The Law of One Price - Purchasing Power Parity - Assignment Example

Question 1a) Possible foreign exchange risk and economic implications for a managed floating exchange rate. A managed currency can be described as an exchange rate that basically is floating in the foreign exchange (forex) markets which however is prone to intervention regularly by the respective monetary authorities so as to thwart fluctuations that may be deemed undesirable. In normal circumstances, the currency freely floats in the market-implying that its value is arrived at by the demand and supply forces for a particular currency. Nevertheless, the central bank and the government of a given country may make use of intervention in the currency market as a technique of influencing its value so as to accomplish some particular macroeconomic goals (Jongwanich, 2007). Multinational companies operating in countries such as those may be faced by risk emanating from their trade especially when there is a drawdown as well as repayment of Import/ Export Forex Loans in addition to disbursements of import/Export Bills denominated mostly in foreign currencies. Such companies will also be faced by risk emanating from Inward/Outward Remittances which are also denominated in currencies from other countries. There is also risk coming from overseas dividends that are arising from repatriating profit from overseas back home as well as operating expenses of overseas such as paying employees working in overseas. Lastly foreign exchange risk may emanate from assets held in overseas countries such as excess cash balances of subsidiaries operating in overseas together with overseas liabilities that may result from borrowing of foreign currency (Sharan, 2012). These fluctuations in foreign exchange rates may trigger changes in the value of the cash flows, liabilities and assets, particularly when they are denominated in foreign currencies. This means therefore such fluctuations may adversely affect a company’s outgoing import disbursements and incoming export funds. This is why management of foreign exchange risk is very important since it can help in minimising the risk or maximising the firm’s profit (Berg, 2010). Economic implications A managed floating exchange rate is crucial for not only economic restructuring but also optimization of allocation of resources. This is because an exchange rate symbolizes price relations that exist between non-tradable and tradable goods and services. A regime of managed floating exchange rate improves the effectiveness of resource allocation, direct resources to the economic sectors that are mainly fuelled by domestic demand for instance the services sector, promotion of industrial upgrading, transformation of the economic pattern development, reduction of trade imbalances together with over-reliance on exports, all these stimulate economic demand to have an influential role in economic development and hence leads to promotion of balanced and sustained economic growth(Siddaiah, 2010). A managed foreign exchange rate regime also improves and strengthens macroeconomic policy-making. A managed floating exchange rate regime thus can assist in enhancing the capability and proactiveness of macroeconomic management as well as the efficiency of monetary policy, control asset bubbles and inflation together with containing macroeconomic risks. All these form a very conducive environment for business growth and prosperity implying a managed foreign exchange rate is suitable for companies in such countries. Lastly, a floating exchange rate regime creates long-term fundamental interests by deepening reforms, opening up and adoption of the new development pattern. In addition, it leads to enhancement of market-based institutional arrangements as well as financial regulation which improves resilience particularly of the corporate sector (Siddaiah, 2010). b) Fixed exchange rate linked to a basket of currencies A fixed exchange rate is also at times known as a pegged exchange rate and is a kind of exchange rate regime whereby one currency’s value is usually fixed against either a basket of some other currencies, to the value of another single currency or rather to a further measure like gold. This kind of exchange rate regime has its own risks as well as benefits. This kind of exchange rate system is normally used so as to make the value of a currency stable by fixing directly its value in a ratio that is predetermined to a different more stable or globally prevalent currencies or currency, to which that value is pegged(Cencini,2012). The main risks involved in fixed exchange rate are as follows. Flexible exchange rates are usually used in adjusting balance of trade. In case of a trade deficit taking place under a floating exchange rate, a rising demand for the foreign (instead of domestic) currency occurs, which in turn pushes the price up of the foreign currency in regard to the local currency. This scenario leads to the prices of foreign goods being less attractive to the local market which in turn leads to the dropping of the trade deficit. A trade deficit leads to a very unfavorable domestic economic environment in the country which may lead to the multinational subsidiaries to lose or operate under very tough economic atmosphere Another risk of a fixed exchange rate regime lies in the fact that governments also have a difficult task of investing numerous resources in trying to pile up the foreign currency reserves