Purchasing Power Parity (PPP)

and Foreign Exchange Exposure

Aditya Banerjee
Purchasing Power Parity (PPP)
• Absolute PPP: Ratio of local prices of the same basket of goods and services.
• Relative PPP: Rate of change in exchange rates (𝑒) due to difference in inflation 𝜋.
(1 + 𝜋₹ )
(1 + 𝑒) =
(1 + 𝜋$ )
• Real exchange rate (𝑞):
(1 + 𝜋₹ )
𝑞=
(1 + 𝑒)(1 + 𝜋$ )
• 𝑞 = 1: Competitiveness of the domestic country unaltered.
• 𝑞 < 1 : Competitiveness of the domestic country improves.
• 𝑞 > 1 : Competitiveness of the domestic country deteriorates.
• Inflation India is 5.6% and US is 5.3%. How much should ₹ change vs $ annually?
• What if the $ increases in ₹ terms by 1.24%, what would that mean for India?
Fisher Effects
• Real (𝑟₹ ) vs. nominal (𝑖₹ ) interest rates:
• Nominal interest rate is the interest rate that you earn (or pay) on
a loan; this is the rate quoted for deposits/investments or loans.
• Real interest rate is the nominal interest rate adjusted for inflation;
this is the effective interest rate that you earn (or pay).
1 + 𝑖₹ = (1 + 𝑟₹ )(1 + 𝜋₹ )
• If inflation rates in India is 5.6% and your bank FD pays you 4.9%
per annum. How much are you gaining in real term? What is the
real interest rate?
• This equality is often called Fisher Effect
Burgernomics: The Big Mac Index and PPP
https://www.economist.com/big-mac-index
• A McDonald Big Mac (Maharaja Mac) burger costs ₹194
• A Big Mac in USA costs $5.65
• What should be the value of ₹ per $?
• The actual value is: ₹74.19 per $.
• Is the ₹ overvalued or undervalued?
Forecasting Foreign Exchange: Basics
• Based on IRP and PPP
• Instead of using forward price in IRP, we can assume that interest rate
differential predicts future spot price.
• Based on Econometric models
• The fundamental approach: Using econometric models
• The Technical approach: Using graphs to identify patterns
• Forecasting performance
• Measured through mean-squared error (MSE)
• Read more about forecasting methods here: International Financial
Management by Eun and Resnick: Page 171 – 177.
Exposure to Foreign Exchange Risks
• Suppose that Boeing Corporation exported a landing gear of a Boeing 737
aircraft to British Airways and billed £10 million payable in one year. The
money market interest rates and foreign exchange rates are given as
follows:
• The U.S. interest rate: 6.10% per annum
• The U.K. interest rate: 9.00% per annum
• The spot exchange rate: $1.50/£
• The forward exchange rate: $1.46/£ (1-year maturity)
• When Boeing receives £10 million in one year, it will convert the pounds
into dollars at the spot exchange rate prevailing at the time. Since the
future spot rate is unknown today, the dollar proceeds from this foreign
sale is uncertain unless Boeing hedges.
• What will Boeing do?
When Paying a Foreign Currency Obligation
• Suppose Boeing imported a Rolls-Royce jet engine for £5 million
payable in one year. The market condition is summarized as follows:
• The U.S. interest rate: 6.00% per annum
• The U.K. interest rate: 6.50% per annum
• The spot exchange rate: $1.80/£
• The forward exchange rate: $1.75/£ (1-year maturity)
• Given exchange rate fluctuations, Boeing is concerned about the
future dollar cost of this purchase. Facing an account payable, Boeing
will have to try to minimize the dollar cost of paying off the payable.
• Now, what will Boeing do?
What if the currency payment/receipt is
regular?
• Imagine that an Indian company took a 1-year a USD loan from a
British bank. Loan repayment happens every 3-months. How can the
company hedge its foreign exchange exposure?
