Global Economic Analysis - Relative Purchasing Power Parity
Relative purchasing power parity relates the change in two countries' expected inflation rates to the change in their exchange rates. Inflation reduces the real purchasing power of a nation's currency. If a country has an annual inflation rate of 10%, that country's currency will be able to purchase 10% less real goods at the end of one year. Relative purchasing power parity examines the relative changes in price levels between two countries and maintains that exchange rates will change to compensate for inflation differentials.
The relationship can be expressed as follows, using indirect quotes:
S1 / S0 = (1 + Iy) ÷ (1 + Ix)
S0 is the spot exchange rate at the beginning of the time period (measured as the "y" country price of one unit of currency x)
S1 is the spot exchange rate at the end of the time period.
Iy is the expected annualized inflation rate for country y, which is considered to be the foreign country.
Ix is the expected annualized inflation rate for country x, which is considered to be the domestic country.
Note that the spot exchange rate used must be the quantity of currency y (the foreign currency) needed to purchase one unit of currency x (the domestic currency). If we want the spot value of the U.S. dollar in British pounds, the quote must be 0.6667 British pounds per dollar, not $1.50 per British pound.
Suppose that the annual inflation rate is expected to be 8% in the Eurozone and 2% in the
So the relevant equation is:
S0.5 ÷ S0 = (( 1 + Ius) ÷ (1 + Ieurozone))0.5
= S0.5 ÷ $1.20 per euro = (1.02 ÷ 1.08)0.5
Which implies S0.5 = (1.20) × 0.978125 = 1.1662
So the expected spot exchange rate at the end of six months would be $1.1662 per euro.
Assume that the
S0 = 115 yen per dollar. (1 + Iy) is 1.0489, and (1 + Ix) is equal to 1.0623.
The approximation method would indicate that the yen should decline against the dollar by: (Iy - Ix) =(1.0489 - 1.0623) = -0.0134 = -1.34%
So the value of the yen relative to the dollar would be expected to decline to
(1 - 0.0134) × 115 = ¥113.46 per $
We can calculate the rate more exactly as:
S1 = (1.0489) / (1.0623) × 115 = ¥113.55 per $
Purchasing Power Parity and Real Return on Assets
The purchasing power parity principle also applies to the real returns on assets earned by various investors across the world. It holds that the real rate of return on assets should be the same for investors from any nation.
Suppose that a financial asset from
By the approximation method,
Note that purchasing power parity is a theoretical concept that may not be true in the real world, especially in the short run.
Past exams have included questions that require purchasing power parity calculations, so it is a good idea to practice solving questions such as the examples given above.
Financial AdvisorsLearn techniques for emphasizing your CFA Level I status in the Skills and Certifications or Professional Development section of your resume.
ProfessionalsLearn how to prepare for a career as an investment analyst, and read more about how many professionals in the field progress during their careers.
ProfessionalsFind out how the CAIA and CFA designations differ, including which professionals should seek either title based on their career ambitions.
ProfessionalsChapter 1: Equity Valuation: Its Applications and Processes Chapter 2: Return Concepts for Equity Valuation Chapter 3: Industry Analysis With Porter's 5 Forces
ProfessionalsThe Chartered Financial Analyst Level III exam, which is only offered in June, is the last in the series of three tests that CFA candidates must pass.
ProfessionalsBecoming a chartered financial analyst requires the passing of three grueling exams covering an array of topics.
Options & FuturesWe decode the meaning of the many letters that can follow the names of financial professionals.
ProfessionalsPrepare to ace the CFA Level 1 exam by studying systematically.
Personal FinanceMany advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
InvestingManagers, in developing their investment process, need to determine some “general rules” that make it meaningful. We offer six.
Professionals who help individuals manage their finances by providing ...
Formerly known as the Association for Investment Management and ...
A professional designation given by the CFA Institute (formerly ...
A financial professional who studies various industries and companies, ...
The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>