so as to protect or shield the currency so pegged. In addition when a government is making use of fixed instead of dynamic exchange rate it cannot make effective use of fiscal or monetary policies freely. For example, the government can use reflationary tools to stimulate economic growth (by for instance reducing taxes and pumping more funds in the market) and may be in danger of entering into a trade deficit. This kind of scenario is also not conducive for business activities in the economy of a given country (Horcher, 2005). In addition the government’s stubbornness in shielding a fixed exchange rate when caught in a trade deficit forces it to employ deflationary measures which comprise of more taxation and a reduction of money in circulation, a scenario that may create unemployment. Eventually other countries using a fixed exchange rate can also hit back in reaction to a specific country making use of their currency in shielding their exchange rate (Horcher, 2005). c) Fixed exchange rate backed by a currency board system A currency board may be described as a monetary authority that decides on valuation of a country’s currency, particularly whether to peg the local currency’s exchange rate to a foreign currency, an equivalent amount of which is mostly kept in reserves. In addition the currency board then permits for the unrestricted exchange of the domestic, pegged currency for the other country’s currency. Thus a currency board is able to earn the interest acquired on the foreign reserves themselves; hence the rates seem to imitate the current foreign currency rates. Currency boards have definite virtues such as assurance of convertibility, instilling of macroeconomic discipline as well as limiting budget deficits as well as inflation. They also offer a mechanism that warrants adjustments of deficits in balance-of-payments hence creating confidence in the nation’s monetary system. A currency board will be strong in a small economy, open to the world finance and trade such that the cost of not utilising the exchange rate as a tool of adjustment is insignificant. A currency board is also useful in countries which are determined to utilise a fixed exchange rate as a nominal anchor in curbing inflation at whatever cost. There are consequences of implementing a fixed exchange rate which include the fact that the concerned currency board may no longer give out flat funds, but will instead issue only a single unit of domestic currency for every unit of foreign currency that it possesses in its vaults, mostly hard currencies such as the Euro or USD. The excess on the balance of payments of that nation is seen in high amounts of deposits domestic banks have at the central bank and (originally) increased deposits of the (net) exporting companies at their domestic banks. Thus, the increase of the local money supply can now be doubled with the extra deposits that local banks have at their central bank which is equivalent to the extra hard foreign currencies reserves held at the central bank (Pintev, 2003). Nevertheless, there are some risks carried by a currency board include the fact that it is always difficult to gather adequate foreign reserves to support the monetary base wholly at the beginning. There is also the risk of the fixed exchange rate rapidly becoming overvalued especially if the currency board is established in an endeavor to prevent high inflation. In addition a fixed exchange regime can lead to a more painful and costly adjustments by stopping the utilisation of an exchange rate change to aid in the process. Furthermore, a currency board prevents the active utilisation of monetary tools that are instrumental in stabilising the domestic economy. Thus a currency board cannot serve as a lender of last resort particularly when local financial institutions are faced with liquidity crisis. This further eposes an economy to the perils of a possible financial crisis and may force collapse of monetary institutions. Lastly a currency board lacks autonomy and thus its ability to discipline or manage a fiscal policy is perilously dependent upon the political readiness of the particular government to be disciplined. Generally therefore, the significance of the currency board is that issues of currency stability are limited and no longer suffice. Nevertheless, the concerned country lacks the ability of setting monetary policy in regard to other local considerations. In addition, the fixed exchange will rate will, to a greater extent also secure a nation’s trading terms, inspite of economic variations that exist between itself and its trading partners (Pintev, 2003). 2. Purchasing power parity (PPP) Purchasing power parity can be described as an element of some economic theories as well as a method that is used in determining the relative value of various currencies. PPP claims that various exchange rates between diverse currencies are in balance when their respective purchasing power is similar in 2 countries. This therefore implies that the exchange rate between 2 countries ought to be equivalent to the ratio of the 2 nation’s relative price level. This means that if the price level of a given country rises (Country undergoing inflation), its currency will have to depreciate so as to uphold PPP. There are several theories that cite PPP, assuming that in some scenarios (for instance, as a long-run trend) it would cost precisely a similar amount of for example Euros to purchase US dollars and