Purchasing Power Parity
The theory of Purchasing Power Parity (PPP) suggests that currencies should be compared based on the premise of the differences between the levels of domestic and foreign inflation rates (Shapiro 2014). PPP should be seen as a notion that is parallel to the depreciation of domestic currency since it helps to indicate whether two specific currencies are in equilibrium at present (Shapiro 2014). Therefore, PPP is typically seen as an important element of financial analysis. The notion of PPP is often conflated with the law of one price, which posits that differences in exchange rates create the grounds for making financial forecasts in the financial context.
Interest Rate Parity
Unlike the PPP framework, the Interest Rate Parity (IRP) implies that the difference between interest rates of two currencies is equal to the forward exchange rate thereof (Shapiro 2014). The proposed way of viewing alterations in the interest rate contributes to the management of challenges associated with the location of future exchange rates, locate the current interest spot rates, and changes in the foreign exchange rates (Shapiro 2014). IRP is typically considered to be one of the essential notions that allow studying equilibrium economic relationships in a specific market. As a rule, two types of IRP are identified; these include covered and uncovered ones based on whether the no-arbitrage condition could be used for contract-related agreements.
International Fisher Effects
The International Fisher Effects (IFE) is another constituent of the analysis of equilibrium economic relationships. The IFE is defined as the theoretical framework that allows analyzing economic disparities between exchange rates of two different states (Shapiro 2014). Particularly, the IFE theory posits that there is a direct correlation between the exchange rates of currencies of particular states and the nominal interest rates within the countries under analysis (Shapiro 2014). As a result, depreciation of a particular currency can be identified, allowing one to take appropriate measures to address future financial and economic concerns.
Fisher Effect
The Fisher effect allows locating the connection between the real interest rate and the nominal one. Particularly, according to the Fisher effect, the two are equal when taking the levels of inflation into account, which implies that both are reduced significantly once inflation levels rise within a particular state (Shapiro 2014). By adjusting the real interest rate, one can determine the pace of the economic growth within a state, thus outlining the further changes that may need to be made to improve the economic situation (Shapiro 2014). Furthermore, the income that loans produce for lenders can be located with the help of the Fisher effect.
Covered Interest Arbitrage
Since investors face a range of risks in the context of the global market, gauging the expected risk rates is essential for lenders and other participants of economic relationships to reduce the threat of financial losses. The application of the Covered Interest Arbitrage (CIA), in turn, contributes to a drop in risk rates for investors. By considering rate differential, investors reduce risks to a considerable extent.
Reference List
Shapiro, AC 2014, Multinational financial management, 10th edn, Wiley, New York, NY.