The Practical Value of Purchasing Power Parity Theory Report

Background information

Multinational corporations (MNCs) are faced by various risks in their operation (Gallagher & Andrew, n.d, p. 595). One of these risks relate to economic risks.

For example, the cash flows earned from the firms’ operations have to be repatriated to the parent company which means that the cash flows are subject to exchange rate fluctuations. According to Kim (2006, p.110), exchange rate refers to the price that one currency is traded for another.

The exchange rates fluctuate from time to time. In a free market, the exchange rate is determined by market forces of demand and supply (Kim, 2006, p.110). Economists have developed different models that explain how the exchange rate is determined.

One of the elements that managers of multinational corporations take into consideration in their operation relate to exchange rate determination. This arises from the fact that exchange rate impacts the value of the multinational companies and hence their competitiveness.

Additionally, managers of multinational companies must understand how the exchange rate is affected by external forces such as inflation and interest rates (Madura, 2010, p.233). This is due to the fact that increase in the rate of inflation and interest rate may erode the value of multinational company.

Bartram, Dufey and Frenkel (2010) assert that fluctuation in the exchange rate is one of the major risks that multinational corporations are faced with. In extreme situations, exchange rate fluctuations may cause substantial losses to multinational companies and even bankruptcy.

This underscores the importance of multinational corporations managing these risks professionally (Bartram, Dufey & Frenkel, 2010, p.1). There are 5 main theories that explain how the exchange rate is determined. One of these theories is referred to as the purchasing power parity.

To maximize their wealth, investors consider developing an optimal investment portfolio. To achieve this, they integrate different investment vehicles. Some of the investment vehicles considered relate to financial securities such as bonds. Other investors consider investing in the foreign investment markets as the best option.

Examples of these markets include the forward and spot market (Buckley, 2004, p. 82). The investment deals made in these markets are intended to be settled in the future. Therefore, investors make expectations regarding the yield that they will receive from the forward and spot markets. One of the hypotheses that try to explain the impact of the investors’ future expectation on the spot rate is referred to as the expectations hypothesis.

Aim

The objective of this report is to evaluate the practical value of Purchasing Power Parity theory to managers of multinational companies. T he report also evaluates whether the assertion that the forward rate is a valid predictor of the future spot rate according to the expectations hypothesis is true.

Scope

The report is organized into two sections. The first section illustrates the importance of purchasing power parity to managers of multinational corporations. The second part entails an analysis of the expectations hypothesis. Finally, a conclusion and a number of recommendations are outlined.

The value of Purchasing Power Parity theory (PPP) to managers of MNCs

This theory is based on the law of one price which states that the price of commodities in different locations have to be the same. Lack of uniformity in price means that there is a gap left for organizations to make more profit (Mankiw, 2011, p.390).

For example, According to Gallagher and Andrew (n.d, p.595), Purchasing Power Parity Theory (hereafter referred to as PPP) postulates that it is the relative price of products prevailing between two countries that determine the exchange rate between these two countries. This means that a particular currency must have an equal purchasing power across different countries (Mankiw, 2011, p. 390). There are two main forms of PPP. These include:

  1. Absolute PPP
  2. Relative PPP

Absolute form of PPP postulates that in the absence of international barriers, consumers will prefer sourcing their products from markets with the lowest prices (Buckley, 2004, p. 117). On the other hand, relative form of PPP stipulates that changes in the relative price of a particular basket of commodities between two or more countries determine the corresponding adjustment in the exchange rate.

Understanding the PPP theory enhances the effectiveness with which managers of MNCs make various operational decisions. For example, the relative form of PPP theory postulates that the consumers’ purchasing power vary due to existence of various types of market imperfections. These imperfections may arise from imposition of quotas, tariffs, and high transportation cost (Madura, 2010, p.234).

To improve the demand of their products in the international market, managers of MNCs have to develop a comprehensive understanding of the exchange rate movement. This improves the effectiveness with which the firms adjust the price of their products so as to ensure uniformity with the consumer’s purchasing power between the domestic and the foreign market.

Lack of uniformity in the consumers’ purchasing power may result into consumers shifting to the competitors products. The resultant effect is that the multinational corporation may experience a decline in its sales revenue (Madura, 2010, p.235). Therefore, the theory of PPP is important to managers of MNCs in making adjustment to the price of their products.

