Free Essay About Purchasing Power Parity (Ppp)
International Parity Conditions in Corporate Finance – Study of Theoretical Relationships
International Parity Conditions in Corporate Finance – Study of Theoretical Relationships
International Parity Conditions in Corporate Finance - An Introduction
Apart from factors like inflation and interest rates, there is another economic variable which is the critically most important determinant of the economic health and progress of every country. This is known as the exchange rate and its management. This rate plays a vital role in the free market economy all over the world by active influence on worldwide trade activity of every country.
In addition to the inflation and interest rate, an exchange rate is carefully watched, analyzed and mostly manipulated economic measure. The three economic variables identified have a direct influence over the real return of a portfolio from an investor's perspective. Therefore, this paper is written to identify the five theoretical relationships between spot/forward exchange rates, inflation and the level of interest rates within and between different economies.
In this research paper, an elegant and simple set of five parity (or equilibrium) conditions are examined. These five theoretical relationships concerning international parity apply to interest rates, product prices and forward as well as future spot exchange rates if the markets are efficient and not interfered into by any influence. These parity (or equilibrium) conditions, which depict five theoretical relationships between the above said economic variables, provide a simple basis for much of the theoretical and practical framework of international corporate finance. This key framework stresses upon the relationship between among inflation, interest rates, spot rates and forward exchange rates.
Investigating Five Forces of Theoretical Relationship
Under this section, the five theoretical relationships between inflation rates, interest rates, spot and forward rates between countries are analysed followed a general empirical evidences of each to validate their involvement in the real economic world. This establishment of this relationship is important because these economic variables offset each other due to which the balance of trade, inflow and outflow of investments/funds and capital as well as current accounts are affected.
If the law of one price is enforced by an international arbitrage activity, then the exchange rate between domestic goods and the home currency should equal the foreign currency exchange rate between the foreign goods relative to the home currency. In simple terms, one unit of home or domestic currency (expressed in terms of HC) should have the similar purchasing power in an international marketplace.
Therefore, if a single unit of Pound Sterling can buy one pound of bread in Great Britain, then as per the Purchasing Power Parity theory, it should also buy a pound of bread in the United States. For this arbitrage activity (Purchasing Power Parity - PPP) to happen, the exchange rate between commodities or goods must change approximately by the difference between the foreign and domestic inflation rates.
This theory examines the relationship between changes in expected inflation rates in two countries to changes in their respective currency exchange rates. Purchasing Power Parity attempts to study the change in price levels of different commodities between two countries and stresses upon the notion that foreign currency exchange rates change to compensate for differentials in the inflationary pressure.
This is so because an inflationary pressure tends to reduce the real purchasing power of citizens and currency of a given country. If, for instance, any country has a yearly inflation rate of ten percent, every unit of the currency that country could now purchase ten percent less real goods at the end of the economic year. In effect, Purchasing Power Parity dictates that any currency with higher inflation rates should devalue relative to those currencies backed by lower inflation rates.
Empirical Evidence for Purchasing Power Parity (PPP) Theory
Empirical evidence for PPP theory holds true in a manner that by end of January 2015, the average per unit price of Big Mac Burger in China was $2.77 whereas in United States, it was only $4.79 at market-based foreign currency exchange rate. The PPP theory holds that exchange rates, in the long-run, move towards a given currency rate that equalises the prices of an identical basket of products and services between any two countries. Based on this theory, one may say that the above practical (real-life) example that the Chinese Yuan was undervalued by forty two percent on January 2015 as dictated by the "raw" Big Mac index. In the same manner, the average price per unit of Big Mac Burger in Switzerland is $7.54 based on the market data. Relative to the US dollar, it can be said that the Swiss Franc was overvalued by fifty seven percent approximately where the actual exchange rate between these countries is US$ 1 = SFr 0.86 .
The Fisher effect theory suggests that the nominal rate of interest equals an adjustment for inflationary pressure plus the real interest rate. Through arbitrage, the Fisher effect stresses upon a generalized version of its concept that real rates of return are equal across different countries. Capital investment would flow from the second to the first currency, if expected real rates of return are greater in one currency than another. In absence of intervention by the government, arbitrage activity would continue until expected real rates of return become equal. With no government interference and in equilibrium, the nominal interest differential becomes equivalent to the anticipated inflation differential. In effect, the Fisher effect theory follows that any currency with higher inflation rate should be followed by higher rates of interest than currencies with lower inflationary pressure.