then make use of the proceeds to purchase a market basket of products as it would cost to utilise those Euros directly in buying the market basket of products (Ignatiuk, 2008). The notion of PPP permits someone to approximate the value of exchange rate between 2 currencies would have to be so that the exchange rate would be equivalent to the purchasing power of the 2 currencies of the 2 countries. Making use of that given rate for theoretical currency exchanges, a certain figure of a given currency therefore has an equivalent purchasing power whether directly used in buying a market basket of products or utilised in converting at the PPP rate relative to the other currency and then buying the market basket by using that same currency. Noted variations of the exchange rate from the PPP are determined by variations of the real exchange rate from its purchasing power parity value of 1(Ignatiuk, 2008). Purchasing power parity assists in reducing deceptive international comparisons that can crop up by using market conversion rates. For instance, supposing 2 countries produce similar physical quantities of goods as one another in every one of 2 different years. Because exchange rates in the market considerably change, when one country’s GDP calculated in its own currency is changed to the other currency of the other country, by use of exchange rates in the markets, one country may be deemed to have a real GDP that is higher than the other country in a given year, even though lesser in the other one. Nevertheless, either of these assumptions would not succeed in reflecting the certainty of their comparative production levels. However if the GDP of one country is changed into the currency of the other country by use of purchasing power parity exchange rates instead of practical exchange rates in the markets, then there would be no false assumptions taking place(Taylor,2013). The “law of price” is the foundation for PPP. When transportation costs as well as other transaction costs are absent, competitive markets will normally make even the cost of an identical product in 2 nations especially when the prices are articulated in the same currency. Thus, for instance, when the conversion rate is 1.5 CAD/USD, a certain radio that retails at Vancouver for 750 (CAD) ought to retail at $500 in New York. Thus, if the cost of the radio in Vancouver were 700 CAD only, customers in New York would rather purchase the radio in Vancouver.Thus if this procedure of purchasing a radio in Vancouver and later disposing it in Seattle(referred to as arbitrage) is done on a large scale ,consumers in the US purchasing Canadian products will bid up Canadian Dollars’ value. This will make Canadian products pricier to them. Such a process as this will go on until the prices become equal when expressed in one currency. Nevertheless, this law of a single price has 3 caveats; first and foremost transportation costs, trade barriers as well as other related costs of transactions can be considerable. Secondly there should be existence of competitive markets for products in both countries and finally the one price law is applicable only to immobile goods, tradable goods like houses as well as local services are obviously not traded amongst countries (Berg, 2010). There are 2 functions served by purchasing power parity which include comparing between countries since they remain relatively steady from time to time which could range from daily to weekly and only fluctuate moderately, from one year to the next. Secondly, exchange rates seem to shift in the PPP’s general direction exchange rate ,over a couple of years, hence there is some worth in being aware which direction the exchange rate is more liable to move in the long run(Cencini,2012). Nevertheless, PPP theory claims that differences in prices between nations cannot be sustained in the long run since market forces will make prices equal between countries and in so doing shift exchange rates. Interest rate parity (IRP) is a condition of no-arbitrage and a representation of a state of equilibrium under which investors become indifferent to available interest rates on bank deposits particularly in 2 countries. Since this situation does not hold all the time, it permits for possible prospects of earning profit that is riskless arising due to covered interest arbitrage. There are two postulations key to IRP; foremost is perfect substitutability and second is capital mobility of both foreign and domestic assets. Provided equilibrium in foreign exchange market, the IRP situation means that the anticipated return on local assets will be equivalent to the exchange rate-amended anticipated return on assets valued in foreign currency. Thus investors are unable to earn arbitrage returns through borrowing in nation that has low interest rates, converting to foreign currency, in addition to investing in an overseas nation having high interest rate because of losses or gains resulting from converting back to their local currency once maturity is reached (Ignatiuk, 2008). It should also be important to note that IRP assumes 2 distinct forms; covered IRP and uncovered IRP. Covered IRP may be described as the condition whereby a forward contract is employed to cover (eradicate exposure to) the risk of exchange rate. Uncovered IRP on the other hand may be defined as the parity condition whereby foreign exchange risks (Unexpected fluctuations in exchange rates) exposure is unrestrained. Every kind of