While understanding about of foreign exchange, you will come across various theories related with currency exchange. The Forex market basically runs on a variety of methods and theories. These theories are used by the participants in the foreign exchange market. Participants namely are the inter-banks, commercial banks, brokers, dealers and the customers.
These major currency exchange theories are adopted by many participants. We will go through some of the major theories which help us in trading smoothly in foreign exchange process. We have listed down the three major theories.
- The theory of balance of payments: balance of payment is the amount of the country’s capital account or the current account, which still has to be paid to the other country. Basically the balance of payment is calculated on the basis of two major segments of a country. The list of all transaction done by the country, and the time period of the payment.
The country’s goods which go to other countries, creates the balance of payments. The current account of the country is affected more by the balance of payment theory of economics. The balance of payment will explain about the country’s goods which are traded more to the other country. Whenever the country’s imports are more than its export, then country’s currency value falls down. Similarly, when the country’s exports goes up, the value of its currency increases.
- Purchasing Power Parity: Purchasing Power Parity theory explains that amount of adjustment which is required in between the exchange rate of two different countries while keeping the exchange rate same. The country’s exchange rate can be maintained for longer period of time if the adjustments are done on equal platform. This will also accelerate the purchasing power of a country. Also, the purchasing power parity explains about the difference between the prices of two different countries.
- Interest Rate Parity: Interest rate parity, theory of currency exchange is another significant theory of currency exchange. This theory explains about the common difference between the forward exchange value and the spot exchange value. According to this theory if the rates of interest of two different countries have no difference, then the value of the currency of that particular country will not increase. This also results in no gain to the country by the transactions.