The theory of PPP is also of great value to managers of MNCs in that it enables them to project how the exchange rate will respond to changes in the rate of inflation in the domestic and the foreign market. The theory asserts that the relationship between the exchange rate and the price of commodities in the foreign market is direct.

On the other hand, the relationship is indirect with regard to price level in the domestic market (Ignatiuk, 2009, p.5). If the domestic country experiences an increment in the price level (inflation), the exchange rate of the domestic country relative to the foreign country will depreciate proportionately so as to reinstate the purchasing power parity between the two countries (Ignatiuk, 2009, p.5).

Illustration 1

The exchange rate of country X’s currency which was initially stable experiences an increment in the rate of inflation with a margin of 5%. Similarly, the exchange rate in country Y’s currency experiences an increment in the rate of inflation with a margin of 3%. According to PPP theory, inflation in the domestic and foreign market will affect the rate of exchange between these two countries. The formula below illustrates the corresponding change in the exchange rate between the two countries.

ef= [1+ Ih/ 1+ If]-1

= [1+0.05/1+0.03]-1

=0.0194 or 1.94%.

As a result of the high inflation in the domestic market compared to the foreign market, the exchange rate in the home country will appreciate with a rate of 1.94%. The resultant effect is that the price index in the foreign market will increase similar to the domestic market.

Therefore, the domestic and foreign consumers will experience an increment in the price of commodities (Madura, 2010, p.236). The above illustration shows that the price level of commodities in the home and the foreign country will increase with 5%. This means that purchasing power parity between the two countries will be restored.

Illustration 2

If the rate of inflation in the foreign country is higher than the domestic market, the foreign currency will depreciate. For example, if country Y’s inflation is 7% while that of country X is 4%, the foreign currency will depreciate with 2.8% compared to the domestic currency as illustrated below.

ef = [1+Ih/1+If]-1

= [1+.04/1+0.7] -1

= -0.28

=-2.8%.

Depreciation in the foreign currency as a result of the high rate of inflation will result into decline in the price of foreign commodities according to the domestic consumers’ perception (Madura, 2010, p. 236). The differential in the rate of inflation between the two countries will result into an increment in the price of commodities in the two countries with a margin of 4% (Madura, 2010, p.236).

From the above illustrations, it is evident that the theory of PPP is important to managers of MNCs in that it enables them to understand how the exchange rate will be affected by inflation.

The resultant effect is that managers of MNCs can be able to project their firms’ future cash flows. The PPP theory enables managers of MNCs to determine the impact of exchange rate fluctuations on its future cost and revenues (Papaioannou, 2006, p. 236).

The PPP theory can also enable a firm to formulate effective risk management strategies (Madura, 2010, p. 236). For example, the firm can be able to hedge against economic risks such as exchange rate fluctuations.

Additionally, understanding how inflation rate differentials between countries impact the exchange rate can enable managers of multinational companies to make effective expansion decisions. The resultant effect will be improvement in the competitiveness of the company (Papaioannou, 2006, p. 135).

The expectation hypothesis

There are various financial instruments that investors can consider when investing in the foreign exchange market. Some of these instruments relate to investment in transactions of currencies (Buckley, 2004, p. 83).

Examples of currency transactions include forward and spot transaction According to Wesso (1999, p.13), there are a number of hypothesis which have been formulated in an effort to explain the relationship between forward rates and spot rates.

One of these theories is the expectations hypothesis asserts that the forward rate of exchange fully reflects the future spot rate (Wesso, 1999, p. 13). For example, the hypothesis suggests that a 90-day GBP / EUR Forward Rate is a valid predictor of the GBP / EUR Spot Rate in 90 days’ time.

Choudhry (2004, p.61) emphasizes on the assertion that the forward rate is a valid predictor of the future spot rate. In their investment decisions, investors expect the spot rate will in the future.

However, the hypothesis has been criticized by a number of authors. For example, Buckley (2004, p.125) asserts that the forward rate of is not always equal to the future spot rate. The forward rate tends to be higher than the future spot rate. This means that the forward rate over-estimates the spot-rate which means that the forward rate is not a valid predictor of the future spot rate (Choudhry, 2004, p. 62).

It is also difficult for investors to project the future spot rate that will be applicable after a long period for example 30 years.

