PPP
The value of a currency in one country is determined by the amount of goods
and services that can be purchased with a unit of that currency. This is called
the purchasing power of the currency (the reciprocal of the price level). As
there are more than one currency in the world, the exchange rate between the
two currencies must provide the same purchasing power for each currency.
This condition is called the purchasing power parity.
One of the most popular theories in international finance is the purchasing
power parity (PPP) theory, which explains the inflation exchange relationship.
The purchasing power parity theory describes the relationship between the
average price levels in a country and its exchange rates. It states that a unit of
home currency should have the same purchasing power in all countries. The
purchasing power parity theory is based on the law of one price. The
connection between exchange rates and commodity prices is known as the
law of one price.
The law of one price
According to the law of one price, if a commodity or product can be sold in
two different markets, its price should be the same in both markets, given that
there are no transportation costs, transaction costs, tariffs, no restrictions on
movement of goods and there is no product differentiation. The law of price
holds good only if there is no transportation and transaction cost and no
tariffs that are imposed on the movement of products from one market to
another. If such a cost exists, the price of the product may differ from one
market to another and give rise to an arbitrage opportunity for traders.
Traders buy the product in one market and sell in another market to make a
riskless profit. Such traders are known as product or commodity arbitrageurs.
The trader’s arbitrage activities will continue till the arbitrage opportunity to
make profit is eliminated.
Forms of PPP
There are three forms of purchasing power parity--- the absolute form, the
relative form and the expectation form.
1. The absolute form
The absolute form of PPP theory is based on the prepositions that a
commodity costs the same regardless of what currency is used to buy it or
where it is selling. If a commodity or product is sold in two different markets,
its price in terms of a common currency should be same in both the markets. If
standard basket of goods and services is involved, its price in different
countries should also be same when measured in a common currency. Let us
assume that price of a standard basket of goods and services in India (home
country) as represented by its price index is PINR. The price of the same basket
of goods and services in the United States (foreign country) as represented by
its price index is PUSD. In such a case, the spot exchange rate (So) between INR
and USD is expressed as:
So = PINR / PUSD
Example: Assume that the spot rate between the Indian rupee and US $ is Rs
63 in year 1. In the first quarter of the year 2, the price index of India is 105
and that of US is 102 (with year 1as the base year, 100). Based on the data, the
likely new exchange rate of the Indian rupee and US $ will be determined as
follows.
Solution: Exchange rate: (INR / US$) = Rs 63 × (105/102) = Rs 64.85/1$
Thus, the PPP in its absolute version states that the exchange rate at any time
exactly reflects the ratio of price indices in two countries, or the purchasing
powers of two currencies. Absolute PPP is also known as the static form of
PPP.
2. The relative form
The absolute form of PPP theory tells how exchange rates between two
currencies of different countries are determined. Relative PPP on the other
hand tells what determines the changes in the exchange rates. The relative
form is also known as the dynamic form of PPP. The relative form states that
the rates of inflation, is considered to be a better determinant of exchange
rates. It states that the percentage change in the exchange rate between the
home currency and the foreign currency should equal the percentage change
in the ratio of price indices in the two countries.
That is, the exchange rate would change to offset the difference in the inflation
rates between the two countries. The foreign currency depreciates when the
inflation rate in the foreign country is more than the domestic inflation rate
and the foreign currency appreciates when the domestic inflation rate is more
than the foreign country’s inflation rate. This means that the currency of a
country with a high rate of inflation would depreciate relative to the currency
of a country with a lower rate of inflation.
Thus, in the absolute form of PPP, the price levels are represented by price
indices while in the relative PPP, the rates of change in price levels (or change
in inflation rates) are considered. Let So (B/A) be the spot exchange rate
between the currency of country X (home country) as denoted by “A” and the
currency of country Y (foreign country) as denoted by “B”. The relative form
of
PPP can be expressed as:
St (B/A) / So (B/A) = (1 + ix) / (1 + iy)
Or change in exchange rate = [(1 + ix) / (1 + iy)] - 1
Where, ix and iy are the respective inflation rates in country X and country Y.
St (B/A) is the spot exchange rate at time t.
