Purchasing Power Parity (P PP)

Download as ppt, pdf, or txt
Download as ppt, pdf, or txt
You are on page 1of 22

Purchasing Power

Parity(PPP)
Absolute Form of PPP :The absolute form of
PPP is based on the idea that, in the absence
of international barriers, consumers will shift
their demand to wherever prices are lowest.
The implication is that prices of the same
basket of products in two different countries
should be equal when measured in a
common currency.
If there is a discrepancy in the prices as
measured by such a common currency, then
demand should shift so that these prices
converge.
EXAMPLE If the same basket of products is
produced by the United States and the
United Kingdom and if the price in the
United Kingdom is lower when measured in
a common currency, then the demand for
that basket should increase in the United
Kingdom and decline in the United States.
Both forces would eventually cause the
prices of the baskets to match when
measured in a common currency. l The
existence of transportation costs, tariffs,
and quotas renders the ab
Relative Form of PPP The relative form of PPP
accounts for such market imperfections as
transportation costs, tariffs, and quotas.
This version acknowledges that these
imperfections make it unlikely for prices of the
same basket of products in different countries to
be the same when measured in a common
currency.
However, this form of PPP suggests that the rate
of change in the prices of those baskets should
be comparable when measured in a common
currency (assuming that transportation costs
and trade barriers are unchanged).
Assume that the United States and the United Kingdom trade
extensively with each other and initially have zero inflation.
Now suppose that the United States experiences a 9 percent
inflation rate while the United Kingdom experiences a 5
percent inflation rate. Under these conditions, PPP theory
suggests that the British pound should appreciate by
approximately 4 percent (the difference between their
inflation rates).
Given British inflation of 5 percent and the pound’s
appreciation of 4 percent, U.S. consumers will have to pay
about 9 percent more for British products than they paid in
the initial equilibrium state. That value is equal to the 9
percent increase in prices of U.S. products due to U.S.
inflation.
The exchange rate should adjust to offset the differential in
the two countries’ inflation rates, in which case the prices of
products in the two countries should appear similar to c
The relative PPP theory is based on the
notion that exchange rate adjustment is
necessary for the relative purchasing
power to be the same whether buying
products locally or from another country.
If that purchasing power is not equal,
then consumers will shift purchases to
wherever products are cheaper until
purchasing power equalizes.
Reconsider the previous example but now suppose that
the pound appreciated by only 1 percent in response to
the inflation differential. In this case, the increased price
of British products to U.S. consumers will be
approximately 6 percent (5 percent inflation and 1
percent appreciation in the British pound), which is less
than the 9 percent increase in the price of U.S. products
to U.S. consumers.
We should therefore expect U.S. consumers to continue
shifting their consumption to British products. Purchasing
power parity suggests that this increased U.S.
consumption of British products by U.S. consumers would
persist until the pound appreciated by about 4 percent.
Thus, from the U.S. consumer’s viewpoint, any level of
appreciation lower than this would result in lower British
prices than U.S. prices.
From the British consumer’s viewpoint, the price
of U.S. products would have initially increased by
4 percent more than British products.
Thus British consumers would continue to reduce
their imports from the United States until the
pound appreciated enough to make U.S. products
no more expensive than British products.
The net effect of the pound appreciating by 4
percent is that the prices of U.S. products would
increase by approximately 5 percent to British
consumers (9 percent inflation minus the 4
percent savings to British consumers due to the
pound’s 4 percent appreciation). l
Assume that the price indexes of the
home country (h) and a foreign country
(f ) are equal. Now assume that, over
time, the home country experiences an
inflation rate of Ih while the foreign
country experiences an inflation rate of If.
Because of this inflation, the price index
of products in the consumer’s home
country (Ph) becomes Ph ð1 þ IhÞ The
price index of the foreign country (Pf) will
also change in response to inflation in
that country.
PPP