parity condition exhibits a distinctive relationship having implications for future forecasts of exchange rates (forward and spot) (Harvey, 2009). There is empirical evidence that has been discovered by economists that suggests covered IRP usually holds, even though there is no precision because of the impact of different costs, taxation, risks as well as eventual variations in liquidity. In situations when the two forms of parity hold, a relationship is exposed signifying that the forward rate is an impartial forecaster of the future spot rate. Thus such a relationship as this can be used in testing whether uncovered IRP holds, something that has resulted in mixed results. The holding together of IRP and PPP, illuminates a correlation referred to as real interest rate parity. This implies that anticipated real interest rates symbolize anticipated alterations in the real exchange rate. Such an association strongly holds amongst emerging market nations as well as over prolonged terms (Taylor & Sarno, 2003).IRP is based on 2 assumptions; that capital is movable and investors can easily exchange local assets for foreign ones. Secondly that there should be perfect substitutability in assets arising from their liquidity and riskiness. Provided with perfect substitutability and capital mobility, investors would be projected to hold onto those assets that provide more profits, whether foreign or local assets. Nevertheless, investors hold both foreign and local assets. The fact that no difference can be present between the gains on local assets as well as the gains on foreign assets must hold true. This however does not imply that foreign investors and local investors will get equal profits, but that one investor on either side would anticipate getting equal profits from any of their investment decisions (Rodseth, 2000). Evidence for this theory The Law of One Price is one of the pointers that PPP may hold since international products have a relation to it. Thus the cost of an product that is internationally traded ought to be similar at any given country in the world, the moment that cost is determined in a currency that is common, because people could earn riskless returns via shipping the products from places where the cost is low to places where the cost is high, hence making a profit though arbitraging. Were the same products to enter every country’s market basket utilised in constructing the cumulative price level having similar weight, then that means that the Law of one Price and a PPP exchange rate must hold between the concerned countries. In long term, no evidence exists as to why, when exchanged, at prevailing market exchange rate, into the same currency, there should be differing of price levels across countries that are economically integrated. In fact, if a product is tradable, then its cost must balance across various countries because of the Law of One Price. In case price differentials exist, this should be because of tariffs, transportation costs and market imperfections like monopolistic power or imperfect information. Nevertheless, in case price differentials turn out to be structural, they are anticipated to continue being stable or evolve gradually. Even if they fail, the real exchange rate must slip back to a stabilized level at the cumulative levels, on the basis of macroeconomic modification discovered in the 18th century by David Hume and referred to as price-specie flow mechanism which is a balance of payments’ self-stabilizing property. Nevertheless, the law of one price is undermined by governmental trade barriers and transport costs, which easily make it costly to transport products from one market to another situated in a different nation. Thus transportation costs cut the link between the prices of products and exchange rates illustrated by Law of one Price (Ignatiuk, 2008). As transportation costs rises, the bigger the gap of fluctuations in exchange rate. This is also true for official trade barriers since the fees imposed by customs impact the profits of the importer in a similar manner just like shipping fees. The Big Mac Index is evidence that PPT exists. This was made popular by The Economist and is basically a comparison of Big Mac’s burger prices in various MacDonald’s restaurants across the world. This index is seemingly useful even though it is on the basis of one consumer good that may not be distinctive. Nevertheless, it is a comparatively regularized product that comprises input costs emanating from a broad range of domestic economic sectors such as labor, advertising, agricultural commodities, real estate, transportation etc (Ignatiuk, 2008). Arguments against this theory include the fact that it offers a direct practical relation centered on the purchasing powers of the currencies of 2 countries as well as their exchange rates. In reality, however, there is nothing like precise and direct association between the 2.There exists numerous factors such as speculation, tariff and capital flows that significantly impact exchange rate. In accordance with the theory, to determine the present rate of equilibrium, the base rate (old rate) ought to be known. However, it is hard to ascertain the specific rate which was prevailing as the equilibrium rate between the currencies. In addition, the determined new rate would symbolize the rate of equilibrium at PPP only when there has been no change in economic conditions (Ignatiuk, 2008). List of references Read More