Example: The exchange rate between $ and £ is $2/£. Suppose, US is expected
to have an inflation rate of 10% and UK is expected to have an inflation rate of
20% over the same period. As per relative PPP, US $ should increase by 10%
relative to £. The new exchange rate would be:
$ / £ = $2 (1+ 0.10) / 1£ (1 + 0.20) = $1.833/£ = $1.833 = £
As the US is expected to have lower inflation rate as compared to UK, the value
of dollar ($) would improve from $2/£ to $1.83/£. It means that the home
currency will appreciate and increase in the value of US dollar (home
currency) would be as follows:
Change in exchange rate = [(1 + 0.1) / (1 + 0.2)] – 1
= -0.08333.
Example: The consumer price index in India rose from 200 to 216 over the
period 1 January-31 December and the US consumer price index increased
from 100 to 105 over the same period. The exchange rate between USD/INR
on 1 January was INR 64. The exchange rate between the Indian rupee and the
United States dollar on 31 December will be calculated as follows:
The rate of inflation in India can be calculated as
(216/200) – 1 = 1.08 – 1 = 0.08 or 8%
The rate of inflation in United States will be:
(105/100) – 1 = 1.05 – 1 = 0.05 or 5%
The equilibrium exchange rate between USD/INR on 31 December should be:
St (USD/INR) = So (USD/INR) [(1+ih) (1+if)]
= 64 × [(1+0.08) (1+0.04)]
= 66.4615
The percentage change in the exchange rate is:
(66.4615 – 64) / 64 = 0.0385 or 3.85%
This implies that USD should appreciate by 3.85 percent in order for the
exchange to be in equilibrium as per purchasing power parity (PPP) theory.
3. The expectation form
The expectation form of PPP theory states that the exchange rate and the
inflation rate being expressed in expected terms i.e the expected percentage
change in the exchange rate equals the expected inflation differential in the
two countries. The expectation form of PPP is also known as the efficient
market form or speculative form of PPP. The expectation form of PPP can be
represented as:
Ŝ (A/B) = ίX - ίy
Where,
A = Currency of country X
B = Currency of country Y
Ŝ (A/B) = Expected spot exchange rate
ίX = Expected inflation rate in Country X
ίy = Expected inflation rate in Country Y
The relative and the expectation form of PPP theory appear very similar but
they are different. If the markets are rational in their expectations, then the
expected values of the inflation rates and the exchange rates will be equal to
the actual rate of change in these two variables on average over a long period
of time. Sometimes the actual or realized change in exchange rates will exceed
the values predicted by realized inflation in the countries, and sometimes the
change in exchange rate will be less than predicted. On average, over a long
period of time, the over and under predictions of exchange rates should
cancel. In other words, it is only in situations of normal price level changes
(low inflation rate) that the determinants of exchange rate other than inflation
will have significant role in exchange rate determinant.
Arbitrage, Interest Rate and Exchange Rate
Movement of funds from one country to another is a common phenomenon in
order to maximize the wealth of the investors. Investors borrow in markets
where interest rates are low and then exchange the currency to invest in the
markets where interest rates are higher. This situation gives them an
opportunity for arbitrage. The term arbitrage refers to an act of buying
currency in one market (at lower price) and selling it in another country (at
higher price). Thus, difference in these exchange rates in the two markets
provides an opportunity to earn profit without risk. Arbitrage or international
arbitrage can be of three types:
Locational arbitrage
Locational arbitrage is the process of buying a currency at the location where
it is cheap and immediately selling it at another location where it is priced
higher. Locational arbitrage is also known as simple arbitrage. For example, at
two forex centers, the following INR-US $ rates are quoted:
London Rs. 62.5730-62.6100; Tokyo Rs.62.6350-62.6675
The arbitrage possibilities for an arbitrageur who has Rs. 100 million may be
found by the following modus operandi:
(i) He will purchase US $ from the London forex market at the rate of Rs.
62.6100, as it is the cheaper as compared the Tokyo forex market
(Rs.62.6350). He will obtain US $ 1,597,188.95 (Rs 100 million/Rs
62.6100) on conversion.
(ii) He will sell US $ 1,597,188.95 at the rate of Rs 62.6350 per US $ and will
obtain Rs 100,039,909.90
(iii) As a result of arbitrage, he will earn a profit of Rs 39,909.90 (Rs
100,039,909.90 – Rs 100 million) without any risk.
Triangular arbitrage
Triangular arbitrage is also known as three point arbitrage as there are three
currencies involving three markets. For example: the following are three
quotes in three forex markets.
