Advanced Financial Management · Foreign Exchange Exposure and Risk Management

Interest Rate and Purchasing Power Parity for CA Final AFM

Updated 5 October 2026 · Fact-checked

Interest rate parity (IRP) links the forward rate to the interest rate gap between two currencies. Purchasing power parity (PPP) links the expected spot rate to the inflation gap. To solve, put the home currency per unit of foreign currency, multiply spot by the ratio (1 + home rate or inflation) ÷ (1 + foreign rate or inflation), and match the time period.

Understand Interest Rate and Purchasing Power Parity

Exchange rates do not move at random in theory. Parity theories say that rates adjust so that nobody earns a risk-free profit just by moving money or goods across borders. You use them to forecast a forward rate or a future spot rate.

Interest Rate Parity (IRP) is about the forward rate today. If India's interest rate is higher than the US rate, the rupee must trade at a forward discount against the dollar. Otherwise you could borrow in the cheap currency, invest in the dear one, lock the exchange back with a forward and earn a free profit. IRP removes that gap. It uses nominal interest rates and a forward contract.

Purchasing Power Parity (PPP) is about the expected spot rate in future. The idea is that the same basket of goods should cost the same in both countries once converted. If inflation in India is higher than in the US, the rupee is expected to weaken by about that gap. PPP uses inflation rates and gives an expected spot rate, not a rate you can lock in.

The Fisher effect connects interest rates and inflation. Nominal rate = real rate plus expected inflation. If real rates are equal across countries, the nominal rate gap equals the inflation gap. The International Fisher Effect (IFE) then says the expected change in spot rate equals the nominal interest rate gap. So IRP, PPP and IFE all point to the same direction: the higher-rate or higher-inflation currency weakens.

Key difference: IRP gives the forward rate and is enforced by arbitrage. PPP and IFE give the expected future spot rate and are forecasts. Exams often give both rate and inflation data, so first read which one the question asks you to use.

Key rules to remember

Interest Rate Parity (forward rate): F ÷ S = (1 + i_h × n) ÷ (1 + i_f × n) [simple, for periods up to one year]; S and F are home currency per one unit of foreign currency. i_h is the home rate and i_f the foreign rate, both for the same n years. For multi-year, use (1 + i_h)^n ÷ (1 + i_f)^n.
IRP with periodic rates: F = S × (1 + home rate for the period) ÷ (1 + foreign rate for the period); If annual rates are given for 6 months, use half the annual rate (simple method) unless the question says compound.
Purchasing Power Parity (expected spot): S₁ = S₀ × (1 + inflation_h) ÷ (1 + inflation_f); For n years use the ratio raised to the power n. Quote must be home currency per unit of foreign currency.
Relative PPP (approximate): Expected % change in spot ≈ inflation_h − inflation_f; Approximation only. Use the exact ratio form if the question asks for a precise rate.
Fisher effect: (1 + nominal rate) = (1 + real rate) × (1 + expected inflation); Approximately nominal rate ≈ real rate + inflation.
International Fisher Effect: S₁ ÷ S₀ = (1 + i_h) ÷ (1 + i_f); Gives the expected future spot from nominal interest rates. Same form as IRP but gives expected spot, not the forward rate.
Forward premium or discount (annualised): (F − S) ÷ S × (12 ÷ months) × 100; Positive means the foreign currency is at a premium. Negative means a discount.

How to solve Interest Rate and Purchasing Power Parity questions

Use this order for any parity question. It prevents the usual direction and period errors.

1Identify what is asked: forward rate today (use IRP), expected future spot (use PPP or IFE), or a missing interest rate or inflation rate.
2Fix the quote as home currency per one unit of foreign currency. For an Indian student, that is ₹ per USD, ₹ per EUR and so on. Invert the quote if it is given the other way.
3Pick the right data: interest rates for IRP and IFE, inflation rates for PPP. Do not mix them.
4Convert rates to the period of the contract. A 3-month forward uses a quarter of the annual rate under the simple method.
5Write the ratio with the home currency on top: (1 + home) ÷ (1 + foreign). Multiply by the spot.
6Compute and check direction. The higher-rate or higher-inflation currency should be at a forward discount or expected to depreciate.
7State the result with the unit, and add a premium or discount percentage if the question asks.
8If asked for a profit or comparison, carry the forward rate into the borrow-invest or hedge working.

Quickest way: Ratio shortcut with a direction check

When to use it: Use for plain forward or expected spot questions where the quote is already home per foreign unit.

Write: Answer = Spot × (1 + home) ÷ (1 + foreign).
Put the period fraction on both rates before adding 1.
Do a sanity check: if home rate is higher, answer must be above spot.
If the quote is foreign per home unit, flip the ratio instead of inverting the spot.
Round only at the end, normally to four decimals for rates.

