Financial Management · Causes of exchange rate differences and interest rate fluctuations

Expectations Theory and Other Causes of Exchange Rate Movements

Updated 11 October 2026 · Fact-checked

Expectations theory says today's forward rate is an unbiased predictor of the future spot rate. Exchange rates also move because of trade flows, capital flows, speculation, interest rates, inflation and government intervention. In FM you calculate forward rates, compare them with expected spot rates, and explain the cause of any currency movement.

Understand Expectations Theory and Other Causes of Exchange Rate Movements

An exchange rate is the price of one currency in terms of another. Like any price, it moves with supply and demand. Demand for a currency comes from people who need it to buy a country's goods, services or assets. Supply comes from people selling it to buy foreign currency.

Expectations theory is about forecasting. It says the forward rate for a future date equals the market's expected spot rate for that date. If the 6-month forward rate is 1.60, the market expects the spot rate in 6 months to be about 1.60. The forward rate is seen as an unbiased predictor: it will be wrong in any single case, but not wrong in a consistent direction. The theory rests on efficient markets, where traders act on their expectations and push the forward rate to match them.

In practice the forward rate is usually set from the spot rate and the interest rate differential (interest rate parity). So expectations theory links to interest rates and inflation. A currency with higher interest rates trades at a forward discount. The theory says this discount signals expected depreciation. The evidence is mixed, and forward rates are often poor predictors over short periods.

Other causes of movement work through the balance of payments. Trade flows (the current account): a country that exports more creates demand for its currency, which pushes it up. A large import bill increases supply of the currency, which pushes it down. Capital flows: foreign investment, bank deposits and the purchase of bonds and shares need the local currency. Higher interest rates attract capital and strengthen the currency.

Speculation adds short-term swings. Traders buy a currency they expect to rise and sell one they expect to fall, and this can become self-fulfilling. Government intervention also matters. A central bank can buy its own currency using reserves to support it, sell it to weaken it, or change interest rates. Governments may also use exchange controls or tariffs. Inflation differences, covered by purchasing power parity, are a further long-term driver.

Key rules to remember

Expectations theory: Forward rate (time t) = Expected future spot rate (time t); Forward rate is an unbiased predictor, not a perfect one.
Forward rate from interest rates (interest rate parity): F = S × (1 + i quoted currency) ÷ (1 + i base currency); Use rates for the period to the forward date. Base currency is the one that appears as 1 in the quote.
Expected spot rate from inflation (purchasing power parity): S1 = S0 × (1 + h quoted currency) ÷ (1 + h base currency); h means inflation rate. It explains long-run movements.
Direction of movement rule: Higher inflation or lower interest rates → currency weakens; trade surplus or capital inflow → currency strengthens; Other things being equal. State this condition in answers.

How to solve Expectations Theory and Other Causes of Exchange Rate Movements questions

Use this method for numerical and discussion questions on exchange rate prediction and causes.

1Read the quote carefully and identify the base currency (the one equal to 1) and the quoted currency.
2Decide what is asked: a forward rate, an expected spot rate, or the reason a currency moves.
3For a forward rate, apply the interest rate parity formula using interest rates for the correct time period (scale annual rates for months).
4If asked about expectations theory, state that the forward rate is taken as the expected future spot rate.
5Compare the forward rate with any other forecast, such as one from inflation differences.
6For cause-based questions, name the factor (trade flows, capital flows, speculation, intervention, interest or inflation) and say which direction it moves the currency and why.
7Link to the business impact, such as the cost of imports, the value of receipts or the need to hedge.
8State any limits: markets may be inefficient, and forward rates are often poor short-term predictors.

Quickest way: Forward rate shortcut and cause checklist

When to use it: Use in Section A and OT case questions where you have a minute or two.

Identify which currency has the higher interest rate. That currency trades at a forward discount.
Move the rate in that direction. If the quoted currency has the higher rate, the base currency becomes more expensive in forward terms, so the forward rate is higher.
Compute the precise figure only to pick between the options and check it agrees with your direction.
For cause questions, ask: does this raise demand for the currency or supply of it? Demand up means strengthens; supply up means weakens.
Eliminate options that reverse the direction, such as a trade deficit strengthening a currency.