$ 1= Rs. 63.51 in Mumbai
£ 1 = Rs. 99.68 in London
£ 1 = $1.62 in New York
Assuming that there are no transaction costs and the arbitrageur has US $
1,000,000. Arbitrage gains are possible since the cross rate between US $/
British £ by using the rates at London and at Mumbai is different (Rs
99.68/Rs 63.51 = US $ 1.5965/£ 1) from that of New York ($ 1.62). The
arbitrageur can adopt the following steps to realize arbitrage gain.
a) The arbitrageur will buy Indian rupees with US $ 1 million. The total
proceeds he obtains is (Rs 63.51 × $ 1 million US $) Rs 63,510,000.
b) He converts Indian rupees in British £ at the London forex market. He
receives (Rs 63,510,000/Rs 99.68) £ 637,138.844.
c) He then converts £ 637,138.844 at the New York forex market. He then
obtains (£ 637,138.844 × $ 1.62) US $ 1,032,164.93
d) Thus he has net gain of (US $ 1,032,164.93 - $ 1,000,000) US $
32,164.93.
INTEREST RATE PARITY
Interest rate parity describes the relationship between forward rates and
interest rates. Once market forces cause interest rates and exchange rates to
adjust such that covered interest arbitrage is no longer feasible, there is an
equilibrium state referred to as interest rate parity (IRP). In equilibrium, the
forward rate differs from the spot rate by a sufficient amount to offset the
interest rate differential between two currencies. The basic principle is that
there is an interconnection between the interest rates and the exchange rates.
The IRP theory states that premium or discount of one currency in relation to
the other should reflect the interest rate differentials between the two
currencies. In other words, the interest rate parity theory states that the
difference in the interest rates (risk-free) on two currencies should be equal
to the difference between the forward exchange rate and the spot exchange
rate if there are to be no arbitrage opportunities. IRP can be summarized by
saying that where the interest rate differ from one country to the other, the
spot and forward rates will not be same. The spread between the spot rate
and forward rate is influenced by the interest rate differential between the
two currencies. Thus, interest rate parity can be represented by the following
equation:
The formula for IRP can be expressed as follows:
f 1+i d
=
s 1+i f
Where:
F = Forward exchange rate
S = Spot exchange rate
id = Interest rate in the domestic currency
if = Interest rate in the foreign currency
Let’s consider an example involving two countries: the United States and
Canada.
Spot Exchange Rate (S): Assume 1 USD=1.25
Interest Rate in the United States (i_d): 2% per annum.
Interest Rate in Canada (i_f): 1% per annum.
Forward Exchange Rate (F): Let's calculate the expected forward exchange
rate based on the IRP.
f 1+i d
=
s 1+i f
f 1+0.02
=
1.25 1+0.01
F = 1.25 x 1.00990099 = 1.262375
Interpretation
The forward exchange rate calculated as approximately 1.2624 CAD per USD
implies that, according to IRP, if you invest $1 in the United States at a 2%
interest rate for one year, you would have $1.02 at the end of the year. If you
converted that to CA$ at the forward rate of 1.2624, you would get around
CAD 1.285 which, when invested at 1% for one year, would also yield
approximately CAD 1.299 (which matches the return from the US investment).
Example: The interest rate in India and the United States are 8 percent per
annum and 6 percent per annum, respectively. The current spot rate is
USD/INR 62.4354. If the interest rate parity holds, what is the three month
forward rate?
Solution: The three month forward rate will be:
F90 = 62.4354 [(1 + 0.08/4) / (1 + 0.06 /4)] = 64.6394
The USD has a three month forward rate of INR 64.6394. This forward rate
can also be taken as the expected spot rate in three months.
Example: The spot rate of the Indian rupee against the British Pound is 100.
The interest rate in the United Kingdom is 8 percent and in India it is 6
percent. What is the forward rate premium or discount of the Indian Rupee
with respect to the British pound if interest rate parity exists?
What is the forward rate (one year) of the British pound in terms of the Indian
Rupee?
Solution: The forward premium or discount of the GBP with respect to the INR
will be:
Premium = (1 + Kh / 1 + Kf) – 1
= [(1 + 0.06) / (1 + 0.08)] – 1
= - 0.0185
Thus, the GBP is at forward discount of 1.85 percent with respect to the INR.
The one month forward rate of the GBP is:
Ft = So (1 + P)
F1 = 100 (1 – 0.0185) = 98.15
