Professional Documents
Culture Documents
International
Parity Conditions
International Parity Conditions:
Learning Objectives
P$ S = P¥
Where the price of the product in US dollars (P$), multiplied
by the spot exchange rate (S, yen per dollar), equals the
price of the product in Japanese yen (P¥)
P¥
S $
P
• If the Law of One Price were true for all goods, the
purchasing power parity (PPP) exchange rate
could be found from any set of prices
• Through price comparison, prices of individual
products can be determined through the PPP
exchange rate
• This is the absolute theory of purchasing power
parity
• Absolute PPP states that the spot exchange rate is
determined by the relative prices of similar basket
of goods
$
$ C $
E E x FC
R N
C
7-15 © 2012 Pearson Education, Inc. All rights reserved.
Exhibit 7.3 IMF’s Real Effective Exchange Rate Indexes
for the United States, Japan, and the Euro Area
Real Effective Exchange Rate Index Interpretation: A falling value of the index
for the euro (RNXM); 2005=100 implies a depreciation of the currency, a
rising value implies an appreciation of
(dashed line) the currency (the euro).
$ € €/$
P BMW PBMW x S
7-20 © 2012 Pearson Education, Inc. All rights reserved.
Exchange Rate Pass-Through
$
P BMW, 2 $40,000
$
1.1429, or 14.29%
P BMW, 1 $35,000
S1 S2 $
x 100 i i ¥
S2
FC 90
1 i x 360
FC/$ FC/$
F 90 S x
$ 90
1 i x 360
90
1 0.400 x 360
Sfr/$
F90 Sfr1.4800 x
Sfr1.4800 x
1.01
Sfr1.4655/$
90 1.02
1 0.800 x 360
• Rule of Thumb:
– If the difference in interest rates is greater than
the forward premium (or expected change in
the spot rate), invest in the higher yielding
currency.
– If the difference in interest rates is less than the
forward premium (or expected change in the
spot rate), invest in the lower yielding currency.