• Swap contract may be used here
• Swap is like a portfolio of forward contracts
• For each interest payment, the forward rate is different and predetermined
• Banks act as intermediaries in such contracts.
 Interest Rate Swap
• Interest Rate SWAP: two parties, called counterparties, make a contractual
agreement to exchange cash flows at periodic intervals.
• There are two types of interest rate swaps.
• One is a single-currency interest rate swap. The name of this type is typically shortened to
interest rate swap.
• The other type can be called a cross-currency interest rate swap. This type is usually just
called a currency swap.
• In the basic (“plain vanilla”) fixed-for-floating rate interest rate swap, one
counter-party exchanges the interest payments of a floating-rate debt obligation
for the fixed-rate interest payments of the other counterparty. Both debt
obligations are denominated in the same currency.
• In a currency swap, one counterparty exchanges the debt service obligations of
a bond denominated in one currency for the debt service obligations of the
other counterparty denominated in another currency. The basic currency swap
involves the exchange of fixed-for-fixed rate debt service.
 Swap Bank
• A swap bank is a generic term to describe a financial institution that
facilitates swaps between counterparties.
• A swap bank can be an international commercial bank, an investment
bank, a merchant bank, or an independent operator.
• The swap bank serves as either a swap broker or swap dealer.
• As a broker, the swap bank matches counterparties but does not assume
any risk of the swap. The swap broker receives a commission for this
service.
• Today, most swap banks serve as dealers or market makers.
• As a market maker, the swap bank stands willing to accept either side of a
currency swap, and then later lay it off, or match it with a counterparty.
• The dealer capacity is obviously more risky, and the swap bank would receive a
portion of the cash flows passed through it to compensate it for bearing this risk.
 Swap Quotation
• Swap banks will tailor the terms of interest rate and currency swaps to
customers’ needs.
• They also make a market in generic “plain vanilla” swaps and provide
current market quotations applicable to counterparties with Aa or Aaa
credit ratings.
• A swap bank will typically quote a fixed-rate bid-ask spread (either
semiannual or annual) versus three-month or six-month dollar LIBOR flat,
that is, no credit premium.
• Suppose the quote for a five-year swap with semiannual payments is 8.50–8.60
percent against six-month LIBOR flat.
• This means the swap bank will pay semiannual fixed-rate dollar payments of 8.50
percent on notional principal against receiving six-month dollar LIBOR on the same
amount
• Or it will receive semiannual fixed-rate dollar payments at 8.60 percent against
paying six-month dollar LIBOR.
 More about SWAP
• To know more about SWAP and see how swaps actually
look like, refer to the following:
International Financial Management by Eun and Resnick
(7th Edition): Chapter 14, Pages 348 - 353
Operating (Economic) Exposure
• Operating exposure, also referred to as economic exposure, competitive
exposure, or strategic exposure, measures any change in the present value of
a firm resulting from changes in future operating cash flows caused by any
unexpected change in exchange rates.
• Operating exposure analysis assesses the impact of changing exchange rates
on a firm’s own operations over coming months and years and on its
competitive position vis-à-vis other firms.
• The goal is to identify strategic moves or operating techniques the firm might
wish to adopt to enhance its value in the face of unexpected exchange rate
changes.
• Operating exposure and transaction exposure are related in that they both
deal with future cash flows.
Operating (Economic) Exposure (contd.)
• The net operating exposure of any individual business reflects the
cash inflows and cash outflows by currency of its competitive position
in the market.
• Accounts receivable are the cash flow proceeds from sales, and accounts
payable are all ongoing operating costs associated with the purchase of labor,
materials, and other inputs.
• Operating exposure is inevitably subjective because it depends on
estimates of future cash flow changes over an arbitrary time horizon.
• Thus, it does not spring from the accounting process but rather from
operating analysis.
• Planning for operating exposure is a total management responsibility
depending upon the interaction of strategies in finance, marketing,
purchasing, and production.
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