PURCHASING POWER PARITY THEORY

PURCHASING POWER PARITY PRINCIPLE

The Purchasing Power Parity Principle was enunciated by a Swedish economist G. Cassel in 1918 . According to this theory , the price in different countries determine the exchange rate of these countries currencies. The basic tenet of this principle is that the exchange rates between various currencies reflect the purchasing power of these currencies .This tenet is based on Law of One Price .

Law of One Price According to this law , in equilibrium conditions, the price of a commodity has to be the same across the world . If it is not true , arbitrageurs would drive the price towards equality by buying in the cheaper market and in the dearer one. Assumptions : Free movement of goods No transportation cost No transaction cost No tariffs

The Absolute Form of PPP According to this theory the exchange rate between two countries` currencies is determined by the respective price levels in the two countries. Spot ( A/B) = Price A / Price B If the cost of a particular basket of goods and services are Rs.2125/- in India and the same costs $ 50 in USA , then the exchange rate between rupee and the dollar would be : Spot INR/ USD = P INR / P USA = INR 2125 / USD 50 = INR 52.50 / USD

Illustration 1: A customer spends GBP 6.525 to buy a commodity in UK. The same commodity can be bought for USD 10 in USA. What is the rate for GBP/USD ?

Next year to purchase the same commodity the customer had to spend GBP 6.595 and USD 10.55.Does the exchange rate change?
What is the rate of inflation ?

Year 1

Spot GBP/ USD = GBP 6.525 USD 10 = GBP 0.6525 / USD Spot GBP/ USD = GBP 6.595 USD10.55 = GBP 0.6251 / USD

Year 2

GBP has appreciated with respect to USD due to inflation.

 Rate of inflation in GBP = (Change in Price Level Original Price Level)100 = (6.595 - 6.525) 6.525 = 0.0107=1.07%

Rate of inflation in USD = (10.55-10) 10 = 0.055= 5.5% Year 2 Spot GBP/ USD =Year 1 Spot GBP/ USD * [(1+ i GBP) (1+ i USD)] = 0.6525 x [( 1+ 0.0107) (1+ 0.055)] = 0.6525 x [1.0107 1.055] = 0.6251 GBP/ USD

Illustration 2: A customer spends DM100 to buy a commodity .The same commodity can be bought for FFr 300.What is the rate for DM / FFr ? Next year to purchase the same commodity the customer had to spend DM 110 and FFr 360.Does the exchange rate change?

What is the rate of inflation ?

 Spot yr 1 DM/ FFr =100 300 = DM 0.33 / FFr Spot yr 2 DM/ FFr =110 360 = DM 0.3055 / FFr

DM has appreciated with respect to French Franc due to inflation.

 Rate of inflation in DM = (110-100) 100=.1=10% Rate of inflation in FFr = (360-300) 300=.2=20%

Year 2 spot DM/ FFr = Year 1 spot DM/ FFr * [(1+ i DM) (1+ i FFr) ]

The Relative Form of PPP

According to this theory the proportionate ( % ) change in the exchange rate between two currencies A and B over a period of time equals the difference in the inflation rates in the two countries over the same period of time . Change S (A/B) = i
A

- i B

, where

i A = inflation rate in country A i B = inflation rate in country B

 Rate of inflation in GBP= (6.595 - 6.525) 6.525 = 0.0107=1.07% Rate of inflation in USD= (10.55-10) 10 = 0.055= 5.5% Change in Inflation =0.0107- 0.055= 0.0443= 4.43% Change in GBP/ USD = [(0.6525 - 0.6251) 0.6525 ]100 =4.19%

Illustration3:

The US inflation is expected to average about 4 % annually, while the Indian rate of inflation is expected to average about 12% annually. If the current spot rate for rupee is USD 0.0285, what is the expected spot rate in two years?

 Expected spot rate for USD/INR after one year will be: =Spot USD / INR* (1+i USA 1+i INR) = USD 0.0285* [(1+ 0.04) (1+0.12)]
Expected spot rate for USD/INR after two years will be: = USD 0.0285 * [(1+ 0.04) (1+0.12)] * [(1+ 0.04) (1+0.12)] = USD 0.0245 / INR

Illustration4: The consumer price index in India rose from 200 to 216 over the period Jan1 Dec31 2010 and the US consumer price index increased from 100 to 105 over the same period. If the exchange rate between INR / USD on Jan1,2010 was 49.55.What would be the exchange rate on Dec 31 2010.

Solution Rate of Inflation in India : = (216-200) 200 = 0.08 =

8%

Rate of Inflation in USA : = (105-100) 100= 0.05= 5% The exchange rate for INR / USD on Dec 31 2010 Spot INR / USD [1+i INR 1+ i USD] = 49.55 [ (1+0.08) (1+0.05)] = INR 50.965 / USD

Real Exchange Rates It is a measure of exchange rate between two currencies adjusted for relative purchasing power of the currencies. R (A/B) = S(A/B) [ Price Indices in B / Price Indices in A ] , where R (A/B) : Real Exchange Rate S(A/B) : Spot Exchange Rate
Price Indices of the two countries should be with reference to the same base year . An increase in Real Exchange Rate implies depreciation in currency A while a decrease means real appreciation.

