Topic Four

Purchasing Power Parity

What is the rationale for using PPP as a currency trading rule?

Topic Four

Sub-Topics

The Law of One Price

From Law of One Price to Purchasing Power Parity

PPP as a Trading Rule

04-2
Topic Four

Learning Objectives
After completing this topic you should be able to do the following:

Define the Law of One Price.

Distinguish among absolute, relative and ex ante PPP.

Explain how PPP can be used as a trading rule.

04-3
Topic Four

References

Textbook

Moosa, I.A., 2004, International Finance: an Analytical
Approach, 2nd edition, McGraw Hill Australia. Chapter 9.

04-4
The Law of One Price
Definition

In the absence of frictions, the price of a commodity

expressed in a common currency must be the same in
every country:
Pi
S=
Pi *
⇒ Pi = S × Pi*

04-5
The Law of One Price
Example 4-1: Law of One Price

The price of a commodity in the United States is

USD2.54, while the price of the same commodity in
Australia is AUD3.00 and the AUD/USD exchange rate is
at 1.8769.
 What is the Australian dollar price of the commodity compatible
with the Law of One Price? Is there a violation of LOP?
 What will happen?
 What is the LOP compatible exchange rate?

04-6
The Law of One Price
Example 4-1: Law of One Price

What is the Australian dollar price of the commodity

compatible with the Law of One Price? Is there a
violation of LOP?

04-7
The Law of One Price
Example 4-1: Law of One Price

What will happen?

Arbitragers will buy commodity in Australia and sell the
commodity in US making a profit equal to 4.77 – 3.00 =
AUD1.77. As a result of the arbitrage demand for the
commodity will rise in Australia, causing the AUD price of
the commodity to rise. At the same time supply of the
commodity will rise in the US causing the USD price of
the commodity to fall. Alternatively, Australian exports
will rise causing the demand for the AUD to rise and the
supply of the USD to rise, which will both have the effect
of reducing the AUD/USD.

04-8
The Law of One Price
Example 4-1: Law of One Price

What is the LOP compatible exchange rate?

04-9
From the LOP to PPP
Absolute PPP

Absolute PPP can be derived from LOP by assuming

that it holds for each and every commodity:
n n

∑ i i ∑ i Pi
w P
i =1
= S w* *

i =1

If we assume that the weights assigned to the same

commodity are equal across countries, then
P
P = SP ⇒ S = *
*

P
when wi = wi* for all i
04-10
From the LOP to PPP
Generalized Absolute PPP

The generalized absolute PPP is defined as:

 P
S = a + b * 
P 

Assumptions:
 Free movement of commodities
 No transportation costs
 No tariffs
 Risk-neutrality
 Equal weights

04-11
From the LOP to PPP
Relative PPP

Relative PPP can be derived by assuming that absolute

PPP holds at two points in time:

P1 S1 P1*
=
P0 S0 P0*
(1 + P& ) = (1 + S& )(1 + P& * )
S& = P& − P& *

04-12
From the LOP to PPP
Example 4-2: Relative PPP

The AUD/USD exchange rate at 31/12/01 was 1.9585

and at 31/12/02 was 1.7662. The 2002 inflation rates
were 2.4% for Australia and 1.55% for the United States.
 Was the change in the AUD/USD exchange rate consistent with
Relative PPP theory in 2002?

04-13
From the LOP to PPP
Example 4-2: Relative PPP

Was the change in the AUD/USD exchange rate

consistent with Relative PPP theory in 2002?

The change in the exchange rate is

04-14
From the LOP to PPP
Ex Ante PPP

Ex Ante PPP can be derived from the behaviour of

agents involved in inter-temporal speculation:

S& e = P& e − P& *e

04-15
From the LOP to PPP
Example 4-3: Ex Ante PPP

At the beginning of 2003 the AUD/USD exchange rate

was 1.7662 and the forecast inflation rates were 3.00%
for Australia and 2.50% for the United States.
 What is the AUD/USD exchange rate forecast to be at the end of
the year, according to Ex Ante PPP theory?

04-16
From the LOP to PPP
Example 4-3: Ex Ante PPP

What is the AUD/USD exchange rate forecast to be at

the end of the year, according to Ex Ante PPP theory?

04-17
From the LOP to PPP
Deviation from PPP

Deviation from PPP can be calculated from the actual

and PPP exchange rates:

 Pt / P0 
St = S 0  * * 
 Pt / P0 
S −S 
D = 100  
 S 

04-18
From the LOP to PPP
Example 4-4: Deviation from PPP

The AUD/USD exchange rate at 31/12/01 was 1.9585

and at 31/12/02 was 1.7662. The CPI in Australia was
respectively 135.4 and 139.5 based on 1989/90, in the
US it was 116.2 and 118.0 based on 1995.
 What was the deviation, if any from PPP theory?
From the LOP to PPP
Example 4-4: Deviation from PPP

What was the deviation, if any from PPP theory?

Firstly, you need to rebase the price index figures so that
they have the same base as the exchange rate.

Australian CPI for 31/12/01

Australian CPI for 31/12/02

US CPI for 31/12/01

US CPI for 31/12/02

04-20
From the LOP to PPP
Example 4-4: Deviation from PPP

Secondly, you need to calculate the PPP compatible

exchange rate.

04-21
From the LOP to PPP
Example 4-4: Deviation from PPP

Now you can calculate the deviation.

04-22
PPP as a Trading Rule
Trading Signals

Buy foreign currency (sell domestic currency) when the

actual exchange rate is less than the PPP derived rate.

Sell foreign currency (buy domestic currency) when the
actual exchange rate is greater than the PPP derived
rate.

 P 
S = f *
P 
S = f ( S , X 1, X 2 ,....., X n )

04-23
PPP as a Trading Rule
Example 4-5: Trading Rule

The AUD/USD exchange rate at 31/12/01 was 1.9585

and at 31/12/02 was 1.7662. The CPI in Australia was
respectively 135.4 and 139.5 based on 1989/90, in the
US it was 116.2 and 118.0 based on 1995.

Based on the deviation calculated in Example 4-4, would
you buy or sell the AUD against the USD?

04-24