Buckley (2004, p. 125) asserts that a study conducted on a number of currencies (Swiss Franc, US dollar, the Swiss Franc and the Deutschmark) with regard to the forward and spot rate revealed that the forward rate is only a valid predictor of the future spot rate if the period to maturity is 30 days and not 90 days.

This illustrates that the accuracy of the forward rate as an estimator of the spot rate diminishes as the period to maturity increases (Choudhry, 2004, p.62).

The criticism of expectations hypothesis is also emphasized by the fact that the future spot rate is determined by movement in forces of demand and supply in the exchange market. Investors cannot accurately predict how the market will change thus making it difficult to estimate the future spot rate on the basis of the forward rate.

A study conducted by Kaserman on the validity of the expectation hypotheses revealed that forward rate result into undervaluation of the spot rate. This phenomenon is mainly experienced if the forward rate is on an upward trajectory. The hypothesis assumes that investors are risk neutral in their investment. However, investors are risk averse in their investment process (Hallwood & MacDonald, 2000, p. 35).

Manzur (1993, p.18) assert that the risk averse nature of investors makes them to demand a premium in order to invest in the foreign exchange market.

Therefore, a risk premium has to be included in the forward contract which means that the forward rate is not a valid predictor of the future spot rate (Manzur, 1993, p. 18). According to Buckley (2004, p. 125), the prevailing spot rate is a more effective predictor of the future spot rate compared to the forward rate.

Conclusion

From the above analysis, it is evident that the theory of PPP is very important to managers of MNCs. By incorporating the theory of PPP in their strategic management practices, managers of MNCs are able to understand how the exchange rates are affected by inflation. The resultant effect is that they are able to formulate effective strategies to deal with economic risks arising from exchange rate fluctuation.

Effective risk management in the international market is vital in improving the value of multinational corporations. The theory also enables managers of MNCs to understand the exchange rate fluctuations and hence how their future cash flows will be affected.

The theory also enables managers of MNCs to develop a comprehensive understanding of the effect of inflation rate differentials between the domestic and the foreign country. The resultant effect is that the firm is able to make optimal international expansion decisions. The report has also illustrated the criticisms that have been advanced with regard to the expectation hypothesis.

The report has outlined various illustrations which show that the forward rate is a biased predictor of the future spot rate. For example, the validity of the forward rate as an estimator of the future spot rate is only applicable in the short term but not in the long term. Additionally, using the forward rate to estimate the future spot rate may result into over-estimation or under-estimation of the spot rate.

Recommendations

To be effective in executing their duties, managers of MNCs should consider the following.

  • Incorporating the theory of Purchasing Power Parity so as to understand how the exchange rate is determined and how it fluctuates due to variations in the rate of inflation.
  • To be effective in estimating the future spot rate, investors and managers should not only rely on the forward rate. However, they should take into consideration the market changes. This is due to the fact that the information provided by the forward rate is usually inefficient.

Reference List

Bartram, S., Dufey, G., & Frenkel, M., 2010. A primer on the exposure of nonfinancial corporations to foreign exchange rate risk. Journal of Multinational Financial Management. Vol. 15, issue 4, pp. 394-413.

Buckley, A., 2004. Multinational finance. New York: FT Prentice –Hall.

Choudhry, M., 2004. Corporate bonds and structured financial products. Amsterdam: Elsevier Butterworth.

Gallagher, N., & Andrew, S., n.d. Financial management: Principles and practice. New York: Freeload Press Inc.

Hallwood, C., & MacDonald, R., 2000. International money and finance. Malden: Blackwell.

Ignatiuk, A., 2009. The principle, practice and problems of purchasing power parity theory. Munchen, Germany: Munchen GRIN Verlag.

Kim, S., 2006. Global corporate finance. Malden: Blackwell.

Madura, J., 2010. Financial markets and institutions. Mason: Cengage.

Madura, J., 2010. International financial management. Australia: Cengage.

Mankiw, G., 2011. Principles of macroeconomics. New York: Cengage Learning. Manzur, M., 1993. Exchange rate, prices, and world trade: New methods, evidence and implications. New York: Routledge.

Papaioannou, M., 2006. Exchange rate risk measurement and management: Issues and approaches for firms. South Eastern Europe Journal of Economics. Vol. 2, pp. 129-146. New York: International Monetary Fund.

Wesso, G., 1999. The forward rate as an optimal predicator of the future spot rate in South Africa: An econometric analysis. Web.

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