Illustration5: Suppose between 1997-2007 the CPI in USA has gone up by 30% while in India it has gone up by 80%.Over the same period the INR/USD rate has gone up from 36.00 to 45.00.With 1997 as the base . The real exchange rate in 1997 would be the same as the nominal exchange rate viz 36.00.What would be the real exchange rate in 2007 with 1997 as the base rate?

Solution: The real exchange rate INR/USD in 2007 with 1997 as the base rate would be =Spot rate in 2007 for INR/USD x [P USD P INR]

=45 [130 180] = INR 32.50 / USD

This means that after adjusting for changes in purchasing power of rupee and dollar, dollar has declined from Rs 36 to Rs 32.5 i.e. rupee has appreciated in real terms.

Forecasting the Exchange Rate

A Economic Approach Structure of Balance of Payment Gold and Foreign Exchange Reserves in the Country Comparative Analysis of Interest Rates Comparative Analysis of Inflation Study of Activity and Employment Level B Sociological and Political Approach Recommendations of IMF, Proximity to election, etc

INTEREST RATE PARITY

INTEREST RATE PARITY / COVERED INTEREST PARITY

According to this theory , the cost of money ( i.e. the cost of borrowing money or the rate of return on financial investment ) , when adjusted with the cost of covering the foreign exchange risk , is equal across different currencies.

Theorem

In the absence of restrictions on capital flows and transaction costs , for any pair of currencies A and B the following relation must hold:
S (A/B) (1+r A) = F (A/B) (1+r B)

where rA and rB are annual Euro deposit rates, F is forward rate and S is spot rate , n -year.
(1+r A) / (1+r B) = F (A/B) / S (A/B)

Let the domestic currency be A ; the foreign currency be B ; Return on domestic currency r A and Return on foreign currency r B ; Spot rate is S(A/B) and Forward rate is F(A/B) . A businessmen has Investible Fund (I) . a) Investment in domestic currency after 1 year will fetch : Investible Fund ( 1+ r A) b) On converting this into foreign currency , he will get : Investible Fund / S (A/B) units of currency B c) This when invested , will at the end of 1 year will give : [ Investible Fund / S (A/B)] * ( 1+ r B)

d)

When converted at forward rate will give : {[Investible Fund / S (A/B) ] *( 1+ r B)} F (A/B) units of currency A.

I ) If ( 1+r A) > F (A/B) / S (A/B) * ( 1+ r B) Then investor will prefer to invest in securities denominated in currency A , rather than in currency B , as it will fetch them a higher returns . II) If ( 1+r A) < F (A/B) / S (A/B) * ( 1+ r B) Then investor will prefer to invest in securities denominated in currency B , rather than in currency A , as it will fetch them a higher returns . III) If ( 1+r A) = F (A/B) / S (A/B) * ( 1+ r B) That is returns on both the investments were equal , the investor will show his indifference as to the choice of the currency.

If ( 1+r A) = F (A/ B) / S (A/B) * ( 1+ r B)

r A = r B + [ F (A/ B) - S (A/B) / S (A/B) ] * ( 1+ r B) r A = r B + m [ F (A/ B) - S (A/B) where m = 12/n / S (A/B) ] * ( 1+ r B/ m)

Therefore , the forward rate at which the investor will show his indifference can be calculated as F (A/B) = S (A/B) * ( 1+ r A) / ( 1+ r B)

ILLUSTRATION

: Spot INR/USD : r INR : r USD : 1-yr.F INR/USD : Investible Funds :

45. 50 14 % 5% 49.75 Rs. 1crore

Covered Yield on Dollar Deposit :

r A= r B +{[ F (A/ B) - S (A/B)] [S (A/B) ]} *( 1+ r B) r Rs= r $ +{ [F (INR/USD ) S(INR/USD)] [S(INR/USD)]} * ( 1 + r $] r Rs= 0.05 + [ (49.75 45.50) (45.50) ] * ( 1 + 0.05) r Rs= 0.05 + (0.0934) * ( 1.05) r Rs= 0.05 + 0.098 = 0.148 i. e. 14.80 %

a)If the investor invests in a rupee deposit , at the end of 1 year he would get : Investible Fund ( 1+ r Rs.) Rs. 100,00,000 ( 1+ 0.14) = INR 11,40,000 b)If instead he wants to invest this amount in dollar deposit , he would first need to convert his rupee holdings into dollars. This Rs. 1,000 will fetch him : Investible Fund S (INR/USD) $ 100,00,000 45. 50 = USD 2,19,780

c) Dollar deposit of USD 2,19,780 after a year would fetch :

[ Investible Fund S (INR/USD) ] ( 1+ r USD)

USD 2,19,780 ( 1+ 0. 05)

= USD 2,30,769

d) When converted into rupee at forward rate it will give :

{ [Investible Fund S (INR/USD)] ( 1+ r USD) }F (INR/USD) USD 2,30,769 ( 49. 75) = INR 114,80,757.75
(INR 114,80,757.75 INR 100,00,000= INR 14,80,757.75) Since the covered yield in the dollar deposit is higher than the rupee yield the investor will invest money in the latter.

The forward rate at which the investor will show his indifference can be calculated as :

F (INR/USD) = S (INR/USD) [( 1+ r INR) ( 1+ r USD)]

= 45. 50 [( 1+ 0.14 ) ( 1+ 0. 05)] = Rs. 49. 40

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