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International
Parity Conditions
Learning Objectives
• If the law of one price were true for all goods and
services, the purchasing power parity (PPP)
exchange rate could be found from any individual
set of prices.
• By comparing the prices of identical products
denominated in different currencies, we could
determine the “real” or PPP exchange rate that
should exist if markets were efficient.
• This is the absolute version of the PPP theory.
• A fun example is the Big Mac Index published
annually by the Economist. Exhibit 6.1 illustrates.
In the yen carry trade, the investor borrows Japanese yen at relatively low interest rates, converts
the proceeds to another currency such as the U.S. dollar where the funds are invested at a higher
interest rate for a term. At the end of the period, the investor exchanges the dollars back to yen to
repay the loan, pocketing the difference as arbitrage profit. If the spot rate at the end of the period
is roughly the same as at the start, or the yen has fallen in value against the dollar, the investor
profits. If, however, the yen were to appreciate versus the dollar over the period, the investment
may result in significant loss.