Common mistakes in Expectations Theory and Other Causes of Exchange Rate Movements

Saying the forward rate is a guaranteed or accurate forecast.
Students read 'predictor' as 'perfect predictor'.
Fix: Say it is an unbiased predictor: it is right on average but usually wrong on any one occasion.
Putting the interest rates the wrong way round in the forward rate formula.
Confusion over which currency is the base.
Fix: Quoted currency rate goes on top and base currency rate on the bottom. Check the direction with the discount rule.
Using annual interest rates for a 3 or 6 month forward rate.
Rushing and ignoring the time period.
Fix: Scale the rate: use i × months ÷ 12 for the period, unless the question says otherwise.
Claiming higher interest rates always strengthen a currency.
Treating a rule of thumb as law.
Fix: Say higher rates tend to attract capital and strengthen the currency, but inflation expectations and other factors can offset this.
Listing causes without explaining the mechanism.
Memorised lists replace reasoning in Section C.
Fix: For each cause, say what happens to demand or supply of the currency and the resulting direction.

Worked examples

Example 1

The spot rate is $1.5000 per £1 (base currency £). Annual interest rates are 6% in the US and 4% in the UK. Calculate the 6-month forward rate and state what expectations theory implies.

Show the solution

Base currency is £ and quoted currency is $.
6-month interest rates: US 6% × 6/12 = 3%; UK 4% × 6/12 = 2%.
F = 1.5000 × 1.03 ÷ 1.02.
1.5000 × 1.03 = 1.545. Then 1.545 ÷ 1.02 = 1.5147.
Expectations theory takes this forward rate as the expected spot rate in 6 months.

Answer: The 6-month forward rate is about $1.5147 per £1. The theory implies the market expects the pound to strengthen slightly against the dollar, from 1.5000 to about 1.5147, with the dollar at a forward discount.

Example 2

Explain to a finance director why a country's currency might weaken if it runs a large trade deficit and the central bank cuts interest rates.

Show the solution

Trade deficit: the country imports more than it exports. Importers sell the local currency to buy foreign currency, so supply of the currency rises relative to demand.
Lower interest rates: returns on local deposits and bonds fall, so foreign investors buy less local currency. Local investors may move funds abroad. Capital inflows fall.
Speculators who expect the currency to fall may sell it, which adds to the downward pressure.
Offsetting factor: the central bank could intervene by buying its currency with reserves. This is limited by the size of its reserves.
Business impact: imports become more expensive and exporters gain competitiveness.

Answer: The currency is likely to weaken, other things equal, because the trade deficit increases supply of the currency and lower interest rates reduce capital inflows. Speculation may amplify the fall. Intervention could slow it, but only within the limits of the central bank's reserves.

Exam tips

In OT questions, check the quote direction first. Many wrong answers come from inverting the rate.
Always give the direction of movement and the reason. A cause without a direction earns nothing in Section C.
Use the phrase 'other things being equal' when stating cause and effect.
When asked whether the forward rate predicts the future spot rate, give the theory and also one limitation.
Remember OT questions are all or nothing, so recheck the arithmetic and the time scale on interest rates before choosing.

Practice questions from Causes of exchange rate differences and interest rate fluctuations

Expectations Theory and Other Causes of Exchange Rate Movements: frequently asked questions

What is expectations theory in ACCA FM?

It says the forward exchange rate is an unbiased predictor of the future spot rate. The forward rate equals the market's expected spot rate for that date. It is accurate on average, not on every occasion.

What causes exchange rates to fluctuate?

The main causes are trade flows, capital flows, speculation, government intervention, interest rate differences and inflation differences. Each changes the demand for or supply of a currency. The net effect decides the direction.

How does the balance of payments affect the exchange rate?

A current account surplus means more demand for the currency and tends to strengthen it. A deficit tends to weaken it. Capital account inflows add demand and outflows add supply.

How can a government influence its exchange rate?

A central bank can buy or sell its own currency using reserves, or change interest rates to attract or deter capital. Governments can also impose exchange controls or trade barriers. Reserves limit how long support can last.