Topic 13 - ppp

• Purchasing power parity theory

  The equilibrium exchange rate between two currencies equals the ratio of price levels in both nations

  
• Absolute purchasing power parity

  S= P/P*

  Where S = exchange rate or spot rate

  P = general price level in home nation

  P* = general price level in foreign nation

  
• Law of one price

  A given commodity should have the same price (so that the purchasing power of the two currencies is at parity) in both countries when expressed in terms of the same currency
• Purchasing power parity theory

  • It appears to give exchange rate that equilibrates trade in goods and services while ignoring capital account
  • It will not even give exchange rate that equilibrates trade in goods and services because of existence of nontraded goods

  
• Relative purchasing power parity

  S1 = (P1 / P0) / (P*1 / P*0) x S0

  where S1 and S0 = exchange rates in period 1 and base period

  
• Since 1986, The Economist magazine has published the Big Mac index as a "light- hearted guide to whether currencies are at their 'correct' level based on the theory of purchasing power parity"

  
• Big Macs are sold by McDonald's all around the world and are supposed to taste the same wherever they are sold
• The Economist collects prices (in the local currency) of Big Macs sold in 56 different regions and countries, then uses these prices to compare the exchange rate implied by PP P and the Big Mac index

  
• If inflation occurs and the exchange rate of the foreign currency changes, the foreign price index from the home consumer's perspective becomes

  Pf(1 + If)(1 + ef)

  where ef represents the percentage change in the value of the foreign currency

  
• According to PPP theory, the percentage change in the foreign currency (ef) should change to maintain parity in the new price indexes of the two countries

  
• When the inflation differential is small, the PPP relationship can be simplified as:

  ef = Inflh - Inflf

  
• Empirical studies indicate that the relationship between inflation differentials and exchange rates is not perfect

  
• PPP does not occur consistently due to confounding effects and a lack of substitutes for some traded goods
• Empirical relevance of PPP

  • PPP works well for highly traded individual commodities
  • PPP works less well for all traded goods together
  • PPP works not so well for all goods (including nontraded goods)
  • PPP works well over long periods of time (many decades)
  • PPP works less well for one or two decades
  • PPP works not so well in the short run
  • PPP works well in cases of purely monetary disturbances and inflationary periods
  • PPP works less well in periods of monetary stability
  • PPP works not so well in situations of major structural change
• Fisher effect


  Countries with higher inflation rates have higher interest rates
• International Fisher effect (IFE)


  Currency with the lower interest rate is expected to appreciate relative to the one with a higher rate
• IFE


  ēt/e0 = (1 + rh)t/(1 + rf)t

  Where ēt is the expected exchange rate in period t

  
• If rf is relatively small:

  rh - rf = (e1-e0)/e0
• Interest rate parity should hold (more or less) due to the threat of arbitrage (risk free) profits
• Purchasing power parity holds for large differences in inflation rates, based on trade
• International Fisher effect is based on investment, suggesting the exchange rate will change to offset any gains from the carry trade
• Interest rate parity (IRP)

  Links interest rates and forward rates by a simple arbitrage condition. It holds (almost) perfectly by construction.

  
• Purchasing power parity (PPP)


  Based on trade. The exchange rate adjusts to offset inflation differences. Holds for large differences.

  
• International Fisher effect (IFE)


  Based on investment. Investing in countries with higher interest rates is known as the carry trade. IFE suggests that the exchange rate will change to offset any gains.
• The parity conditions based on expectations (PPP and IFE) are more likely to be violated than IRP
• If PPP and IFE held perfectly, then inflation, interest rates and exchange rates would have the same variation over time, which does not happen in practice

  
• Parity conditions (beyond IRP and PPP)


  Appear of little use, but provide the market's best guess under the assumption of no expected profits given current prices. They eliminate the need to "pay" for professional analysis and provide a simple framework to determine financial linkages between countries.

  
• Over longer horizons, parity conditions provide a pretty good story of economic behavior and have implications for international corporate planning horizons
• Country risk


  The potentially adverse impact of a country's environment on forex returns. It is more likely to be binary (e.g. government allows or denies) rather than normally distributed (e.g. errors in cash flow estimates).
• Uses of country risk analysis


  • To devise a risk management strategy appropriate to a country
  • As a screening device to avoid conducting business in countries with excessive risk
  • To revise investment or financing decisions considering recent events
• Political risk factors


  • Attitude of consumers in the host country
  • Actions of host government
  • Blockage of fund transfers
  • Currency inconvertibility
  • War
  • Bureaucracy
  • Corruption
• Corruption Perception Index


  Indicator of corruption in a country

  
• Financial risk factors


  • Indicators of economic growth
  • Interest rates
  • Exchange rates
  • Inflation
• Political risk can deter FDI inflow
• Macroassessment of country risk


  Overall risk assessment of a country without considering the MNC's business
• Microassessment of country risk


  Risk assessment of a country with respect to the MNC's type of business
• Types of country risk assessment


  • Macropolitical risk
  • Macrofinancial risk
  • Micropolitical risk
  • Microfinancial risk

  
• Techniques of assessing country risk


  • Checklist approach
  • Delphi technique
  • Quantitative analysis
  • Inspection visits
• Checklist approach to measuring country risk


  1. Assigning values and weights to political and financial risk factors

  2. Multiplying factor values with weights and summing to get political and financial risk ratings

  3. Assigning weights to the risk ratings

  4. Multiplying ratings with weights and summing to get the overall country risk rating

  
• Foreign investment risk matrix (FIRM)


  Displays financial (or economic) and political risk by intervals ranging from 'poor' to 'good' to compare risk ratings among countries