Empirical Evidence for Fisher Effect
After studying this theory, it is important to investigate into the notion if there is any empirical evidence in the real world supporting the Fisher Effect. Many researchers have established that there is hardly any relationship between interest rates and their positive and significant impact on expected rates of inflation . However, there are some studies where researchers have been successful to find a strong relationship between current rates of interest and inflation rates of the past . In one study, the inflation rates were compared with nominal rates of interest for a sample of twenty two countries. The researchers reached a suitable conclusion that in countries where inflation rate are high, they tend to have higher levels of interest rates which provides succinct evidence about the existence of Fisher Effect Theory in the real economic world. This is so because most of the fluctuations in nominal rates of interest are normally dictated by differentials in expected inflation rates across countries .
International Fisher Effect
The key to understand the possible effect of relative changes in nominal rates of interest on the value of foreign currency exchange rate across countries is to recall the implications of Purchasing Power Parity and the generalized version of Fisher effect. Purchasing Power Parity (PPP) dictates that currency exchange rates move to neutralize changes in inflation rate differentials. Therefore, an increase in rate of inflation across the U.S. relative to inflation in other countries will reflect a fall in the value of every unit of dollar. This activity will also depict an increase in the interest rate across United States relative to interest rates in foreign countries.
The International Fisher Effect (sometimes recognized with the name of as Fisher's open hypothesis) reflects a financial hypothesis which stipulates that differences in nominal rates of interest reflect the expected fluctuation in the spot rate of the foreign currency across countries. Specifically, spot exchange rates are more likely to change in exactly an opposite direction of the interest rate differential.
With this in mind, one can understand that the currency of any country backed by higher nominal rate of interest is more expected or vulnerable to depreciation in value against any country’s currency with the lower nominal rates of interest. This is so because higher levels of nominal interest rates normally reflect an increase in expected inflationary pressure. By an overall theoretical analysis, one can observe that the International Fisher Effect (IFE) theory dictates that currencies with higher levels of interest rates are expected to decline in their value (depreciation) relative to those currencies of countries where nominal interest rates are low.
Empirical Evidence for International Fisher Effect
In a recent study conducted in 2009, Hatemi used an asset pricing approach to derive International Fisher Effect in an analytical manner. In his study, he tried to research on stock market that occurred on October 1987. Considering the sample period from 1964 to 2001, the researcher used the monthly data from stock markets of United States and United Kingdom. It was found that the crash brought significant breaks in risk premiums but not in International Fisher Effect. Results made it clear the interest rate differentials in the United States and United Kingdom were significantly and positively by the differentials in inflation between these two economies. The study further concluded that markets are still to be considered as efficient because there were no transaction costs and benefit from earning arbitrage was impossible .
Interest Rate Parity Theory
A major determinant of the spread between spot and forward exchange rates is the change in short-term funds across currencies of different countries for taking advantage of differentials in interest rates. In other words, Interest Rate Parity theory dictates that the forward premium or discount is closely related to the differential in rates of interest between two currencies.
According to the theory of interest rate parity, a country’s currency with a lower rate of interest should represent a forward premium relative to country’s currency with higher interest rate. Specifically, when there are no transaction costs and the market is efficient, the interest differential should equal the differential in forward exchange rates. Here, the forward rates are said to be at interest rate parity one the above mentioned condition is met followed by an equilibrium position in the money markets.
The Interest Rate Parity theory emphasizes that the differences between the forward and spot foreign currency exchange rates are equal to the interest rates differential in two currencies. Interest parity theory makes sure that the return on a covered (or "hedged") foreign investment should be equal to the domestic interest rate on investment containing similar risk profile, which eliminates the possibility of overnight money making by investors.
In other words, this theory makes a prediction that the countries with the high levels of interest rate will witness depreciation to the forward rate of their currency and vice versa. Interest Rate Parity Theory (IRPT) justifies that lower rates of interest on investments denominated in any currency are offset or neutralised by forward premiums and that higher rate of interest is neutralised by a discount in forward exchange rates.
