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Chapter04

# Chapter04 - Chapter 4 International Parity Conditions...

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Chapter 4 International Parity Conditions Outline This chapter introduces the financial theories that link several economic variables across different countries. In real life, some of these theoretical relationships hold better than others. Typically the relationships that create true arbitrage opportunities when out of balance are more trustworthy than the ones based on expectations about future. I. Prices and Exchange Rates A) The Law of one price states that an identical product or service will have the same price regardless of location. This is also known as absolute Purchasing Power Parity (PPP). The driving force behind the theory of absolute PPP is that if the prices are not equal, the traders will buy the product at the low price location in order to sell it at the high price location. The underlying assumptions are that there are no restrictions on buying and selling the product in different countries, and no transportation costs. If the law of one price holds, an exchange rate between two currencies can be stated in terms of local prices. For example, if an apple costs \$1 in the U.S. and ¥150 in Japan, the spot rate between the yen and the dollar must be ¥150/\$1. In other words, it takes 150 yen to buy one dollar. The law of one price does not hold very well in reality. We can use the information in Exhibit 4.1 to see that the price of the Big Mac in China was \$1.26. Given that the fixed rate of Renminbi is about 8.277 CNY/USD, we can infer that the in local currency, the Big Mac was worth 1.26(8.277) = CNY10.43. The local price that would have been consistent with the Law of One Price is 2.90(8.277) = CNY24.00. For PPP to hold, the exchange rate should have been CNY10.43/\$2.90 = 3.60. This tells us that the Renminbi is overvalued versus the dollar by 3.60 8.277 0.565 56.5% 8.277 - = - = - While the fixed Renminbi rate has been a topic of debate recently, one could also argue in this case that it is the Big Mac that is undervalued in China. So, either hamburgers are too cheap in China or dollars are too expensive. B) The Relative Purchasing Power Parity: While the law of one price may not hold, the relative PPP suggests that the relative price changes between two countries are inversely reflected in exchange rate changes. In other words, the relative PPP predicts that the currencies of countries with high inflation rates (read: countries with fast-increasing prices) will depreciate. The driving

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Chapter04 - Chapter 4 International Parity Conditions...

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