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CHAPTER-4
THE FUNDAMENTAL INTERNATIONAL PARITY
CONDITIONS
Content
The purchase power parity principle
Interest parity
THE PURCHASING POWER PARITY PRINCIPLE
Among the different factors influencing the exchange rates, one factor is
considered to be particularly important for explaining currency movements over
the long run, that factor is inflation.
The theory and the evidence for a long run connection between inflation and
exchange rate has become known as the Purchasing power parity (PPP)
principle.
The PPP principle popularized by Gustav Cassel in 1920’s.
According to PPP theory, when exchange rates are of a fluctuating nature, the rate
of exchange between two currencies in the long run will be fixed by their
respective purchasing powers in their own nations.
Foreign currency is demanded by the people because it has some purchasing power
in its own nation. Also domestic currency has a certain purchasing power.
Because it can buy some amount of goods/services in the domestic economy.
Thus, when home currency is exchanged for any foreign currency, in fact the
domestic purchasing is being exchanged for the purchasing power, because it can
buy some amount of goods/services in the domestic economy.
Thus, when home currency is exchanged for any foreign currency, infact the
domestic purchasing power is being exchanged for the purchasing power of that
foreign currency.
This exchange of the purchasing power takes place at some specified rate where
purchasing of two currencies nations get equalized.
Thus the relative purchasing power of the two currencies determines the exchange
rate.
The exchange rate under this theory is in equilibrium when their domestic
purchasing powers at that rate of exchanges are equivalent.
For example, suppose certain bundle of goods/services in USA costs U.S $ 10 and
the same bundle in Oman costs, OMR 4 then the exchange rate between OMR and
U.S dollar is $1= 0.4 OMR, because this is the exchange rate at which the parity
between the purchasing power of two nations is maintained.
A change in the purchasing power of any currency will reflect in the exchange rates
also.
Hence under this theory the external value of the currency depends on the
domestic purchasing power of that currency relative to that of another currency.
Gustav Cassel has presented the PPP theory in two versions
1) Absolute Version of the PPP theory and
2) Relative Version of the PPP theory.
ABSOLUTE VERSION OF THE PPP THEORY
According to the absolute version of the purchasing power parity (PPP) theory, the
exchange rates between two currencies should reflect the relation between the
international purchasing powers of various currencies.
In simple words the exchange rate would be determined, at the point where the
internal purchasing power of the respective currencies gets equalized.
Example, suppose particular basket of goods cost OMR 100 in Oman and $300 in
the U.S.A that means the exchange rate would be OMR 1 = $3 US dollars.
The exchange rate can be determined with the following equation:
Pb x QoR= --------------------
Pa x Qo
Where,
R = Exchange Rate
Pa = Prices in nation a.
Pb = Prices in nation b.
Qo = Corresponding weights
In this equation ‘P’ i.e. prices are related to the respective bundle of goods with same
weights assigned in both the countries.
Thus, the above equation explains that the equilibrium exchange rate is determined
by the ration of the internal purchasing power of foreign currency and domestic
currency in their own countries.
The absolute version of this theory maintains that the absolute purchasing power of
respective currencies does play a vital role in determining the equilibrium
exchange rate.
RELATIVE VERSION OF THE PPP THEORY
The relative version was developed in order to find the strength of the changes in
the equilibrium exchange rate. Any deviation from the equilibrium will lead to the
disequilibrium.
It can take place due to changes in the internal purchasing power of a particular
currency.
The changes in the purchasing power are measured with the help of domestic price
indices of the respective nation.
In this theory we need to assume any past rate of exchange as a base exchange rate
in order to know the percentage change in the exchange rate.
If we compare the price indices in the past i.e. base period with that of the present
period, the new equilibrium exchange rate could be found out.
It can be simplified by the following equation,
(Pb1 / Pb0)
Rn = Rn-1 x --------------
(Pa1 / Pa0)
Where,
Rn = New equilibrium exchange rate
Rn-1 = Base period exchange rate
Pb0 = Price index of nation b in base period
Pb1 = Price index of nation b in current period
Pa0 = Price index of nation a in base period
Pa1 = Price index of nation a in current period
According to the above equation when the price level in concerned nation changes,
automatically the internal purchasing power of the currency of that nation goes on
changing. This change leads to the change in the equilibrium exchange rate.
Thus under this theory Gustav Cassel tried to link the purchasing power of two
currencies in determining the equilibrium exchange rate.
