International Corporate Finance Chp 6:International parity conditions Xin Chen Visiting Associate Professor Aarhus School of Business
1 International Corporate Finance Chp 6: International parity conditions Xin Chen Visiting Associate Professor Aarhus School of Business
International Parity Conditions Some fundamental questions managers of MNEs,international portfolio investors,importers,exporters and government officials must deal with every day are: 路 What are the determinants of exchange rates? Are changes in exchange rates predictable? 特 The economic theories that link exchange rates,price levels, and interest rates together are called international parity conditions. These international parity conditions form the core of the financial theory that is unique to international finance
International Parity Conditions Some fundamental questions managers of MNEs, international portfolio investors, importers, exporters and government officials must deal with every day are: What are the determinants of exchange rates? Are changes in exchange rates predictable? The economic theories that link exchange rates, price levels, and interest rates together are called international parity conditions. These international parity conditions form the core of the financial theory that is unique to international finance
International Parity Conditions These theories do not always work out to be 'true"when compared to what students and practitioners observe in the real world,but they are central to any understanding of how multinational business is conducted and funded in the world today. The mistake is often not with the theory itself, but with the interpretation and application of said theories
International Parity Conditions These theories do not always work out to be “true” when compared to what students and practitioners observe in the real world, but they are central to any understanding of how multinational business is conducted and funded in the world today. The mistake is often not with the theory itself, but with the interpretation and application of said theories
Law of one price The law of one price states that the price of goods of identical quality should be the same in different markets. --Transportation costs must be zero. --No barriers to trade. 袋 Market forces tend to push prices toward equality. Arbitrage:buy the good in the less expensive country and sell the good in the more expensive country
Law of one price The law of one price states that the price of goods of identical quality should be the same in different markets. --Transportation costs must be zero. --No barriers to trade. Market forces tend to push prices toward equality. Arbitrage: buy the good in the less expensive country and sell the good in the more expensive country
Absolute purchasing power parity A primary principle of competitive markets is that prices will equalize across markets if frictions (transportation costs)do not exist. Comparing prices then,would require only a conversion from one currency to the other: P$XS=P￥ Where the product price in US dollars is (Ps),the spot exchange rate is (S)and the price in Yen is (P*)
Absolute purchasing power parity A primary principle of competitive markets is that prices will equalize across markets if frictions (transportation costs) do not exist. Comparing prices then, would require only a conversion from one currency to the other: P$ x S = P¥ Where the product price in US dollars is (P$), the spot exchange rate is (S) and the price in Yen is (P¥)
Absolute purchasing power parity If the law of one price were true for all goods and services,the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products denominated in different currencies,we could determine the "real"or PPP exchange rate that should exist if markets were efficient. This is the absolute version of the PPP theory
Absolute purchasing power parity If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products denominated in different currencies, we could determine the “real” or PPP exchange rate that should exist if markets were efficient. This is the absolute version of the PPP theory
Absolute purchasing power parity the Big Mac Index Assuming that the Big Mac is identical in all countries,it serves as a comparison point as to whether or not currencies are trading at market prices. Big Mac in China costs Yuan11,while the same Big Mac in the US costs $3.41. The actual exchange rate was Yuan7.60/$at the time. The price of a Big Mac in China in US dollars: Yuan11/(Yuan7.60/s)=$1.45
Absolute purchasing power parity the Big Mac Index Assuming that the Big Mac is identical in all countries, it serves as a comparison point as to whether or not currencies are trading at market prices. Big Mac in China costs Yuan11, while the same Big Mac in the US costs $3.41. The actual exchange rate was Yuan7.60/$ at the time. The price of a Big Mac in China in US dollars: Yuan11/ ( Yuan7.60/$ ) = $1.45
Absolute purchasing power parity the Big Mac Index The implied PPP exchange rate: Yuan11/$3.41=Yuan3.23/$ Compare the implied PPP exchange rate with the actual exchange rate: (Yuan3.23/$-Yuan7.60/$)Yuan7.60/$=-58%
Absolute purchasing power parity the Big Mac Index The implied PPP exchange rate: Yuan11/$3.41= Yuan3.23/$ Compare the implied PPP exchange rate with the actual exchange rate: ( Yuan3.23/$ -Yuan7.60/$ ) /Yuan7.60/$ =-58%
Relative purchasing power parity The relative PPP explains the changes in exchanges rates over time rather than the absolute levels of exchange rates. The change in the exchange rate is (approximately)determined by the difference in inflation rates. If Japan has a inflation of 4%lower than the US,the relative PPP predicts that the Yen will appreciate by 4%per annum to the US Dollar
Relative purchasing power parity The relative PPP explains the changes in exchanges rates over time rather than the absolute levels of exchange rates. The change in the exchange rate is (approximately) determined by the difference in inflation rates. If Japan has a inflation of 4% lower than the US, the relative PPP predicts that the Yen will appreciate by 4% per annum to the US Dollar
Exhibit 6.2 Relative Purchasing Power Parity (PPP) Percentage change in the spot exchange rate for foreign 4 P currency 3 PPP Line 2 1 5 -4-3 -2 -1 1 23456 -1 Percentage difference in expected rates of -2 inflation(foreign relative to home country) 4
Exhibit 6.2 Relative Purchasing Power Parity (PPP)