve normally slope upwards?
- A central bank unexpectedly raises its base rate to curb inflation. Which is the most likely immediate effect on a company with substantial …
- A 1-year zero-coupon government bond yields 4% and a 2-year zero-coupon bond yields 6%. Using the expectations theory, what is the implied o…
- Which of the following would most likely cause the interest rate on a corporate bond to be higher than that on a government bond of the same…
- According to the expectations theory of interest rates, what is a upward-sloping yield curve evidence of?
- A company holds quotes: USD/EUR 1.1000 – 1.1040 (euros per dollar) and USD/JPY 148.00 – 148.60 (yen per dollar). It wants to convert JPY 16,…
Causes of exchange rate differences and interest rate fluctuations in other exams
The same ground in other exams, if you are preparing for more than one or want another angle on it.
Causes of exchange rate differences and interest rate fluctuations: frequently asked questions
What is the difference between purchasing power parity and interest rate parity?
Purchasing power parity links exchange rate changes to differences in inflation. Interest rate parity links the forward rate to differences in interest rates. PPP forecasts a future spot rate, while IRP gives a forward rate.
How do I decide which currency goes on top in the formula?
Look at the quote. The currency whose units appear in the numerator of the rate goes on top in the ratio. Then check that the weaker currency is the one with the higher inflation or interest rate.
Is this chapter more likely to appear in Section A or Section C?
It can appear in objective questions, objective test cases and constructed response questions. Forecast rates are often an input to longer investment or hedging questions. Treat it as useful across the whole paper.
What does an inverted yield curve mean?
It means short-term interest rates are higher than long-term rates. It is often read as a sign that markets expect rates to fall, sometimes because of a slowdown. It is a signal, not a certainty.
Do I need to learn the theories or just the formulas?
You need both. Formulas win marks in calculations. Short explanations of what each theory says and where it fails help in written answers and in objective questions on concepts.