CRITICISM OF PURCHASING POWER PARITY THEORY
1) LIMITATION OF THE PRICE INDEX: In the relative version theory the
author uses the price index in order to measure the changes in the equilibrium
rate of exchange. (however, price indices suffer from various limitations and thus
the theory too)
2) NEGLECT OF THE DEMAND/SUPPLY APPROACH : The theory fails to
explain the demand for as well as the supply of foreign exchange. The PPP theory
proves to be unsatisfactory due to this neglect. Because in actual practice the
exchange rate is determined according to the market forces such as the demand
and supply of foreign currency.
3) UNREALISTIC APPROACH: The PPP theory uses price indices which itself
proves to be unrealistic. The reason for this is that the quality of goods and services
included in the indices differs from nation to nation. Thus, any comparison without
due significance for the quality proves to be unrealistic.
4) UNREALISTIC ASSUMPTIONS: The PPP theory is based on unrealistic
assumptions such as absence of transport cost and assuming that there is an absence of
any barriers to the international trade.
5) NEGLECTS IMPACT OF INTERNATIONAL CAPITAL FLOW: The PPP
theory neglects the impact of the international capital movements on the foreign
exchange market. International capital flows may cause fluctuations in the existing
exchange rate.
CONCLUSION ON PURCHASING POWER PARITY
THEORY
Despite these criticisms the theory focuses on the following major points:
1) It tries to establish relationship between domestic price level and the exchange
rates.
2) the theory explains the nature of trade as well as considers the BOP (balance of
payments) of a nation.
INTEREST PARITY
The purchasing power parity (PPP) condition applies to product markets. There is
another important, parallel parity condition that applies to financial markets. This
is the covered interest parity condition.
It 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.
In this unit we derive the covered interest parity condition and show its connection
to the PPP principle
The term ‘covered interest rate parity’ refers to a condition where the relationship
between interest rates and the spot and forward currency values of two countries
are in equilibrium. As a result, there are no interest rate arbitrage opportunities
between those two countries.
Example, assume country X’s currency is trading at par with country Z’s currency,
but the interest rate in country X is 6% and the interest rate in country Z is 3%.
All other things being equal, it would make good sense to borrow in the currency
of Z, convert it in the spot market to currency X and invest in country X. however,
in order to repay the loan in currency Z, one must enter into a forward contract to
exchange the currency back from X to Z.
There are two versions of interest rate parity:
1. Covered Interest Rate parity
2. Uncovered Interest Rate parity
According to covered interest rate parity, forward exchange rates should
incorporate the difference in interest rates between two countries; otherwise an
arbitrage opportunity would exist. In other words, there is no interest rate
advantage if an investor borrows in a low interest rate currency to invest in a
currency offering higher interest rate.
Typically, the investor would take the following steps:
1) Borrow an amount in a currency with a lower interest rate.
2) Convert the borrowed amount into a currency with a higher interest rate.
3) Invest the proceeds in an interest-bearing instrument in the higher interest rate
currency.
4) Simultaneously hedge exchange risk by buying a forward contract to convert the
investment proceeds into the first lower interest rate currency.
The returns in this case would be the same as those obtained from investing in
interest bearing instruments in the lower interest rate currency.
Under the covered interest rate parity condition, the cost of hedging exchange risk
negates the higher returns that would accrue from investing in a currency that offers
a higher interest rate.
UNCOVERED INTEREST RATE PARITY
Uncovered interest rate parity (UIP) states that the difference in interest rates
between two countries equals the expected change in exchange rates between those
two countries.
Theoretically, if the interest rate differential between two countries is 3%, then the
currency of the nation with the higher interest rate would be expected to depreciate
3% against the other currency.
In reality, however, it is a different story, due to the introduction of floating exchange
rates, currencies of countries with high interest rates have tended to appreciate,
rather than depreciate as the uncovered interest rate parity equation states.
Interest rate parity is fundamental knowledge for traders of foreign currencies. In
order to fully understand the two kinds of interest rate parity, however the trader
must first grasp the basics of forward exchange rates and hedging strategies.
With this knowledge the forex trader will then be able to use interest rate
differentials to his or her advantage.
Review questions
Define PPP principle. Or What is purchase power parity theory?
What are the two versions of Gustav Cassel’s PPP theory?
What is absolute version of PPP theory?
Explain the equation to determine exchange rate according to PPP theory.
What does the relative version of PPP theory determine?
Explain the equation to determine the equilibrium exchange rate as per PPP
theory.
Explain any four criticism for purchase power parity theory.
Define interest parity theory
What are the conclusions of purchase power parity theory?
Define interest rate parity theory.
Define covered interest rate parity theory. Explain the steps typically a investor
would take as per covered interest rate parity theory.
What is the meaning of uncovered interest rate parity?
Differentiate between spot exchange and forward exchange contract.
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