 Pfð1 þ IfÞ

 If Ih > If and if the exchange rate between the two


countries’ currencies does not change, then the
consumer’s purchasing power is greater for foreign than
for home products. In this case, PPP does not hold.
 If Ih < If and again the exchange rate remains unchanged,
then the consumer’s purchasing power is greater for home
than for foreign products. So in this case, too, PPP does not
hold.
 The PPP theory suggests that the exchange rate will not
remain constant butwill adjust to maintain the parity in
purchasing power. If inflation occurs and the exchange
rate of the foreign currency changes, then the foreign
price index from the home consumer’s perspective
becomes
Interest Rate Parity (IRP)
 When market forces cause interest rates and exchange rates to
adjust such that covered interest arbitrage is no longer feasible,
the result is an equilibrium state known as interest rate parity
(IRP).
In equilibrium, the forward rate differs from the spot rate by a
sufficient amount to offset the interest rate differential between
two currencies.
In the previous example, the U.S. investor receives a higher
interest rate from the foreign investment; yet there is an offsetting
effect because the investor must pay more per unit of foreign
currency (at the spot rate) than is received per unit when the
currency is sold forward (at the forward rate).
Recall that when the forward rate is less than the spot rate, this
implies that the forward rate exhibits a discount
Derivation of Interest Rate Parity (IRP)
 The relationship between a forward premium (or discount) of a
foreign currency and the interest rates representing these
currencies according to IRP can be determined as follows.
Consider a U.S. investor who attempts covered interest arbitrage.
The investor’s return from using this strategy can be calculated
from the following information:
■ the amount of the home currency (U.S. dollars, in our
example) that is initially invested (Ah),
■ the spot rate (S) in dollars when the foreign currency is
purchased,
■ the interest rate on the foreign deposit (if), and
 ■ the forward rate (F) in dollars at which the foreign currency
will be converted back to U.S. dollars.
Derivation of Interest Rate Parity (IRP)
With this strategy, the amount of home currency
received at the end of the deposit period is An ¼
ðAh=SÞð1 þ ifÞF Because F is simply S multiplied
by 1 plus the forward premium p, we can rewrite
this equation as An ¼ ðAh=SÞð1 þ ifÞ½Sð1 þ pÞ ¼
Afð1 þ ifÞð1 þ pÞ The rate of return from this
investment (called R) is given as follows: R ¼ An
Ah Ah ¼ ½Ahð1 þ ifÞð1 þ pÞ Ah Ah ¼ ð1 þ ifÞð1 þ
pÞ 1
 If IRP exists, then the rate of return R achieved
from covered interest arbitrage should
Functional Activity of Treasury
Department

Front Office

Back Office

Mid Office
Activity of Front Office
Box 1: Activities of Treasury Front Office
 Statutory management
 Forming market views through fundamental and technical
analysis
 To manage investment by participating in money market and
forex market
 Preparing daily exchange rate sheet and quotation
 Maintenance of daily dealing blotter
 Participate in the inter-bank market to buy and sell foreign
currency
 Manage currency composition
 Deal slip preparation
 Helping the back office for any unreconciled entry due to any
discrepancy
 Propose interest rate matrix and various investment options to
the ALCO
 Center for market and risk management activity
Source: Survey Result
Activity of Back Office
Box 2: Activities of Treasury Back Office
 Preparation of daily position and reconciliation with front office
 Recording deals and Deal slip verification
 Processing and sending deal confirmation
 Receiving deal confirmation from counterparties and checking
 Preparation, checking and passing of vouchers
 Ensuring accounting entries
 Management and Reconciliation of NOSTRO funds
 Revaluation of exchange position
 Justification of rate reasonability for all deals done
 Managing discrepancies and disputes
 Settlements
 Statutory report to Bangladesh Bank
 Monitoring approved exposure and position limits
 Head of Back Office reports to the Managing Director on daily
basis showing details of the deals

Source: Survey Result


Activity of Mid Office
Box 3: Activities of Treasury Mid Office
 Monitoring dealers adherence to various internal and regulatory
limits
 Monitoring dealers adherence to various counterparty limits
 Reporting any limit excesses and follow-up for measures
 Various internal and regulatory reporting
 Revision of counterparty limits, dealer’s limit, stop loss limit with
the approval of the competent authority
 Audit the records of the front-office and back-office to ensure that
they are consistent and accurate
 Interacting with the bank’s risk management department on
liquidity and market risk

Source: Survey Result


Integrated Treasury Management

Earlier, different treasury operations were performed


by different departments of banks.

Recently, the traditional practice of treasury


management has been changed due to deregulations
of interest rate and partial convertibility of taka by the
central bank.

Therefore, the concept of integrated treasury evolved,


which refers to integration of money market, security
market and foreign exchange operations under a
single umbrella.
Functions of Integrated Treasury

 Meeting Reserve Requirements and Investment

 Liquidity and Fund Management

 Asset-Liability Management

 Risk Management

 Transfer Pricing

 Derivative Products

 Own Account Trading

 Forex Market
Risk Exposure in Banking
Foreign Exchange Risk
Market Risk
Interest Rate Risk

Transaction Risk
Credit Risk
Portfolio Concentration
Bank Risk
Risks
Funding Liquidity Risk
Liquidity Risk
Trading Liquidity Risk

Operational Risk

Legal and Regulatory Risk


Challenges of Treasury Department
 Overall Market Liquidity

 Deterring Core Banking Activity of PDs

 Limited Products

 Limited Market Participants

 Lack of Product Knowledge

 Lack of Skilled Treasury Personnel

 Weak Forecasting

 No reference rate/ benchmark curve

 Absence of Derivative Instruments

 Absence of Secondary Bond Market


THANK YOU ALL

You might also like