THE PURCHASING POWER PARITY PRINCIPLE

Q-1 PURCHASING POWER PARITY?

ANSWER
Purchasing power parity, also known as PPP, is a “method for calculating the
correct value of a currency, which may differ from its current market value,”
according to "The Economist". It is useful for comparing international living standards
between countries as it defines the correct exchange rates for comparing prices and
incomes in different currencies. Purchasing power parity theory states that goods
and services should cost the same everywhere after converting to a common
currency.
Definition

The purchasing power parity theory establishes the idea that the ratio of price
level and exchange rate between two countries must be equivalent. That means that
a product should cost the same in two countries once your account for the exchange
rate and its effects on the economy of each country over time. This effect is known
as the law of one price.
Theory
PPP revolves around the “law of one price.” The law maintains that
competitive markets will equalize the price of an identical product in both countries.
This requires both countries’ prices to be expressed in a common currency. For
example, if a widget costs 750 Canadian dollars in Canada, the same widget should
cost 500 U.S. dollars in the United States when the exchange rate is 1.5 CAD/USD.
When the prices do not match--say the widget costs 700 CAD-U.S. consumers will
buy the widget in Canada to save money; this is called arbitrage. When arbitrage is
widespread, U.S. consumers drive up the price of the Canadian dollar eventually
causing the goods to equal out in price.
Stipulations and Contingencies

The law of one price has three caveats involving transport and transaction
expenses, a competitive market and limit to tradable goods. Transport and
transaction costs as well as other barriers to free trade can cause significant change
to price parity. PPP requires both countries to have an active competitive market.
Local services and immobile goods, such as houses, are not tradable and so PPP
does not apply.
Types

The two version of Purchasing Power Parity are Absolute PPP and relative
PPP. Absolute PPP references the equalizing of price levels of a product country to
country. Relative PPP describes the inflation rate, or the appreciation rate of a
currency by calculating the difference between two countries’ exchange rates.
Relative PPP is the more dynamic version of absolute PPP theory.
Pros and Cons

Economists argue that if the exchange rate moves too far away from its PPP,
trade and financial flow can move into disequilibrium. Others suggest that PPP is too
narrow a measure because it only includes traded goods, which make up only part of
a country’s economy. Some economists prefer to use the newer Fundamental
Equilibrium Exchange Rate that takes into account all three: traded goods, services
and capital flows.
Q-2 THE LAW OF ONE PRICE?
ANSWER:
The law of one price is the economic theory that the price of a given security,
commodity or asset has the same price when exchange rates are taken into
consideration. The law of one price is another way of stating the concept of
purchasing power parity.
Definition
An economic rule stating that a given security must have the same price no
matter how the security is created. If the payoff of a security can be synthetically
created by a package of other securities, the implication is that the price of the
package and the price of the security whose payoff it replicates must be equal. If it is
unequal, an arbitrage opportunity would present itself.

Law of one price

An economic rule stating that a given security must have the same price no m
atter how the security is created. If thepayoff of a security can be synthetically create
d by a package of other securities, the implication is that the price ofthe package and
the price of the security whose payoff it replicates must be equal. If it is unequal, an
arbitrageopportunity would present itself.

Absolute Form of Purchasing Power Parity

A theory stating that the same good or service costs the same amount regardl
ess of the currency in which it ismeasured. For instance, if 1 pound is equivalent to 2
dollars, and a widget costs 1 pound in England, then the absoluteform of purchasing
power parity would state that the same widget would cost 2 dollars in the United Stat
es. Thisconcept is also called the law of one price. In securities, any deviations from
the absolute form of purchasing powerparity create opportunities for arbitrage (profiti
ng from inefficiencies in prices).

Explanation
The Law of One Price says that identical goods should sell for the same price
in two separate markets. This assumes no transportation costs and no differential
taxes applied in the two markets. Economists generally assume that the law of one
price can be applied in liquid financial markets because of the possibility of arbitrage.
Unlike in international trade, where it takes time and effort to move goods physically
from one place to another, there are very little barriers in global financial markets.
 If the price of a security, commodity or asset is different in two different
markets, then an arbitrageur purchases the asset in the cheaper market and sells it
where prices are higher. When the purchasing power parity doesn't hold, arbitrage
profits will persist until the price converges across markets.

