Select two of the following exchange rate theories and explain how they work:

Interest Rate Parity
Purchasing Power Parity
International Fisher Effect

Apply the selected exchange rate theories to test them against the USD/Foreign Currency exchange rate. Show your data, calculations and results.

Do the theories explain the observed exchange rate behavior? Is one theory more accurate than the other? Interpret your findings.

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Interest rate parity and purchasing power parity are theories that are being used to explain the movement and changes in exchange rates.

Interest rate parity represents situation where no arbitrage is possible. Key characteristics of this model are perfect mobility of capital and substitutability of assets. It is equilibrium of its own kind and presumes equality in gains that an investor can achieve no matter where money is invested. In reality these two assumptions can't hold because there are assets that can't be substituted and certain countries are allowed to restrict capital mobility in a given time period. Thereby investors are able to earn extra profit due to market imperfection....
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