Financial Management · Hedging techniques for foreign currency risk

Interest Rate Parity and Purchasing Power Parity for ACCA FM

Updated 11 October 2026 · Fact-checked

Interest rate parity (IRP) predicts the forward rate from interest rate differentials. Purchasing power parity (PPP) predicts the future spot rate from inflation differentials. Both use the same shape: spot × (1 + rate of the quoted currency) ÷ (1 + rate of the base currency). Get the currency direction right and the answer follows.

Understand Interest Rate Parity and Purchasing Power Parity

Exchange rates move because money flows between countries. Two ideas explain much of it: interest rates and inflation. FM tests both as formulas you must apply with care.

Purchasing power parity (PPP) says the same goods should cost the same in every country once you convert at the exchange rate. If one country has higher inflation, its currency should weaken by the same proportion. So PPP forecasts a future spot rate from the expected inflation rates in the two countries.

Interest rate parity (IRP) says the forward rate is set so that you cannot make a risk-free profit by borrowing in one currency, converting, investing in the other, and locking in the return with a forward contract. The currency with the higher interest rate trades at a forward discount. So IRP gives the forward rate from the interest rates in the two countries.

The key difference: PPP uses inflation and predicts a future spot rate (a forecast, which may be wrong). IRP uses interest rates and gives a forward rate (a rate you can actually lock in, and which holds closely in efficient markets). Both are linked by the Fisher effect, where interest rate differences reflect inflation differences.

The skill the exam rewards is direction. Work out which currency is the base (the one with 1 in the quote, such as 1 $ = X foreign) and which is the quoted currency. The quoted currency's rate goes on top. If the quoted currency has the higher rate, it weakens, so more of it is needed per unit of base.

Key rules to remember

Interest rate parity (forward rate): F₀ = S₀ × (1 + iᶜ) ÷ (1 + iᵇ); S₀ is the spot rate quoted as units of currency c per 1 unit of currency b. iᶜ is the interest rate of the quoted currency c. iᵇ is the interest rate of the base currency b. Use rates for the same period as the forward contract.
Purchasing power parity (future spot rate): S₁ = S₀ × (1 + hᶜ) ÷ (1 + hᵇ); Same layout as IRP but with expected inflation rates h. S₁ is the expected spot rate at the end of the year. Use the inflation rates for the period.
Quick direction rule: Higher rate (interest or inflation) = weaker currency; The currency with the higher rate depreciates against the other. Use this to check your answer is sensible.
Multi-year PPP: S_n = S₀ × [(1 + hᶜ) ÷ (1 + hᵇ)]ⁿ; Use when inflation rates are constant for n years. If rates differ by year, apply each year's ratio in turn.
Change in rate over less than a year: F₀ = S₀ × (1 + iᶜ × m ÷ 12) ÷ (1 + iᵇ × m ÷ 12); Use when the question gives annual rates and a period of m months. Convert annual rates to the period by simple proportion unless told otherwise.

How to solve Interest Rate Parity and Purchasing Power Parity questions

Use this method for any IRP or PPP question, whatever the currencies.

1Identify what is asked: a forward rate (use interest rates, IRP) or a future spot rate (use inflation rates, PPP).
2Write the spot rate and note which currency is quoted and which is the base. For example, 1 £ = $1.60 means $ is quoted and £ is the base.
3Put the quoted currency's rate on top and the base currency's rate on the bottom, as (1 + rate) ÷ (1 + rate).
4Adjust the rates to match the period if it is not a full year, and raise to a power for several years.
5Multiply the spot rate by the ratio and calculate to at least four decimal places.
6Sense-check: the currency with the higher rate should be weaker, meaning more of it per unit of the other currency.
7Answer in the form asked, and state the conclusion, such as the currency is at a forward discount or premium.

Quickest way: Top-and-bottom check

When to use it: Use in Section A and B objective questions where time is short and you only need the final rate.

Circle the currency with 'per 1' in the quote. That is the base, and goes on the bottom.
Write S₀ × (quoted ÷ base) using (1 + rate) for each.
Before calculating, decide whether the answer should be larger or smaller than spot. Higher quoted rate means a larger number.
Calculate and eliminate options on the wrong side of spot.
If two options remain, recheck the period (months) and whether interest or inflation was asked for.