Common mistakes in Interest Rate and Purchasing Power Parity

Putting the foreign rate on top of the ratio when the quote is home per foreign unit.
Students memorise the formula without checking the quote direction.
Fix: Always write the quote first. For ₹ per USD, the rupee rate goes on top. Check the direction: higher home rate means a higher forward rate.
Using the full annual rate for a 3 or 6 month forward.
The period is stated in the question but is skipped in a rush.
Fix: Multiply each annual rate by n (months ÷ 12) before adding 1, unless the question asks for compounding.
Using inflation rates in IRP or interest rates in PPP.
Both formulas look alike and the data table has both.
Fix: Remember the pairing: interest rates with forward rate, inflation with expected spot. IFE is the only case where interest rates give an expected spot.
Treating the PPP result as a forward rate you can lock.
Both results are called 'future rate'.
Fix: PPP gives an expectation. A forward is a contract priced by IRP. Label each answer correctly.
Using the approximation (difference in rates) when exact figures are needed.
The approximation is quicker and appears in notes.
Fix: Use the ratio form for numerical answers. Use the difference only for quick direction or an estimate.
Mixing up which currency is 'home' and which is 'foreign' when the quote is between two non-rupee currencies, such as USD per EUR.
Students always assume the rupee is the home currency.
Fix: For a quote of A per 1 B, treat A as the 'home' (price) currency and B as the 'foreign' (unit) currency. Put A's rate on top and B's rate at the bottom: F = S × (1 + i_A) ÷ (1 + i_B).

Worked examples

Example 1

A company in India expects to receive US$ 5,00,000 in 6 months. Spot is ₹83.00 per US$. Annual interest rates are 8% in India and 4% in the USA. Using interest rate parity (simple rates), find the 6-month forward rate and the rupees receivable if the company hedges with a forward contract.

Show the solution

Quote is ₹ per US$, so India is home and the USA is foreign.
Period is 6 months, so n = 0.5. Indian rate = 8% × 0.5 = 4%. US rate = 4% × 0.5 = 2%.
Forward = 83.00 × (1 + 0.04) ÷ (1 + 0.02) = 83.00 × 1.04 ÷ 1.02.
1.04 ÷ 1.02 = 1.019608 (approx). 83.00 × 1.019608 = 84.6275 (approx).
Forward rate ≈ ₹84.63 per US$. The dollar is at a premium since India's rate is higher.
Rupees receivable = 5,00,000 × 84.6275 = ₹4,23,13,750 (approx). Using the rounded rate 84.63 gives ₹4,23,15,000.

Answer: 6-month forward rate ≈ ₹84.63 per US$ (84.6275 before rounding). Hedged receipt ≈ ₹4,23,13,750, or ₹4,23,15,000 with the rounded rate.

Example 2

Spot is ₹90.00 per euro. Expected inflation is 6% a year in India and 2% a year in the Eurozone. Using purchasing power parity, find the expected spot rate after 2 years. Also find the expected spot after 1 year if the 1-year nominal interest rates are 9% in India and 5% in the Eurozone, using the international Fisher effect.

Show the solution

Quote is ₹ per euro, so India is home.
PPP for 2 years: S₂ = 90 × (1.06 ÷ 1.02)².
1.06 ÷ 1.02 = 1.039216 (approx). Squared = 1.079970 (approx).
S₂ = 90 × 1.079970 = 97.197 (approx), so about ₹97.20 per euro.
IFE for 1 year: S₁ = 90 × (1.09 ÷ 1.05).
1.09 ÷ 1.05 = 1.038095 (approx). S₁ = 90 × 1.038095 = 93.4286 (approx), so about ₹93.43 per euro.

Answer: Expected spot after 2 years under PPP ≈ ₹97.20 per euro. Expected spot after 1 year under IFE ≈ ₹93.43 per euro. In both cases the rupee is expected to weaken.

Exam tips

Read the question for the word 'forward' or 'expected spot'. It tells you whether IRP or PPP applies.
Write the quote direction and the home currency on the first line of your answer. Examiners award marks for the setup.
If both simple and compound conventions could apply, state your assumption. Simple rates for periods up to a year is the usual practice in exam problems.
In case-scenario MCQs, check direction first. You can often eliminate two options because the higher-rate currency must be at a forward discount.
Use IRP as the check in arbitrage questions: compare the market forward with the IRP forward, then do the borrow-convert-invest working.

Practice questions from Foreign Exchange Exposure and Risk Management

Interest Rate 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 and Purchasing Power Parity: frequently asked questions

What is the difference between PPP and IRP?

IRP links the forward rate to the interest rate gap and is enforced by covered arbitrage. PPP links the expected future spot rate to the inflation gap and is a forecast with no arbitrage lock. Use IRP for forward rates and PPP for expected spot rates.

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

Write the quote as home currency per foreign unit. Then multiply the spot by (1 + home rate for the period) ÷ (1 + foreign rate for the period). Convert annual rates to the contract period first.

What is the international Fisher effect in CA Final AFM?

It says the expected change in the spot rate equals the gap in nominal interest rates between two countries. The currency with the higher nominal rate is expected to depreciate. The formula is S₁ ÷ S₀ = (1 + i_h) ÷ (1 + i_f).

Do I use simple or compound interest in IRP problems?

For periods up to one year, exam solutions normally use simple rates scaled to the period. For longer periods, use compounding with power n. If the question states a convention, follow it.