Purchasing Power Parity Principle (PPP) • Inflation is one of the important factor that affect the exchange rate in the long run. • long-run connection between inflation and exchange rates is the PPP principle Session 4 - International Parity Condition- Instructor: Bimesh Law of one price • Connection between exchange rates and the local-currency price of an individual commodity in different countries is the law of one price. • The law of one price states that a commodity will have the same price in terms of a common currency in every country. • People who buy in one market and sell in another are commodity arbitragers. • the law of one price states that: • This is the absolute or static form of law of one price. Session 4 - International Parity Condition- Instructor: Bimesh Law of one price Session 4 - International Parity Condition- Instructor: Bimesh PPP • For example, if the basket costs $1,000 in the United States and £600 in Britain, the exchange rate according to equation should be $1.67/£. • However we know that different baskets of goods are used in different countries for computing price indexes. Different baskets are used because tastes and needs differ between countries, affecting what people buy. Session 4 - International Parity Condition- Instructor: Bimesh PPP • For example, if heating oil prices increased more than olive oil prices, the country with a bigger weight in its price index for heating oil would have a larger price index increase than the olive-oil-consuming country, even though heating oil and olive oil prices increased the same amount in both countries. • Partly for this reason, an alternative form of the PPP condition which is stated in terms of rates of inflation can be very useful. This form is called the relative (or dynamic) form of PPP. Session 4 - International Parity Condition- Instructor: Bimesh PPP Session 4 - International Parity Condition- Instructor: Bimesh Relative form of PPP Session 4 - International Parity Condition- Instructor: Bimesh Relative form of PPP Equation (7.7) is the PPP condition in its relative (or dynamic) form. Session 4 - International Parity Condition- Instructor: Bimesh Relative form of PPP Session 4 - International Parity Condition- Instructor: Bimesh Relative form of PPP This condition holds true only when the inflation is low, when inflation is high this condition may not hold true. Session 4 - International Parity Condition- Instructor: Bimesh Reasons for departure from PPP • Restrictions on the movement of the goods – Transportation cost – Import tariff – Quotas • Price indexes and non traded outputs – Many of the items that are included in the commonly used price indexes do not enter into international trade. – There are immovable items like land, building, highly perishable commodities. • How ever movement of buyers some how help to maintain PPP Session 4 - International Parity Condition- Instructor: Bimesh Interest Parity • The purchasing power parity, inflation and law of one price dealt with goods and service market. • Similar or parallel condition that applies to the financial market is the covered interest parity condition. • This covered interest parity condition states that when steps have been taken to avoid foreign exchange risk by use of forward contracts, rates of return on investments, and costs of borrowing, will be equal irrespective of the currency of denomination of the investment or the currency borrowed. Session 4 - International Parity Condition- Instructor: Bimesh Interest parity • There is a consideration of the ‘‘frictions’’ that must be absent for the covered interest-parity condition to hold. The frictions that must be absent include legal restrictions on the movement of capital, transaction costs, and taxes. • These frictions play an analogous role to the frictions that must be absent for PPP to hold, namely, restrictions on the movement of goods between markets, transportation costs, and tariffs. Session 4 - International Parity Condition- Instructor: Bimesh Interest parity • Our focus is on investment yields and borrowing costs in different currencies. • Therefore we must determine – Which currency to invest – Which currency to borrow Session 4 - International Parity Condition- Instructor: Bimesh Interest parity • Determining the currency to invest – Let us assume Aviva company is one of the investment company and plans to invest in its domestic currency in us dollars. – The investment done in us dollar would result in the final wealth as depicted above. Session 4 - International Parity Condition- Instructor: Bimesh Interest parity Session 4 - International Parity Condition- Instructor: Bimesh Interest parity Session 4 - International Parity Condition- Instructor: Bimesh Interest parity Session 4 - International Parity Condition- Instructor: Bimesh Interest parity Session 4 - International Parity Condition- Instructor: Bimesh Session 4 - International Parity Condition- Instructor: Bimesh Interest parity Session 4 - International Parity Condition- Instructor: Bimesh Interest parity Session 4 - International Parity Condition- Instructor: Bimesh • An investor is indifferent when: Domestic Currency Interest Rate = Foreign Currency Interest Rate + Annual Forward Rate Premium / Discount • An investor invests in domestic currency if: Domestic Currency Interest Rate > Foreign Currency Interest Rate + Annual Forward Rate Premium / Discount .......... and vice versa Session 4 - International Parity Condition- Instructor: Bimesh Session 4 - International Parity Condition- Instructor: Bimesh Interest parity • Determining the currency in which to borrow – The firm should borrow when the reverse inequality holds discussed earlier in the investment Session 4 - International Parity Condition- Instructor: Bimesh Borrowing and investing for arbitrage profit Session 4 - International Parity Condition- Instructor: Bimesh • A borrower should borrow in domestic currency if: Domestic Currency Interest Rate < Foreign Currency Interest Rate + Annual Forward Rate Premium / Discount .......... and vice versa Session 4 - International Parity Condition- Instructor: Bimesh