The law of one price is in place to prevent investors from taking advantage of
a price disparity between markets in a situation known as arbitrage. If a particular
security is available for $10 in Market “A” but is selling for the equivalent of $20 in
Market B, investors could purchase the security on Market A and immediately sell it
for $20 on Market B, netting a profit without any true risk or shifting of the markets.
As securities from Market A are sold on Market B, prices on both markets shift in
accordance with the changes in supply and demand. Over time, this would lead to a
balancing of the two markets, returning the security to the state held by the law of
one price.

In efficient markets, the occurrence of arbitrage opportunities are low, most

often caused by an event causing a sudden shift occurring in one market before the
other markets are effected.

What makes the law of one price work?

For example, an ounce of gold should cost the same on commodity
exchanges in Chicago and London. If the gold costs more on one exchange, then
traders would have incentive to purchase the gold on one exchange and sell it at the
other one. They would do what is called an arbitrage.
An arbitrage is a trading strategy that requires the investment of no capital,
with no risk of capital loss, and where there is some positive probability of making
money. Traders with gold would know how much they pay at one exchange and
receive at the other one. They could borrow money to realize immediate beforehand
known profit. They would realize arbitrage risk free profit.
This law does not always hold in practice. The reason is mostly transaction
costs and trade barriers. There may be limits on how much gold one can export or
import out of the country. It costs something to buy gold in Chicago and have it
shipped to London.
The law of one price in financial markets
The law of one price is an economic rule saying that a security must have a
single price in an efficient market regardless of how that security is created. For
example, if a financial instrument or a position can be created using two different
sets of underlying securities, then the aggregate price for each would be the same or
else an arbitrage opportunity would exist.
 The law of one price and purchasing power parity
The purchasing power parity theory is an aggregate application of the law of
one price. If the law of one price says that identical goods should sell for identical
prices in different markets, then the law should apply to all identical goods sold in
both markets. In other words, if the law of one price holds for each individual item in
the market basket, then it should hold for the market baskets as well.
Law of One Price and Commodities

When dealing in commodities, the cost to transport the goods must be

included, resulting in different prices when commodities from two different locations
are examined. If the difference is goes beyond the transportation costs, this can be a
sign of a shortage or excess within a particular region.

The Law of One Expected Return

A continuation of the law of one price is the law of one expected return. This
governs the idea that securities with similar asset prices and similar risks would be
expected to generate similar returns.
Q-3 absolute or static form of purchasing power parity
Answer:
Purchasing power parity is the notion that a bundle of goods in one country
should cost the same in another after exchange rates are considered. There are two
ways to express this concept:
1. Absolute Purchasing Power Parity
A theory that prices of products of two different countries should be equal when mea
sured by a common currency. Also called the "law of one price."
This concept posits that the exchange rate between two countries will be
identical to the ratio of the price levels for those two countries. This concept is
derived from a basic idea known as the law of one price, which states that the real
price of a good must be the same across all countries. To illustrate why this makes
sense, suppose that soybeans are currently priced at $5 a bushel in the U.S., that
soybeans are priced at ¬5.50 per bushel in Europe, and that the exchange rate is
1.10 euros per dollar. Suppose that the price of soybeans goes up to ¬6.05 per
bushel (a 10% increase) in Europe, while the price of soybeans in the U.S. only goes
up on 5%, to $5.25 a bushel. If there is no depreciation in the euro to offset the 5%
difference, then European soybeans will not be competitive on the international
market and trade flowing from the U.S. to Europe will greatly increase. If we take
weighted averages of prices for all goods within an economy, absolute purchase
power parity maintains that the currency exchange rate between two countries
should be identical to the ratio of the two countries' price levels.
This relationship can be expressed as:
Formula 5.5
S= P ÷ P*
Where Sis the spot exchange rate between two countries (the rate of the
amount of foreign currency needed to trade for the domestic currency), P is the price
index for a domestic country and P * is the price index for a foreign country. Note that
the exchange rate used here is an indirect quote. The following conditions must be
met for this relationship to be true:
1. The goods of each country must be freely tradable on the international
market.
 2. The price index for each of the two countries must be comprised of the same
basket of goods.
3. All of the prices need to be indexed to the same year.
Even if the law of one price holds for each individual good across countries,
differences in weighting will cause absolute purchasing power parity. Determining
comparable average national price levels is actually quite difficult and is rarely
attempted. Analysts usually examine changes in price levels (indexes), which are
easier to calculate; this gets around some of the problems of comparability.

