1. International Financial Management: INBU 4200 Fall Semester 2004 Lecture 4: Part 3 International Parity Relationships: The Purchasing Power Parity Model (Chapter 5)

2. Other Parity Models Two other important parity models in use today are: Purchasing Power Parity –Exchange rate between two countries should be equal to the ratio of the two countries price level. –The change in the exchange rate will be equal to, but opposite in sign to, the difference in inflation. International Fisher Effect –The change in the exchange rate will be equal to, but opposite in sign to, the difference in the nominal interest rate between two countries. Both of these models are regarded as longer term forecasting models.

3. Law of One Price The Purchasing Power Parity model is based on the Law of One Price: –The Law of one price states that all else being equal (i.e., no transaction costs or other frictions) a product’s price should be the same in all markets (or between countries). –Why? The principle of competitive markets assumes that prices will equalize if costs of moving such goods does not exist.

4. LAW OF ONE PRICE When prices for a particular product are expressed in different currencies, the law of one price states that after adjusting for exchange rates, prices will be the same. Example (U.S. and Japan): –According to the law of one price, t he price of a product in the U.S. in US dollars (P $ ), multiplied by the spot exchange rate (S = yen per dollar), should equal the price of the same product in Japan in Japanese yen (P ¥ ), or: P$  S = P¥

5. Law of One Price Example If a Big Mac costs $2.00 in the United States and if the current spot rate is ¥111, then the Law of One Price would suggest a Big Mac price in Japan of: $2.00 x ¥111 = ¥222.00

6. Purchasing Power Parity Exchange Rate Conversely, if we have local currency for similar goods we can calculate the equilibrium (i.e., parity) law of one price spot exchange rate. This law of one price spot exchange rate is referred to as the spot Purchasing Power Parity rate (Spot PPP). It is calculated from relative local currency and home currency prices as follows: Spot PPP rate = Foreign Currency Price/Home Currency Price Note: This formula gives us the spot PPP in European Terms (i.e., foreign currency units per 1 U.S. dollar)

7. PPP Example: September 2004 Big Mac: Boulder, Colorado: $2.29 (excluding taxes) Big Mac: Osaka, Japan: ¥250 (excluding taxes) PPP Spot Exchange Rate = Yen Price/Dollar Price PPP Spot Exchange Rate = ¥250/$2.29 = ¥109.17 The PPP spot rate can be compared to the actual rate, to determine if the current spot rate is overvalued or undervalued in relation to the spot PPP –Rate on September 29, 2004 was ¥110.8 Question: What is this model telling us about the yen’s spot rate (i.e., is it overvalued or undervalued?)

8. PPP Rules When comparing the actual spot to the spot PPP rate (using European terms quotes), we can use the following rules: –If Actual spot > PPP spot = currency may be undervalued! –If Actual spot < PPP spot = currency may be overvalued! So in the previous example, the data are suggesting that the yen may be under-valued. –Actual = 110.8; PPP = 109.17

9. Absolute PPP The “absolute” PPP measures the “correctness” of the current spot rate on the bases of similar goods in different countries. –This approach is what we looked at on the previous slides (i.e., calculating the yen’s spot PPP rate) A popular version of the absolute PPP technique is found in the Economist “Big Mac” index.

10. Big Mac Index: Explanation From the Economist Magazine The Economists “Burgernomics” is based on the theory of purchasing-power parity. –Suggests that a dollar should buy the same amount in all countries. –Thus, in the long run, the exchange rate between two countries should move towards that rate that equalizes the prices of an identical basket of goods and services in each country.

11. Big Mac Index: Explanation From the Economist Magazine “The Economist "basket" is a McDonald's Big Mac, which is “produced” in about 120 countries. The Big Mac PPP is the exchange rate that would result in hamburgers costing the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued.”

12. Big Mac Index Web Site The Economist Magazine publishes their Big Mac Index twice a year. –http://www.economist.com/markets/Bigmac/Index.cfmhttp://www.economist.com/markets/Bigmac/Index.cfm Currently the index (May 27, 2004) suggests: –Swiss franc: PPP = 2.17; actual = 1.25 World’s most overvalued currency! –Philippine peso: PPP = 23.8; actual = 55.8 World’s most undervalued currency!

13. OECD PPP MEASURES A more comprehensive measure of a country’s PPP is provided by the OECD for 30 member countries. It can be found on the following web- site: http://www.oecd.org/home/ Or: http://www.oecd.org/department/0,2688,en_264 9_34357_1_1_1_1_1,00.htmlhttp://www.oecd.org/department/0,2688,en_264 9_34357_1_1_1_1_1,00.html

14. Relative Purchasing Power Parity The relative Purchasing Power Parity model is concerned with the “rate of change” in the exchange rate. –Not the absolute level Model suggests that the percent change in the exchange rate should be equal to the difference in the rates of inflation between countries, or % change in FX rate = Home inflation rate – Foreign inflation rate.

15. RELATIVE PPP EXAMPLE Assume the following: –Annual rate of inflation in U.S. = 2.0% –Annual rate of inflation in U.K. = 3.0% According to the relative PPP, the British pound should depreciate 1% per year against the U.S. dollar. If the current rate is $1.80, then –1 year from now the rate should be: $1.7820 –2 years from now the rate should be: $1.7642 –Etc….

16. TESTS OF THE PPP The existing empirical tests of the PPP have proved disappointing. Generally the results do not support the PPP. –Possible reasons: Trade frictions (transportation). Cultural differences affecting local prices However, PPP can still provide us with a “benchmark” test of whether a currency may be overvalued or undervalued against other currencies. –Question: If it is, to what extent are government policies affecting the value and what is the likelihood that these policies may change in the future (e.g., China)?