Foreign Exchange The determination of forex rates can be broken down into 2 calculations: 1. Purchasing Power Parity (PPP) and 2. Interest Rate Parity (IRP) 1. PPP suggests that exchange rates will be affected by the different levels of inflation that hold in each country. For example, if the UK has 3% inflation and the US has 1% inflation, then the UK currency will decline against the US dollar. The price of goods will be the same in each country once you have adjusted for inflation. The calculation is laid out in the text in section 11.2.4, but a more intuitive way of solving these problems can be done as follows:  Take the spot forex quote, eg. $1.444/£1, One currency is the domestic currency and one currency is the foreign currency. The currency with the single unit in the quote is the domestic currency (ie, £) and the currency on the left of the quote (the non single unit, ie the $) is the foreign currency.  Label one currency domestic (DOM) (£) and one currency foreign (FORN) ($)  With the PPP you are looking for the expected spot rate at some time in the future. This can be laid out as follows: Expected spot = =  1 + Foreign inflation rate 1 + Domestic inflation rate 1 + FORN 1 + DOM spot rate spot In this worked example, the spot is $1.444/£1, US inflation (Foreign) is 1%, UK inflation (Domestic) is 3%. The expected spot rate in one year’s time will be: Expected spot = 1.01 1.03 1.444 = 0.98058 * 1.444 = $1.41596/£1  If you wanted the expected rate in six months: (1.01)0.5 (1.03)0.5 1.444 = 1.0049876 1.0148892 1.444 = $1.42991/£1 Expected spot in 6 mths = So the formula becomes: Expected spot =  (1 + Foreign inflation rate)n * spot rate (1 + Domestic inflation rate)n Using other currency pairs, eg Russian Rouble and the euro. If inflation is 11% in Russia and 2% in the euro zone, the spot exchange rate is 34.9969 roubles to the euro, what is the expected spot rate in three months time? First, identify which cu