CHAPTER-4

THE FUNDAMENTAL INTERNATIONAL PARITY

CONDITIONS

Content

The purchase power parity principle

Interest parity

THE PURCHASING POWER PARITY PRINCIPLE

Among the different factors influencing the exchange rates, one factor is

considered to be particularly important for explaining currency movements over

the long run, that factor is inflation.

The theory and the evidence for a long run connection between inflation and

exchange rate has become known as the Purchasing power parity (PPP)

principle.

The PPP principle popularized by Gustav Cassel in 1920’s.

According to PPP theory, when exchange rates are of a fluctuating nature, the rate

of exchange between two currencies in the long run will be fixed by their

respective purchasing powers in their own nations.

Foreign currency is demanded by the people because it has some purchasing power

in its own nation. Also domestic currency has a certain purchasing power.

Because it can buy some amount of goods/services in the domestic economy.

Thus, when home currency is exchanged for any foreign currency, in fact the

domestic purchasing is being exchanged for the purchasing power, because it can

buy some amount of goods/services in the domestic economy.

Thus, when home currency is exchanged for any foreign currency, infact the

domestic purchasing power is being exchanged for the purchasing power of that

foreign currency.

This exchange of the purchasing power takes place at some specified rate where

purchasing of two currencies nations get equalized.

Thus the relative purchasing power of the two currencies determines the exchange

rate.

The exchange rate under this theory is in equilibrium when their domestic

purchasing powers at that rate of exchanges are equivalent.

For example, suppose certain bundle of goods/services in USA costs U.S $ 10 and

the same bundle in Oman costs, OMR 4 then the exchange rate between OMR and

U.S dollar is $1= 0.4 OMR, because this is the exchange rate at which the parity

between the purchasing power of two nations is maintained.

A change in the purchasing power of any currency will reflect in the exchange rates

also.

Hence under this theory the external value of the currency depends on the

domestic purchasing power of that currency relative to that of another currency.

Gustav Cassel has presented the PPP theory in two versions

1) Absolute Version of the PPP theory and

2) Relative Version of the PPP theory.

ABSOLUTE VERSION OF THE PPP THEORY

According to the absolute version of the purchasing power parity (PPP) theory, the

exchange rates between two currencies should reflect the relation between the

international purchasing powers of various currencies.

In simple words the exchange rate would be determined, at the point where the

internal purchasing power of the respective currencies gets equalized.

Example, suppose particular basket of goods cost OMR 100 in Oman and $300 in

the U.S.A that means the exchange rate would be OMR 1 = $3 US dollars.

The exchange rate can be determined with the following equation:

Pb x QoR= --------------------

Pa x Qo

Where,

R = Exchange Rate

Pa = Prices in nation a.

Pb = Prices in nation b.

Qo = Corresponding weights

In this equation ‘P’ i.e. prices are related to the respective bundle of goods with same

weights assigned in both the countries.

Thus, the above equation explains that the equilibrium exchange rate is determined

by the ration of the internal purchasing power of foreign currency and domestic

currency in their own countries.

The absolute version of this theory maintains that the absolute purchasing power of

respective currencies does play a vital role in determining the equilibrium

exchange rate.

RELATIVE VERSION OF THE PPP THEORY

The relative version was developed in order to find the strength of the changes in

the equilibrium exchange rate. Any deviation from the equilibrium will lead to the

disequilibrium.

It can take place due to changes in the internal purchasing power of a particular

currency.

The changes in the purchasing power are measured with the help of domestic price

indices of the respective nation.

In this theory we need to assume any past rate of exchange as a base exchange rate

in order to know the percentage change in the exchange rate.

If we compare the price indices in the past i.e. base period with that of the present

period, the new equilibrium exchange rate could be found out.

It can be simplified by the following equation,

(Pb1 / Pb0)

Rn = Rn-1 x --------------

(Pa1 / Pa0)

Where,

Rn = New equilibrium exchange rate

Rn-1 = Base period exchange rate

Pb0 = Price index of nation b in base period

Pb1 = Price index of nation b in current period

Pa0 = Price index of nation a in base period

Pa1 = Price index of nation a in current period

According to the above equation when the price level in concerned nation changes,

automatically the internal purchasing power of the currency of that nation goes on

changing. This change leads to the change in the equilibrium exchange rate.

Thus under this theory Gustav Cassel tried to link the purchasing power of two

currencies in determining the equilibrium exchange rate.

CRITICISM OF PURCHASING POWER PARITY THEORY

1) LIMITATION OF THE PRICE INDEX: In the relative version theory the

author uses the price index in order to measure the changes in the equilibrium

rate of exchange. (however, price indices suffer from various limitations and thus

the theory too)

2) NEGLECT OF THE DEMAND/SUPPLY APPROACH : The theory fails to

explain the demand for as well as the supply of foreign exchange. The PPP theory

proves to be unsatisfactory due to this neglect. Because in actual practice the

exchange rate is determined according to the market forces such as the demand

and supply of foreign currency.