QUESTION -4 Relative (dynamic) form of purchasing power parity

Answer:
Relative purchasing power parity is an economic theory which predicts a
relationship between the inflation rates of two countries over a specified period and
the movement in the exchange rate between their two currencies over the same
period. It is a dynamic version of the absolute purchasing power parity theory.

Relative purchasing power parity relates the change in two countries'

expected inflation rates to the change in their exchange rates. Inflation reduces the
real purchasing power of a nation's currency. If a country has an annual inflation rate
of 10%, that country's currency will be able to purchase 10% less real goods at the
end of one year. Relative purchasing power parity examines the relative changes in
price levels between two countries and maintains that exchange rates will change to
compensate for inflation differentials.

The relationship can be expressed as follows, using indirect quotes:

Formula 5.6
S1 / S0 = (1 + Iy) ÷ (1 + Ix)

S0 is the spot exchange rate at the beginning of the time period (measured as
the "y" country price of one unit of currency x)
S1 is the spot exchange rate at the end of the time period.
Iy is the expected annualized inflation rate for country y, which is considered to be
the foreign country.
Ix is the expected annualized inflation rate for country x, which is considered to be
the domestic country.
Q-6 INTEREST RATE PARITY?
ANSWER:
What is the 'Interest Rate Parity?'

Interest rate parity is a theory in which the interest rate differential between
two countries is equal to the differential between the forward exchange rate and
the spot exchange rate. Interest rate parity plays an essential role in foreign
exchange markets, connecting interest rates, spot exchange rates and foreign
exchange rates.

EXPLANATION
If one country offers a higher risk-free rate of return in one currency than that
of another, the country that offers the higher risk-free rate of return will be exchanged
at a more expensive future price than the current spot price. In other words, the
interest rate parity presents an idea that there is no arbitrage in the foreign exchange
markets. Investors cannot lock in the current exchange rate in one currency for a
lower price and then purchase another currency from a country offering a higher
interest rate.

Covered vs. Uncovered Interest Rate Parity

The interest rate parity is said to be covered when the no-arbitrage condition
could be satisfied through the use of forward contracts in an attempt to hedge
against foreign exchange risk. Conversely, the interest rate parity is said to be
uncovered when the no-arbitrage condition could be satisfied without the use of
forward contracts to hedge against foreign exchange risk.

Options of Converting Currencies

The relationship can be seen in the two methods an investor may take to
convert foreign currency into U.S. dollars.

One option an investor may take would be to invest the foreign currency
locally at the foreign risk-free rate for a specific time period. The investor would then
simultaneously enter into a forward rate agreement to convert the proceeds from the
investment into U.S. dollars, using a forward exchange rate, at the end of the
investing period.

The second option would be to convert the foreign currency to U.S. dollars at the
spot exchange rate, then invest the dollars for the same amount of time as in option
A, at the local (U.S.) risk-free rate. When no arbitrage opportunities exist, the cash
flows from both options are equal.

Covered Interest Rate Parity Example

For example, assume Australian Treasury bills are offering an annual interest
rate of 1.75%, while U.S. Treasury bills are offering an annual interest rate of 0.5%. If
an investor in the United States seeks to take advantage of the interest rates in
Australia, the investor would have to translate U.S. dollars to Australian dollars to
purchase the Treasury bill. Thereafter, the investor would have to sell a one-year
forward contract on the Australian dollar. However, under the covered interest rate
parity, the transaction would only have a return of 0.5%, or else the no-arbitrage
condition would be violated.