Common mistakes in Interest Rate Parity and Purchasing Power Parity

Putting the rates upside down.
Students memorise the formula without linking it to the way the rate is quoted.
Fix: Always put the quoted currency's rate on top. Then check that the higher-rate currency is weaker.
Using inflation rates for a forward rate, or interest rates for a future spot rate.
Both formulas look identical and the words parity and forward blur together.
Fix: Remember: IRP = interest = forward rate. PPP = prices (inflation) = future spot rate.
Ignoring the time period when the forward is for three or six months.
Students use the annual rates directly.
Fix: Scale annual rates by months ÷ 12 before using them, unless the question gives rates for the period.
Treating the PPP forecast as a guaranteed rate.
The answer is calculated precisely, so it feels certain.
Fix: Say PPP gives an expected spot rate. Only the forward rate can be locked in. PPP also works better over the long term than the short term.
Rounding too early.
Students round the ratio to two decimal places, which changes the fourth decimal of the rate.
Fix: Keep the ratio unrounded and round only the final rate to four decimal places.

Worked examples

Example 1

The spot rate is 1 £ = $1.5000. UK interest rates are 4% a year and US interest rates are 6% a year. Calculate the one-year forward rate using interest rate parity.

Show the solution

The quote is $ per £, so $ is the quoted currency and £ is the base.
Quoted currency (US$) rate = 6%. Base currency (£) rate = 4%.
F₀ = 1.5000 × 1.06 ÷ 1.04.
1.06 ÷ 1.04 = 1.019231.
F₀ = 1.5000 × 1.019231 = 1.5288.
Check: the $ has the higher interest rate, so it is weaker, meaning more $ per £. 1.5288 is above 1.5000, which fits.

Answer: The one-year forward rate is 1 £ = $1.5288. The dollar is at a forward discount.

Example 2

The spot rate is 1 € = ₹90.00. Expected inflation is 3% a year in the eurozone and 7% a year in India. Estimate the spot rate in two years using purchasing power parity.

Show the solution

The quote is ₹ per €, so ₹ is the quoted currency and € is the base.
Quoted currency (₹) inflation = 7%. Base currency (€) inflation = 3%.
Annual ratio = 1.07 ÷ 1.03 = 1.038835.
Square it: 1.038835² = 1.079219.
S₂ = 90.00 × 1.079219 = 97.13.
Check: India has higher inflation, so the rupee weakens and more rupees are needed per euro. 97.13 is above 90.00, which fits.

Answer: The expected spot rate in two years is about 1 € = ₹97.13.

Exam tips

Read the quote first. Many lost marks come from taking the wrong currency as the base, so write which is quoted and which is base before you calculate.
In OT questions, the wrong options are often the inverted-ratio answers. Use the weaker-currency check to remove them.
In Section C, show the formula, the substitution and a one-line comment. A correct method with an arithmetic slip still earns marks.
Be ready to explain the difference: IRP gives a forward rate from interest rates, PPP gives an expected future spot rate from inflation. Written parts often ask for this.
Use the calculated forward or expected spot rate in the hedging comparison that usually follows, such as forward contract against money market hedge.

Practice questions from Hedging techniques for foreign currency risk

Interest Rate Parity and Purchasing Power Parity in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Interest Rate Parity and Purchasing Power Parity: frequently asked questions

What is the interest rate parity formula in ACCA FM?

F₀ = S₀ × (1 + interest rate of quoted currency) ÷ (1 + interest rate of base currency). The quoted currency is the one that appears as the number of units per 1 unit of the base. Use rates for the same period as the forward contract.

What is the difference between PPP and IRP?

IRP uses interest rate differences to give the forward rate. PPP uses inflation differences to forecast the future spot rate. IRP is based on arbitrage, so it holds closely. PPP is a theory about prices, so it is a less reliable forecast in the short term.

How do I calculate a forward rate using interest rate parity?

Take the spot rate and multiply by the ratio of (1 + quoted currency rate) to (1 + base currency rate). If the period is shorter than a year, scale the rates by months ÷ 12 first. Check that the higher-interest currency has weakened.

Which currency goes on top in PPP and IRP?

The quoted currency, which is the one shown as units per 1 unit of the other currency. If the quote is 1 £ = $1.50, the dollar is on top. If the quote is reversed, so is the formula.