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Purchasing power parity

PURCHASING POWER PARITY RELATIONSHIP

Purchasing power parity (PPP) is one of the financial theory which takes in to consideration the long term equilibrium exchange rate of any two country's currencies to equalize their purchasing power in the international market. (Jörg & Bertrand,2005)

It was formulated by Gustav Cassel in 1918. It based on the improvisation of Law of one price, as applied to an aggregate economy, stating that in the efficient markets, any two given goods which are identical in nature should have only one price. (Meher,2008) PPP has its unit of currency, international dollar, with the same purchasing power that the Dollar of United State has at any given point of time. (Breitung & Bertrand, 2005)

 

Above picture depicts the PPP of Gross Domestic Product for the countries of the world - 2003.

Here US economy is used as a reference point and it is is set at 100. We can see that Bermuda has the highest index value, 154, means that the goods sold in Bermuda are 54% costlier than in the US . It is to be noted that all the importers and exporters of any nation are motivated by the cross country price differences, they tend to induce the changes in the spot exchange rate.

(Anisul & Syed, 1999) If we analyze PPP from another angle, it suggests that the transactions of any nations current account will naturally affect its value of the exchange rate on the global exchange rate. It differs with the view stated in the interest rate parity theory which assumes that all the activities undertaken by the investors, who records transactions on the capital account induces the changes in the exchange rate. ( Steven, 2009)

Arriving at the Purchasing Power Parity Relationship :

If the Purchasing Power Parity relations is held, then it can be seen that the exchange rate and the national price levels in any given country should form an equilibrium, it., if we consider Et to be exchange rate which is the domestic price of a foreign currency then taking P1 and P2 to be domestic price index and foreign price index respectively, and n the given t time subscript, we can arrive at the following PPP relation ship.

E = P1t / P2t = Rt

It is also important to note the Rt which is the relative price of domestic against the foreign prices. It will be thus clearly understood that if there is any change in the exchange rate then it will definitely lead to the changes in the relative price levels that exists in a country (domestic) against the foreign goods. PPP test is the real test of this co integration between the relative prices and the exchange rate. (www.jed.or.kr)

Comparision of the standard of living between different nations

Research conducted in 2005, it was revealed that the citizen of Malavi had an average income as 13 153 dollars and in United States the average income was found to be 41557 dollars yearly. This clearly states how well a nation is performing among the other nations of economy. With this outcome where the research is conducted based on PPP even the common man can get a knowledge how his nation is performing globally.(www.nationsonline.org)

Below table depicts the comparision of average income of two countries based on PPP's

Year

Countries

Malavi

US

2005

Average income

13,153 $

41,557 $

INTEREST RATE PARITY RELATIONSHIP

Interest rate parity, which is also called as an International Fisher effect, is an economic theory that connects the interest rates, spot exchange rates and foreign exchange rates. It is the relationship between the sport interest rates of any two currencies under no arbitrage opportunities. It plays a crucial role in the foreign exchange markets.

(www.investopedia.com)

In simple words interest rate parity is the relationship between the two countries interest rates. This proposes well in a given perfect capital market, mobility and a fixed exchange rates and the interest on the similar assets, but in reality we are in a economy that is operating in the capital controls, exchange rates that are quite flexible and imperfect capital markets also divergence between the interest rates are observed. Hence it has lead to two versions of interest rate parity.

Below diagram depicts the two versions of Interest rate Parity :-

Interest Rate

Parity

Covered

Interest Rate

Parity

Uncovered

Interest Rate

Parity

a) Uncovered Interest Rate Parity - If two individual countries whose risks are neutral i.e., which has no capital controls and which operates in a perfect capital markets, the interest differential between the two countries is the change in the exchange rate

Lt - lt = S t+1 - St

Where lt is the interest rate in the domestic market of any nation

Lt is the foreign interest rate on the similar asset

St is the spot exchange rate

Now the risk neutral person can replace the S t+1 by his expectation upon the future exchange rate

it - it* = E (S t+1) - St can be attributed to currency associated risks in the absence of currency premium and expectation bias.

b) Covered Interest Parity - Individuals who don't want to take risk in there venture of investing in foreign countries will like to ensure himself from any adverse effects of the unexpected currency fluctuation which might occur during the period of the deal.