Empirical Evidence Supporting the Interest Rate Parity Theory (IRPT)
In the Euro currency market, the Interest Rate Parity Theory (IRPT) holds true because Euro currency market is able to satisfy each and every assumption of the Interest Rate Parity Theory (IRPT) by operating closely to reflect the trading arena of a perfect capital market where there are no government interference, no taxes imposed and no (or low) transaction costs .
Forward Rate as an Unbiased Predictor
Here, the word “unbiased” means that the difference between forward rate and actual spot rate is, on an average, is zero based on the market efficiency. The unbiased forward rate anticipation hypothesis stipulates that, on day 0, the forward rate fully reflects available market information. It is considered that the forward exchange rate, on day 0, seems to be an unbiased estimate of the future spot rate.
Both the spot and forward rates of exchange are heavily influenced by expectations of future events under a system of freely floating rates. Both of these rates move in tandem and the link among them is based on differentials in rates of interest. New market information, like any favourable or unfavourable fluctuations in interest rate differentials etc, is reflected immediately in both the spot and forward rates with an immediate effect.
For instance, depreciation in the value of pound sterling is expected in the market. Recipients of dollar will purchase pound sterling and will reduce their dollars selling activity in the forward market. In a reactive manner, recipients of sterling will sell this currency forward. These actions in the market will reduce the per unit price of forward rate for pound sterling. In this manner, pressure in the forward market is transferred to the spot market and vice versa.
Equilibrium condition is attained only after the differential in forward exchange rate becomes equals to the anticipated fluctuation in the exchange rate. This is a point where the incentive to sell or buy the currency forward is neutralized or offset. An unbiased nature of a formal statement reflects that the forward rate must reflect the anticipated future spot rate on the settlement date of the forward contract.
Empirical Evidence on Forward Rates as an Unbiased Predictor
The general conclusions about this theory reveal the reality that forward currency exchange rate is an unbiased estimator of future spot rate. However, in econometric, using more powerful techniques, more recent studies present that forward currency rates seem to be biased predictor of future spot rates because of involvement of market risk premium. This may be an invalid conception because the market premium changes their signs being negative at some times and positive at other times and sometimes, they average near zero. Therefore, in the absence of powerful econometric techniques, the market risk premium will not treat the forward exchange rate as an unbiased predictor of the future spot rate.
After a careful analysis of all theoretical relationship between four economic variables, one may conclude that not a single investor could take unfair advantage of the market because if he does so by one economic variable (such as interest rates) in the foreign market, this benefit is offset by an increase in local inflationary pressure which neutralises the arbitrage activity in the global marketplace.
In this research, it can be found that following a Purchasing Power Parity, in countries where inflation rates or product prices are high, their currency tend to depreciate in value compared to currencies backed by lower inflation rates due to a rise in purchasing power.
Similarly, the fisher effect theory influences a currency in a manner that higher inflation rates in any country should reflect a rise in interest rates which cause its currency to devalue and vice versa. This condition is also confirmed by theory behind International Fisher Effect (IFE).
If any country has lower interest rate, return on investment reflects forward premiums in exchange rate to neutralise the arbitrage activity. However, higher interest rates carry discounts n forward exchange rates to offset the investor advantage.
Because risk premiums change their sign frequently in the market, forward rates seem to be unbiased predictors of future spot exchange rates.
Demirag, I. & Goddard, S., 1994. Financial Management for International Business. McGraw-Hill Book Company.
Hatemi-J, A., 2009. The International Fisher Effect: theory and application. Investment management and financial Innovation, 6(1), pp.117-21.
Machiraju, H.R., 2007. International Financial Markets And India. 8th ed. New Age International.
Munzer, M., 2009. Purchasing Power Parity - its theoretical perspective and empirical evidence. GRIN Verlag.
Shapiro, A.C., 1998. Foundations of Multinational Financial Management. PHI Learning Private Limited.
TE, 2015. The Big Mac index. [Online] Available at: http://www.economist.com/content/big-mac-index [Accessed 05 March 2015].
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