Parity conditions and forecasting - Forecasting approaches a...

Learning Outcomes

After reading this article, you will be able to explain the main parity conditions used for exchange rate forecasting, describe how purchasing power parity (PPP) and interest rate parity (IRP) work, perform basic calculations to forecast exchange rates using these models, and assess the limitations of such parity-based approaches for ACCA Financial Management (FM).

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand how parity conditions influence exchange rate forecasting. In particular, focus your revision on:

• The key parity relationships: purchasing power parity (PPP), interest rate parity (IRP), and their role in exchange rate determination
• Techniques for forecasting future exchange rates using PPP and IRP
• The assumptions and practical weaknesses of parity conditions as forecasting tools
• The impact of limitations on the real-world usefulness of these models for financial management decisions

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which parity theory states that future movements in exchange rates will reflect differences in countries’ inflation rates?
2. What does interest rate parity (IRP) predict about the relationship between forward exchange rates and interest rate differentials?
3. True or false? Parity-based forecasts always give accurate predictions of future exchange rates in the short term.
4. Explain one limitation of using purchasing power parity (PPP) for forecasting purposes.

Introduction

In international financial management, exchange rate forecasting is required for risk management, investment appraisal, and budgeting. Parity conditions, including purchasing power parity (PPP) and interest rate parity (IRP), are key theoretical tools in predicting future exchange rate movements. However, their real-world application is limited by several factors, and careful analysis is needed before relying on their forecasts for planning or hedging.

Key Term: parity conditions
The theoretical relationships linking exchange rates with macroeconomic variables such as inflation rates (PPP) or interest rates (IRP).

Parity Conditions and Exchange Rate Forecasting

Forecasting exchange rates is complex. Common forecasting techniques start with parity conditions—theoretical relationships between economic variables and exchange rates.

Purchasing Power Parity (PPP)

PPP states that, in the absence of transport costs and trade barriers, identical goods should have the same price in any two countries when their prices are expressed in a common currency.

PPP predicts that changes in exchange rates should offset differences in inflation rates between two countries. The PPP formula for forecasting the future spot rate is:

Where:

• $S_0$ = current spot exchange rate (e.g. FC/£)
• $S_1$ = forecasted future spot exchange rate
• $h\_{foreign}$ = expected inflation rate in the foreign country
• $h\_{home}$ = expected inflation rate in the home country

Key Term: purchasing power parity (PPP)
A parity condition stating that expected exchange rate movements will offset differences in inflation rates between countries.

Interest Rate Parity (IRP)

IRP links exchange rates to nominal interest rates instead of inflation. The theory states that the difference between spot and forward rates is explained by the difference in interest rates between countries.

The IRP formula for forecasting the forward rate is:

Where:

• $F_0$ = forward exchange rate
• $i\_{foreign}$ = annual interest rate in the foreign country
• $i\_{home}$ = annual interest rate in the home country

Key Term: interest rate parity (IRP)
A theory stating that the forward exchange rate will adjust to offset interest rate differentials between two countries.

Forecasting Using Parity Conditions

Parity conditions allow financial managers to predict future spot exchange rates using expected inflation or interest rates. These tools are often applied in multinational budgeting, risk management, and investment appraisal.

Worked Example 1.1

A UK company is trading with a US partner. The current spot rate is $1.60 = £1. UK inflation is expected at 2% per year, US inflation at 5% per year. What is the projected GBP/USD spot rate in one year using PPP?

Answer:
$S_1 = 1.60 \times \left(\frac{1.05}{1.02}\right) = 1.60 \times 1.0294 = \\$1.647$ per £1. The dollar is expected to depreciate against the pound.

Worked Example 1.2

The current spot rate between the euro and the pound is €1.20 = £1. One-year interest rates are 1% in the UK and 3% in the eurozone. What is the one-year forward rate according to IRP?

Answer:
$F_0 = 1.20 \times \left(\frac{1.03}{1.01}\right) = 1.20 \times 1.0198 = €1.2238$ per £1. The euro is expected to depreciate in the forward market relative to sterling.

Limitations of Parity-Based Forecasting

Despite their theoretical basis, parity conditions have several practical limitations:

• Assumptions rarely hold: Real markets have trading costs, government interventions, taxes, and barriers.
• Short-term inaccuracy: PPP and IRP predict long-term trends but do not reliably forecast short-term exchange rate movements, which are dominated by speculation, capital flows, and unpredictable events.
• Data and estimation issues: Required rates of inflation and interest are themselves forecasts and may be inaccurate.
• Speculative influences: Short-term exchange rate changes are largely driven by investor sentiment and speculation, which parity models cannot capture.

Key Term: forecasting limitations
The practical challenges that reduce the accuracy of parity-based exchange rate forecasts, mainly due to real-world market frictions and speculative activity.

Worked Example 1.3

A financial manager plans to budget for a US$ inflow in 12 months. Using PPP, the expected spot rate is $1.65 = £1. However, after 12 months, the actual spot rate is $1.55 = £1. Why might this occur?

Answer:
The PPP forecast may be incorrect due to speculative capital flows, market intervention, unexpected political events, or inaccurate inflation forecasts. Short-term rates often diverge from parity predictions.

Revision Tip

In exam scenarios, explain limitations of parity models if you are asked about accuracy or practical use—generic faith in PPP/IRP forecasts is not rewardable.

Summary

Parity conditions (PPP and IRP) are widely used for exchange rate forecasting. Both provide formulas for making predictions based on inflation or interest rate differentials. In the long run, these models indicate direction of currency moves, but their forecasting power is weak in the short-term due to practical limitations and external market factors. Always be ready to explain both the method and its weaknesses for the exam.

Key Point Checklist

This article has covered the following key knowledge points:

• Describe purchasing power parity (PPP) and interest rate parity (IRP) and their use in forecasting exchange rates
• Perform simple exchange rate projections using PPP and IRP formulas
• Recognise the limitations of parity-based forecasting in practice
• Identify the main reasons why these models may fail in real-world short-term prediction

Key Terms and Concepts

• parity conditions
• purchasing power parity (PPP)
• interest rate parity (IRP)
• forecasting limitations