He will go for a forward contract market, where he would be purchasing a forward contract and he will be considering the exchange rate mentioned in the contract for all this business deals. Any difference in the interest rate will be equated a forward premium.

it - it* = Ft - St or it - it* = ft

where Ft is forward rate and ft is forward premium. (Vipul & Arvind)

Below diagram depicts the diagram of Parity conditions :-

 

(www.swlearning.com)

CURRENCY SWAP

Currency swap is a financial instrument where two parties agree to exchange principal and fixed rate interest payment on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. (Alastair, 2001)

Usually the companies use this strategy of currency swap to get loan in other currencies and to protect themselves from changes in the fluctuating exchange rates that are likely to affect the value of the loan. (Vipul & Arvind, 2005)

Below diagram depicts the Mechanics of Currency swaps :

Mechanics

Of

Currency

Swaps

Exchange

Of

Principal

amount

Exchange

Of

Interest

Rate

Payments

Reverse the

Exchange of

Principal

amount

Usually one of the parties agrees to pay a fixed interest rate and the other party agrees to pay a floating interest rate, but both of them can pay either fixed or a floating rates. When their contract is expired then both the parties re exchange the principal amount of the currency swap (Elaine,1995). It involves both the parties who enter in to agreement to buy and sell the currencies and at a pre determined rate with a delivery at a late date. It is complex financial instrument that has to be dealt carefully. Actually currency swaps were formulated to give the companies an access to foreign currency to enter the foreign markets. But now the companies arrange the currency swap as mean to new capital market entry.(Elaine, Richard & Colin, 1997)

.

Currency swaps greatly help the companies to regulate the exposure to the interest rates and it reduces the uncertainty associated with the cash flow in future and it will help the companies to modify the debt conditions. (Elaine, Richard & Colin, 1997)It greatly helps in reducing the costs and risks associated with the currency exchange. In the arbitrage comparative advantage in different markets, currency swaps can be used. (Carl, 1992)

The opportunities in arbitrage arise as the lenders demand a large credit premium for borrowers who are having a poor credit ratings raising funds in the currency that are weak, than for the same borrowers who raise funds in strong currencies. (Ravi & Vijaya & Raj)

Disadvantages of currency swaps in the present financial situation can be cited as

They are exposed to credit risk to both the parties as either one or both the parties could default on the interest or principal payment and the either of them will have a control over the other.

It is very much subjected to the government intervention at anytime in the exchange markets. Especially when the government of a country gets in a big foreign debts to temporarily support a declining in currency, which in turn will lead to steep decline in the rates (Brian, 2001)

If either of the parties want to retrieve from the agreement, then it is very expensive.

To illustrate, Company A borrows in US $ while Company B borrows in Euros. The companies then would tend to exchange the amounts borrowed, and make repayments on each borrowing. Then end of the swap period as entered in the agreement , the two companies will reverse the exchange of principals.

Below diagram Depicts the above explained currency swap :-

 

Types of exchange rate exposures and its management

Exchange Rate Exposure

In Financial terms exchange rate is when the price of a country's currency expressed in currency of another country. It can also be explained as the rate at which a country's currency be exchanged for another country's currency. Higher the exchange rate for one Ruppee in terms of one yen, the lower the relative value of the yen. (Shapiro, 1975)

To cite an example, the exchange rate between the US dollar and the Indian Rupee is the number of dollars that will be required to buy one Indian Rupee, which is also called the exchange rate or currency exchange rate. (Hekman,1985)

There are three types of Exchange rate exposures which can be classified as:-

Transaction Exposure

Translation Exposure

Economic Exposure

Types

Of

Exchange

Rate

Exposure

Transaction

Exposure

Translation

Exposure

Economic

Exposure

Above figure depicts the types of exchange of rate exposures.

Transaction Exposure :

Transaction exposure occurs due to the risk of fluctuation of the exchange rates that is contractually binding the future transactions any business that operates in the international market with foreign currency denominated cash flows. It is complicated risk unless dealt carefully may result in the collapse of the whole business (David, 1999)

To deal with the unexpected risk factors, the risk Manager of any international company might choose among two options while he enters in to a financial contracts.:

Leaving the risk unhedged.

Hedging the risk

 

(www.som.yale.edu.com)

Un hedged : Here the exposure is left untouched ant the risk is quite on the higher side than running the business in an hedged alternatives. On the other hand if the exchange rates move favorably, then the business will be able to maximize its profits and if the exchange rates move unfavorably then the business will either suffer a loss or a minimum profit.(Eugene & Michael, 2005)

Hedging ; It is a financial instrument that helps a company to eliminate or minimize the foreign exchange risk. It can be done by four methods.(Francis, 2005)

Forward Market Hedge :.If you are in a business transactions where you owe a foreign currency in future, you may now agree to buy that foreign currency now. It may done by a long position in a forward contract. On the other hand, if you in a business transaction where you are about to buy a foreign currency in future, you may now agree to sell that the foreign currency now at present ,. By entering into a short position in forward contract. (Graham, 2000)

Money Market Hedge : It is a financial technique of borrowing and lending in more than one currencies to reduce or eliminate the currency risk. This can be done by locking value of the foreign currency transaction on one's own country's currency.

