Finance Memo 4 - Law of One Price & Pricing Power Parity (PPP)

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Purchasing Power Parity: An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equal to each currency's purchasing power. PPP states that exchange rates between different currencies are in equilibrium when their purchasing power is the same between two different countries.The Law of One Price: The theory that the price of a given security, commodity or asset will have the same price even after exchange rates have been into consideration. The law of one price is another way of stating the concept of purchasing power parity.Difference: The differences between these two is that the Law of One Price is a theory regardingPurchasing Power Parity, and Purchasing Power Parity is the direct application of that theoryPPP is calculated using the formula S = P1/P2 where S represents the exchange rate of currency 1 to 2, P1 represents cost of good x in currency 1, and P2 represents the cost of good x in currency 2. This formula is designed so that an identical product will have the same respective price in a different country depending on the exchange rate between the two. If the exchange rate between the USD and British Pound Sterling is 1 USD / 0.6 British Pound Sterling a pizza that costs 10 USD in the United States should cost 6 British Pound Sterling in the United Kingdom.Measuring PPP is difficult because the conditions of countries are inconsistent with one another.

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