What is Parity Pricing in International Markets? www.HelpWithAssignment.co m
Dec 05, 2014
What is Parity Pricing in International Markets?
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Table of Content
• Purchasing Power Parity
• Interest Rate Parity
• Interest Rates & Exchange Rates
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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$0.60 in the US
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Parity Pricing in International Markets
Concept of PPP (continued):2. The price of tradable goods, when expressed in a
common currency, will tend to equalise across countries as a result of exchange rate changes
3. Consumers will shift their demand, assuming no international barriers, and purchase goods from the country offering the lowest price for the same goods
4. Where consumers shift their demand abroad, on the basis of price, increased demand will force foreign price rises and therefore re-establish price equilibrium (PPP)
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Parity Pricing in International Markets
Impact of Inflation on PPP:Inflation is defined as the persistent increases in the general level of prices that devalue the worth of money.
• Assume that inflation in Australia is 3.0% and
inflation in the US is 1.0%. General price levels are therefore rising faster in Australia compared to the US
• If consumers switch demand to US goods the exchange rate will adjust (US$ up / AUD down) to re-establish price equilibrium
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Parity Pricing in International Markets
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
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Parity Pricing in International Markets
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
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Parity Pricing in International Markets
• 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?
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Parity Pricing in International Markets
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$199 Australia has the cheapest iPod. Why?
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Parity Pricing in International Markets
Does PPP work?• Exchange rate may not fully adjust because of
i. Interest rate differentials
ii. Growth rate differentials
iii. Inflation rate differentials
iv. Income differentials
v. Government policy differentials
vi.Combination of the above
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Parity Pricing in International Markets
Does PPP work?
In the short run there are variations for the reasons stated, however, over the long run deviations in the exchange rate are reduced and PPP is considered accurate.
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Interest Rate Parity:To extinguish arbitrage opportunities, the quoted difference between the forward fx rate and the spot rate (F – S ) is offset by the interest rate differentials
• Assume that the interest rate in Australia is 6.0% and
interest rate in the UK is 3.0% • If UK investors switch their investments to Australian
dollars, the exchange rate will adjust (AU$ up / GB₤ down) to re-establish interest rate equilibrium
Parity Pricing in International Markets
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Parity Pricing in International Markets
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
$)
P
Q
Currency Equilibrium
SS
DD1
SS1
DDP1
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Parity Pricing in International Markets
Example Interest Rate Parity:
Interest Rates (12 mth) US GB AU
www.bloomberg.com 0.00 5.75 7.5
Exchange Rate US GB AU
www.oanda.com 1.00 0.666 1.458
Forward Rates (12 mth) US GB AU
www.cme.com 1.00 0.664 1.469
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Parity Pricing in International Markets
Interest Rate Parity example (continued)
US$ 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
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Thank You
Hope this presentation helps you in understanding the concepts of Parity Pricing.
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