Page 11 - FINAL CFA II SLIDES JUNE 2019 DAY 4

Purchasing Power Parity READING 11: CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE

The law of one price states that identical goods should MODULE 11.2: MARK-TO-MARKET VALUE, AND PARITY CONDITIONS
have the same price in all locations (if not, arbitraging
will force this to be so); But how?

Doesn’t hold in practice due to the effects of frictions such as tariffs and transportation costs.

Absolute purchasing power parity (absolute PPP) compares the average price of a representative basket of consumption goods
between countries.

S(A/B) = CPI(A) / CPI(B)

In practice, even if the law of one price held for every good in two economies, absolute PPP might not hold because the weights
(consumption patterns) of the various goods in the two economies may not be the same.

Relative Purchasing Power Parity
States that changes in exchange rates should exactly offset the price effects of any inflation differential between two countries.
Simply put, if (over a 1-year period) A has a 6% inflation rate and B has a 4% inflation rate, then A’s currency should depreciate by
approximately 2% relative to B’s over the period.

%ΔS(A/B) = Inflation (A) – Inflation (B) (Where: %ΔS(A/B) = change in spot price (A/B))

Ex-Ante Version of PPP
Same as RPP except that it uses expected inflation instead of actual inflation.

EXAMPLE: Calculating the exchange rate predicted by the ex ante version of PPP: So = USD/AUD = 1.00. You expect the
annualized Australian inflation rate = 5%, and the annualized U.S. inflation rate = 2%. According to the ex-ante version of PPP, what is
the expected change in the spot rate over the coming year?

Answer: Since the AUD has the higher expected inflation rate, we expect that the AUD will depreciate relative to the USD. The expected
change in So = inflation(USD) – inflation(AUD) = 2% – 5% = –3%. Predicts a new USD/AUD rate of approximately 0.97 USD/AUD.