Tài chính doanh nghiệp - Finance 407: Multinational financial management - Topic 6: Purchasing power parity

Topic #6: Purchasing Power paritYL. GattisThe Pennsylvania State University1Finance 407: Multinational Financial ManagementReview2Which of the following is most likely a reason for a weak dollar?Low nominal interest rates and Low InflationHigh nominal interest rates and High inflationHigh nominal interest rates and Low InflationLow nominal interest rates and High inflationWhich of the following is a likely effect of a weak dollar?Decreased U.S. exportsDecreased USD returns to American investments in foreign assets InflationCheaper international travel for U.S. touristsLearning Objectives3Learning ObjectivesStudents can forecast exchange rates and expected appreciations using relative and absolute purchasing power parityDefinitions4The Law of One Price: Two identical goods must sell for the same price.Why: if there is a difference, arbitragers will buy at the low price and sell at the high price to exploit the differential. Arbitragers buying and selling actions will drive prices to equality in equilibriumEquilibrium: state of balance or stabilityArbitrage: the practice of taking advantage of a price difference of an asset between two or more marketsPurchasing Power Parity (PPP)is The Law of One Price applied to exchange rates.states that the equilibrium exchange rate is the ratio of prices of an identical good in two currencies. PPP Example5A Coke sells for $2.00 in New York and ₤1.25 in London.The PPP theoretical exchange rate is $2.00/₤1.25 = $1.60/₤If PPP holds, an American pays $2.00 for a Coke in NY and ₤1.25*($1.60/₤) = $2.00 in London.Say the market exchange rate is $1.50/₤. Then the Coke costs $2.00 in NY and ₤1.25*($1.50/₤) = $1.875 in London. Arbitragers could buy pounds (sell $) to buy Coke in London and sell Coke in NY. These actions will drive up the price of the pound from the market price of $ 1.50/₤ to the PPP exchange rate of $1.60/₤.According to PPP, the pound is undervalued (because Coke is cheaper in London) by 6.25% ((1.5-1.6)/1.6)Poll: Concept Check6A Big Mac is selling for ¥14.7 in Beijing and $4.07 in Philadelphia. The market exchange rate is ¥ 6.45/$. Is the yuan undervalued or overvalued according to PPP?UndervaluedOvervaluedBig MacUSD: $4.07CNY: Y14.7PPP Rate: Y14.7/$4.07 = Y3.60/$Market Rate= Y6.45/$(3.6-6.45) /6.45=-44%Absolute PPP8Absolute PPP states that exchange rates should be the ratio of prices of identical goods such as Big Macs Why do you suppose Big Macs are cheap in China?“Beefed-Up” Big Mac Index9 PPP: Price Index10A more reasonable application of PPP is to use a price of a basket of goodsExample: A basket of widely available goods cost ¥1,000 in Tokyo and $12 in Washington. The PPP Rate = ¥1,000/$12 = ¥83.33If the Market Rate is ¥80The dollar is undervaluedthe yen is overvaluedRelative PPP11Relative PPP allows differences in the absolute prices of goods due to supply and demand factors.Relative PPP predicts that changes in price levels (i.e., inflation) will affect exchange ratesSpecifically, relative PPP states that a country’s currency will devalue if it has higher inflationRelative PPP Formula:e0=current spot rate of currency f in terms of het=expected spot rate at time, tih= Inflation rate from time 0-t in country hif= Inflation rate from time 0-t in country fE.g., Euro will appreciated if $ inflation higher $1.2238/€ = $1.20/€*(1.03/1.01)Where h=$ and f=€, i$=3%, i€=1%, t=1 yearRelative PPP Formulas12The euro will appreciate