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Topic 4
Purchasing Power Parity (PPP)
Dr. Xu Wang
Lecturer in Finance
Faculty of Business and Law
University of Northampton
Lecture outline
• Forward rate
• Purchasing Power Parity (PPP)
• Absolute Form of PPP
• Relative Form of PPP
Learning objectives
• Explain the purchasing power parity (PPP) theory and its implications
for exchange rate changes.
• Apply PPP to determine exchange rates
• List reasons that why PPP does not hold
Lecture outline
• Forward rate
• Purchasing Power Parity (PPP)
• Absolute Form of PPP
• Relative Form of PPP
What is forward rate (1)
• A spot rate is the exchange rate to buy one currency against selling
another currency at an agreed price for settlement on the spot date
• A forward rate is an exchange rate quoted today for settlement at
some future date
• The forward currency contract between currencies states the rate of
exchange at which a foreign currency will be bought or sold forward
at a specific date in the future (typically 30, 60, 90, 180, 270 or 360
days)
Spot transaction – a chart demonstration
• JP Morgan exchange 1 million Euros for dollars at the exchange rate 1
Euro = 1.14 $
>>> 1 million Euros =1.14 million $
Nostro bank: Deutsche Bank
1 million euros
JP Morgan Barclays
JP Morgan account account Barclays
JP Morgan
JP Morgan 1.14 million $ Barclays
account account
Forward transaction – a chart demonstration (1)
• A UK company deliver an order to a US company and is expecting a
receivable of 1 million dollars in 90 days.
Solution 1,
Today Day 90
Deliver the order to he US company Receive 1 million dollars and covert
dollars into £ in a bank
Possibility 1: $ appreciates
Possibility 2: $ depreciates
Forward transaction – a chart demonstration (2)
Solution 2:
Day 1 Day 90
1. Deliver the order to he US company 1. Receive 1 million $
2. Go to a bank 2. Go to the bank
3. Negotiate a 90-day forward exchange 3. Exchange 1 million $ into £
rate (1.6$ per £) with the bank using the exchange rate
4. Set up a forward contract determined on Day 1
4. Receive 625,000£
What is forward rate (2)
• The forward premium or discount is the percentage difference
between the spot and forward rates stated in annual percentage
terms
𝐹 𝐹−𝑆
• Premium/discount in n days: 𝑝 = − 1 𝑜𝑟
𝑆 𝑆
𝐹−𝑆 360
• Annualized premium/discount: p = ×
𝑆 𝑛 𝑑𝑎𝑦𝑠
Week 3 quiz (1)
• The ninety-day Japanese yen to USD dollar forward exchange rate is
109.50¥ =1$.
• The spot rate between ¥ and $ is: 109.38¥ =1$.
• Calculation for annualized forward premium: ?
Lecture outline
• Forward rate
• Purchasing Power Parity (PPP)
• Absolute Form of PPP
• Relative Form of PPP
Absolute Form of PPP
• Purchasing power: is the amount of goods and services that can be
purchased with a unit of currency.
Absolute Form of PPP
• Assumptions:
• it's a competitive market
• there are no transportation costs
• there are no official trade barriers
• Without international barriers, consumers shift their demand to
wherever prices are lower. Prices of the same basket of products in
two different countries should be equal when measured in common
currency.
The Big Mac Index (1)
• The Economist developed the Big Mac
Standard to track PPP.
• 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
• Why use big mac for index?
• Universally available product
• Standardized products (manufacturing process and
ingredients)
The Big Mac Index (2)
• Why prices for the big mac
are different in different
countries?
Lecture outline
• Forward rate
• Purchasing Power Parity (PPP)
• Absolute Form of PPP
• Relative Form of PPP
Relative Form of PPP (1)
• Relative Form of PPP: Due to market imperfections, prices of the
same basket of products in different countries will not necessarily be
the same, but the rate of change in prices should be similar when
measured in common currency
Relative Form of PPP(2)
Derivation of Purchasing Power Parity
Relationship between relative inflation rates (I) and the exchange rate (e).
𝑡
𝐸𝐴/𝐵 1 + 𝐼𝐴
0 = 1 + 𝑒𝐴/𝐵 =
where 𝐸𝐴/𝐵 1 + 𝐼𝐵
eA/B represents the percentage change in the value of the Country A
currency.
0
𝐸𝐴/𝐵 is how many currency A =1 unit of currency B at the beginning of
the period
𝑇
𝐸𝐴/𝐵 is how many currency A =1 unit of currency B at the end of the
period
IA is the inflation rate in the country A
IB is the inflation rate in the country B
Relative Form of PPP – an example
Assume that the spot exchange rate of the British pound is $1.73.
1. How will this spot rate adjust according to PPP if the United Kingdom
experiences an inflation rate of 7% while the United States experiences
an inflation rate of 2%?
2. United states has a lower inflation rate compared with UK, so US
dollars ___ (depreciate/ appreciate)
3. UK has a higher inflation rate compared with UK, so pounds ___
(depreciate/ appreciate)
Relative Form of PPP (3)
Using PPP to Estimate Exchange Rate Effects
• The relative form of PPP can be used to estimate how an exchange
rate will change in response to differential inflation rates between
countries.
• Using a simplified PPP relationship:
𝑒𝐴/𝐵 = 𝐼𝐴 − 𝐼𝐵
• The percentage change in the exchange rate should be
approximately equal to the difference in inflation rates between
the two countries.
Relative Form of PPP (4)
Rational Behind Relative PPP Theory
• Exchange rate adjustment is necessary for the relative purchasing
power to be the same whether buying products locally or from
another country.
• If the purchasing power is not equal, consumers will shift purchases
to wherever products are cheaper until the purchasing power is
equal.
Why Purchasing Power
Parity holds
Relative Form of PPP (5) - Why PPP Does Not Hold
Confounding effects
• A change in a country’s spot rate is driven by more than the
inflation differential between two countries:
• Since the exchange rate movement is not driven solely by ΔINF, the
relationship between the inflation differential and exchange rate
movement cannot be as simple as the PPP theory suggests.
Relative Form of PPP (6) - Why PPP Does Not Hold
No Substitutes for Traded Goods
• If substitute goods are not available domestically, consumers may not
stop buying imported goods.
