PPP vs Interest Rate Parity for forecasting exchange rates — when do I use which?

Great question — exchange rate forecasting appears frequently on the Level III exam. Here's a clear comparison: **Purchasing Power Parity (PPP)** - **Core idea:** Exchange rates adjust so that identical goods cost the same across countries. If inflation is higher in Country A, its currency should depreciate. - **Formula:** E(S₁/S₀) ≈ (1 + π_domestic) / (1 + π_foreign) − 1 - **Best for:** Long-term (5+ year) forecasts - **Limitation:** Terrible for short-term — real exchange rates can deviate from PPP for years or even decades due to capital flows, productivity differences, and government intervention. **Example:** If US inflation is 3% and Eurozone inflation is 1.5%, PPP predicts the USD depreciates by approximately 1.5% per year against the EUR. **Uncovered Interest Rate Parity (UIP)** - **Core idea:** The expected change in the exchange rate equals the interest rate differential between two countries. - **Formula:** E(S₁/S₀) ≈ (1 + r_domestic) / (1 + r_foreign) − 1 - **Best for:** Medium-term directional guidance - **Limitation:** Empirically, UIP is often violated — the "forward rate bias" or "carry trade" anomaly means high-yielding currencies don't depreciate as much as UIP predicts (at least in the short run). **Covered Interest Rate Parity (CIRP)** - **Core idea:** The forward exchange rate is determined by the interest rate differential. This is an *arbitrage* relationship that holds tightly in liquid markets. - **Formula:** F/S = (1 + r_domestic) / (1 + r_foreign) - This isn't really a forecasting model — it's a no-arbitrage pricing relationship for forwards. **When to Use Each:** | Scenario | Best Model | |---|---| | 10-year strategic allocation across currencies | PPP | | Medium-term currency view for tactical tilt | UIP + adjustment for carry | | Pricing a currency hedge via forwards | CIRP | | Short-term trading | None of these — use technical/flow analysis | **Exam Tip:** If a vignette gives you inflation differentials and asks for long-run currency expectations, use PPP. If it gives you interest rate differentials and asks about expected spot rate changes, use UIP. Explore more currency forecasting scenarios in our CFA Level III practice questions.