(www.thecsem.org)

Option Market Hedge : This financial instrument helps one to hedge against the downside while it protects the upside of the potential in the exposure.( Pauleline,2006)

In hedging payables with a currency call option - this instrument provides the right to the buyer so that he can buy a specified amount of foreign currency at a specified time. Within a given period.

In hedging receivables with a currency put option - This instrument provides the the right to sell a specified amount of foreign currency at a specified time within a given period.(Gaston, 2008)

Swap Market Hedge : Use both the combination of Forward Market hedge and Money market hedge instruments. It is an agreement of exchanging the agreed amount of currency in another currency in future at a specified date.(David, 2005)

Operational Techniques :-

Choice of Invoice Currency - It can be made by either shift, diversify or share the risk by either invoicing in foreign sales in its own country's currency or by using the prorating device between the own currency and foreign currency or by using a market basket index. ( www.biz.uiowa.edu)

Lead/Lag Strategy - If the foreign currency is appreciating then make an early payment for the bills denominated in that currency and also you may leave the customers to pay late provided they pay in that currency. If the currency is depreciating then make a late payment as long as the contract allows you to do and you may give some incentives to the customers and induce them to make an early payment to you.

(www.westga.edu.com)

Exposure netting - It is offsetting in one currency by exposure sin the same currency or another currency when the currency exchange rates are moving in a way that either loss or gain the first exposed position should be offset by gain or losses on the second currency exposure.(Hekman,1985)

Below figure depicts the concepts of managing Transaction Exposure.

 

Translation Exposure

It is also called as accounting exposure that gives rise to the change in the value of the companies risks, assets and equities with the fluctuation in the foreign currency. (Moorad, 2006) Financial statements are prepared for providing a relevant and reliable information, but this unobservable changes will make these statements in conflict.

Current and Non Current Method - Current assets and liabilities are translated to current exchange rate and non current assets and liabilities are translated to historical exchange rates. Over the reporting period the income statements are translated to the average exchange rate and depreciation is translated at the historical exchange rate.(Maurice, 2008)

Monetory and Non monetary Method - Monetary assets and liabilities are translated to current exchange rate. Non monetary assets and liabilities are translated to historical exchange rates. Over the reporting period the income statements are translated to the average exchange rate and depreciation is translated at the historical exchange rate.(Suk & Seong, 1999)

Current Rate Method - All assets and liabilities except the common equity are translated to current exchange rates. Common equity is translated in to historical exchange rates. (Pauline, 2006) The income statement is changed to current exchange rate. If any imbalance is found between the book value of the assets and liabilities then it may be recorded as a CTA ie., cumulative Translation Adjustment.

Below figure depicts the concept of Managing Translation Exposure.

 

Economic Exposure

It is the extent to which the company's future international earning power is affected by the fluctuations in the exchange rates. (Marston, 2001)

One way to reduce this type of risk is by distributing the locations to various places so that the company's long term financial being is not effected much.

Another way is not concentrating the assets in the countries where there is currency rise that leads to damaging rise in the foreign prices of the goods produced by the company.

Figure Managing Economic Exposures:-

 

Recommendations to G20 Summit :

At present, both financial markets and the world economy is facing a serious global challenges which calls for an urgent attention of the economist including G20 summit.

The legislation in each country should have a uniform code of conduct for carrying out the international business, who are accountable to the G20 summit in case of any deviations found.

A strong Security and Investment Board which will be operated for G20 summit to monitor the forex exposures and its effects.

They should be assisted by second tier called as Self Regulatory Boards nation wise, to keep a watch over the happenings in their respective countries.

They should have many organizations/boards under it who in turn will help to educate the international firms running in that area to acquire knowledge about the international market. Number of boards operating in the nation to exercise this may vary from one country of another depending upon the economy of that country.

Down the lane, it should be mandatory that every firm to have a finance consultant who will have a thorough knowledge about happening in the international market.

Importers/Exporters should be educated that if they tend to go for a benefit by the fluctuations in exchange rates it is they who will be suffering to the imbalance of the global economy, be it not immediately but for the sure in future.

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[Accessed on 25 June 2009]

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[Accessed on 25 June 2009]

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[Accessed on 25 June 2009]

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