3) UNREALISTIC APPROACH: The PPP theory uses price indices which itself

proves to be unrealistic. The reason for this is that the quality of goods and services

included in the indices differs from nation to nation. Thus, any comparison without

due significance for the quality proves to be unrealistic.

4) UNREALISTIC ASSUMPTIONS: The PPP theory is based on unrealistic

assumptions such as absence of transport cost and assuming that there is an absence of

any barriers to the international trade.

5) NEGLECTS IMPACT OF INTERNATIONAL CAPITAL FLOW: The PPP

theory neglects the impact of the international capital movements on the foreign

exchange market. International capital flows may cause fluctuations in the existing

exchange rate.

CONCLUSION ON PURCHASING POWER PARITY

THEORY

Despite these criticisms the theory focuses on the following major points:

1) It tries to establish relationship between domestic price level and the exchange

rates.

2) the theory explains the nature of trade as well as considers the BOP (balance of

payments) of a nation.

INTEREST PARITY

The purchasing power parity (PPP) condition applies to product markets. There is

another important, parallel parity condition that applies to financial markets. This

is the covered interest parity condition.

It states that when steps have been taken to avoid foreign exchange risk by use of

forward contracts, rates of return on investments, and costs of borrowing, will be

equal irrespective of the currency of denomination of the investment or the

currency borrowed.

In this unit we derive the covered interest parity condition and show its connection

to the PPP principle

The term ‘covered interest rate parity’ refers to a condition where the relationship

between interest rates and the spot and forward currency values of two countries

are in equilibrium. As a result, there are no interest rate arbitrage opportunities

between those two countries.

Example, assume country X’s currency is trading at par with country Z’s currency,

but the interest rate in country X is 6% and the interest rate in country Z is 3%.

All other things being equal, it would make good sense to borrow in the currency

of Z, convert it in the spot market to currency X and invest in country X. however,

in order to repay the loan in currency Z, one must enter into a forward contract to

exchange the currency back from X to Z.

There are two versions of interest rate parity:

1. Covered Interest Rate parity

2. Uncovered Interest Rate parity

According to covered interest rate parity, forward exchange rates should

incorporate the difference in interest rates between two countries; otherwise an

arbitrage opportunity would exist. In other words, there is no interest rate

advantage if an investor borrows in a low interest rate currency to invest in a

currency offering higher interest rate.

Typically, the investor would take the following steps:

1) Borrow an amount in a currency with a lower interest rate.

2) Convert the borrowed amount into a currency with a higher interest rate.

3) Invest the proceeds in an interest-bearing instrument in the higher interest rate

currency.

4) Simultaneously hedge exchange risk by buying a forward contract to convert the

investment proceeds into the first lower interest rate currency.

The returns in this case would be the same as those obtained from investing in

interest bearing instruments in the lower interest rate currency.

Under the covered interest rate parity condition, the cost of hedging exchange risk

negates the higher returns that would accrue from investing in a currency that offers

a higher interest rate.

UNCOVERED INTEREST RATE PARITY

Uncovered interest rate parity (UIP) states that the difference in interest rates

between two countries equals the expected change in exchange rates between those

two countries.

Theoretically, if the interest rate differential between two countries is 3%, then the

currency of the nation with the higher interest rate would be expected to depreciate

3% against the other currency.

In reality, however, it is a different story, due to the introduction of floating exchange

rates, currencies of countries with high interest rates have tended to appreciate,

rather than depreciate as the uncovered interest rate parity equation states.

Interest rate parity is fundamental knowledge for traders of foreign currencies. In

order to fully understand the two kinds of interest rate parity, however the trader

must first grasp the basics of forward exchange rates and hedging strategies.

With this knowledge the forex trader will then be able to use interest rate

differentials to his or her advantage.

Review questions

Define PPP principle. Or What is purchase power parity theory?

What are the two versions of Gustav Cassel’s PPP theory?

What is absolute version of PPP theory?

Explain the equation to determine exchange rate according to PPP theory.

What does the relative version of PPP theory determine?

Explain the equation to determine the equilibrium exchange rate as per PPP

theory.

Explain any four criticism for purchase power parity theory.

Define interest parity theory

What are the conclusions of purchase power parity theory?

Define interest rate parity theory.

Define covered interest rate parity theory. Explain the steps typically a investor

would take as per covered interest rate parity theory.

What is the meaning of uncovered interest rate parity?

Differentiate between spot exchange and forward exchange contract.

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