by approximately the interest rate differential (3%-1%=2%) in one year The euro will appreciate by approximately the interest rate differential x 2*2% (4%) in two yearsRelative PPP Formulas: < 1 year13Relative PPP formula for n monthsThe euro will appreciate by approximately the interest rate differential x ½*2% (1%) in six monthsPoll14Suppose that CAD inflation is 5% and U.S. inflation is 1%. The spot rate is C$1.02/$. Which Currency will appreciate?CADUSDWhat is the expected spot rate inI. 1 year?C$.9811C$1.0604II. 2 years?C$.94378C$1.1024III. 9 months?C$.9905C$1.0504C$.98114C$1.0604Relative PPP15Rearranging termsThe LHS of the equation is (1+the expected appreciation) of currency fSuppose U.S. inflation is 3% and Mexican inflation is 12%. What is the expected appreciation of the peso in one year? A. 8.7% B. 8.04% C. -8.7% D. -8.04%Poll16Suppose the spot price of the HKD is HK$7.75/USD and the one year spot forecast is HKD7.89. U.S. inflation forecast is 3%. What is the expected appreciation of the HKD?Is inflation lower or higher than 3% in Hong Kong?What is expected HKD inflation according to PPP?4.86%-4.86%1.2%-1.2%Assigned Problems17The South African rand is selling at a 5% discount for one year delivery. U.S. inflation is 3%. What is South African inflation according to relative PPP?From PPP; f1,($/R)/e0($/R)=1+Premium=(1+i$)/(1+iR); 1+(-.05) =.95 = 1.03/(1+iR); i = 8.4211% The two-year forward kroner is selling at 9% above the spot price. If inflation in the U.S. is 6% per year, what is the expected Danish inflation? f1,($/Kr)/e0($/Kr)=1+Premium=(1+i$)/(1+iKr); 1.09=(1.06/(1+iKr))^2; 1.09^.5=1.06/(1+iKr); iKr = 1.5296% A latte costs £5.35 in London and $4.35 in New York. The actual pound exchange rate is 1.50 pounds per dollar. According to purchasing power parity, how much is the $ overvalued or undervalued?PPP = 5.35/4.35 = £1.23/$; Actual = £1.5; Act. price of $ too high; $ is overvalued by (1.5-1.23)/1.23=22%Suppose a Big Mac cost $2.43 in New York and Yuan9.90 in China. According to the absolute version of Purchasing Power Parity (PPP), how much is the yuan overvalued or undervalued if the spot Yuan/$ exchange rate is 8.11?PPP = 9.9/2.43 = 4.074, Act = 8.11; $ overvalued, Yuan undervalued; Yuan undervalued by (4.074-8.11)/8.11=-49.8%The U.S. price index increased from 110 to 120. Over the same time, the Japanese price increased from 105 to 106. What should have been the appreciation of the yen? Hine compute the US and yen inflation (% changes in price indexes) and use in PPP formula.i$=(120-110)/110=9.091%; i¥ = (106-105)/105=.9524%; Yen Appr. = (1+i$/(1+i ¥)-1=(1.09091/1.009524)-1=8.06%Assigned Problems18Inflation in the U.S. and Japan is 3% and 1%, respectively. What is the expected appreciation of the Yen in one year? = Guesstimate: Yen will appreciate by 2% because it has lower inflation = PPP: 1 + Apprec iation of Yen = (1+i$)/(1+i¥) = Appreciation of the yen = (1+i$)/(1+i¥) – 1 = 1.03/1.01-1= 1.98% Inflation in the U.S. and Australia is 3% and 2%, respectively. The spot price of the aussie is $1.15. What is the expected spot price of the aussie in one year, two-years, and six-months? = 1-year =1.15*(1.03/1.02)=$1.1613 = 2-year =1.15*(1.03/1.02)^2=$1.1727 = 6-months = $1.15*(1.015/1.01)=$1.1557 Textbook19Shapiro and Sarin’s Foundation of Multinational Finance 6th Ed. Chapter 4 covers purchasing power parity, interest rate parity, unbiased forward rate, and currency forecastingiClicker: Class Evaluation20How would you rate today’s class? Highest Lowest