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What is Parity Pricing in International Markets?

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Table of Content

• Purchasing Power Parity

• Interest Rate Parity

• Interest Rates & Exchange Rates


Parity Pricing in International Markets

Purchasing Power Parity (PPP):• The theory that states that the exchange rate between

one currency and anther is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent

Concept:

1. If the exchange rate is AU$1.00 = US$0.60, the exchange rate is in equilibrium when AU$1.00 will buy the same goods in Australia as US$0.60 in the US



Concept of PPP (continued):2. The price of tradable goods, when expressed in a

common currency, will tend to equalise across countries as a result of exchange rate changes

3. Consumers will shift their demand, assuming no international barriers, and purchase goods from the country offering the lowest price for the same goods

4. Where consumers shift their demand abroad, on the basis of price, increased demand will force foreign price rises and therefore re-establish price equilibrium (PPP)



Impact of Inflation on PPP:Inflation is defined as the persistent increases in the general level of prices that devalue the worth of money.

• Assume that inflation in Australia is 3.0% and

inflation in the US is 1.0%. General price levels are therefore rising faster in Australia compared to the US

• If consumers switch demand to US goods the exchange rate will adjust (US$ up / AUD down) to re-establish price equilibrium



Inflation Rate Differences• Assume inflation rates are

higher in the US than the UK

• US consumers buy GB£ to buy UK goods (& sell US$)

• Supply (SS) GB£ shifts left• Demand (DD) GB£ shifts right

• As a result, GB£ appreciates: GB£ buys more US$ (US$ depreciates) Quantity Supplied of UK Currency

Pri

ce o

f U

K C

urre

ncy

(US

$)

P1

Q

Currency Equilibrium

SS1

DD

SS

DD1P



Example PPP:

Therefore: AU$1.99 = ₤107.00 = HK$1150.00 (21/12/08)

8gb iPod nano AU$ GB₤ HK$

http://store.apple.com/au $199.00

http://store.apple.com/uk ₤107.00

http://store.apple.com/hk $1150.00



• AU$199.00 = ₤107.00 = HK$1150.00• Need to measure in a single currency (AU$)• AU$199.00 = ₤107.00 = HK$1150.00

AU$199.00 AU$199.00 AU$199.00

AU$1.00 = ₤0.537 = HK$5.779• Compare www.oanda.com (21/12/2008)• AU$1.00 = ₤0.457= HK$5.32• So which country has the cheapest iPod?



So which country has the cheapest iPod?• AU$1.00 = ₤0.457= HK$5.32 (indirect)• AU$2.188 = ₤1.00 and AU$0.188 = HK$1.00 (direct)

The respective costs of an iPod are:• UK equiv. = ₤107.00 x AU$2.188 = AU$234.12• HK equiv. = HK$1150.00 x AU$0.188 = AU$216.17• @ AU$199 Australia has the cheapest iPod. Why?



Does PPP work?• Exchange rate may not fully adjust because of

i. Interest rate differentials

ii. Growth rate differentials

iii. Inflation rate differentials

iv. Income differentials

v. Government policy differentials

vi.Combination of the above



Does PPP work?

In the short run there are variations for the reasons stated, however, over the long run deviations in the exchange rate are reduced and PPP is considered accurate.


Interest Rate Parity:To extinguish arbitrage opportunities, the quoted difference between the forward fx rate and the spot rate (F – S ) is offset by the interest rate differentials

• Assume that the interest rate in Australia is 6.0% and

interest rate in the UK is 3.0% • If UK investors switch their investments to Australian

dollars, the exchange rate will adjust (AU$ up / GB₤ down) to re-establish interest rate equilibrium




Interest Rate Differences• Assume interest rates are

higher in the US than the UK

• UK investors invest in US$ and sell of GB£

• Supply (SS) GB£ shifts right

• Demand (DD) GB£ shifts left

• As a result, GB£ depreciates: GB£ buys fewer US$ (US$ appreciates) Quantity Supplied of UK Currency

Pri

ce o

f U

K C

urre

ncy

(US

$)

P

Q

Currency Equilibrium

SS

DD1

SS1

DDP1



Example Interest Rate Parity:

Interest Rates (12 mth) US GB AU

www.bloomberg.com 0.00 5.75 7.5

Exchange Rate US GB AU

www.oanda.com 1.00 0.666 1.458

Forward Rates (12 mth) US GB AU

www.cme.com 1.00 0.664 1.469



Interest Rate Parity example (continued)

US$ GB₤ AU$

US$1,000,000 equiv 1,000,000.00 666,000.00 1,458,000.00

Add interest 0.00 38,295.00 109,350.00

Total 1,000,000 704,295.00 1,567,350.00

Futures Rate (÷ 1.0) (÷ 0.664) (÷ 1.469)

Convert back to US$ 1,000,000 US$1,060,685 US$1,060,143

Effective Rate of Interest 0.00 0.0607 0.0601


Thank You

Hope this presentation helps you in understanding the concepts of Parity Pricing.

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