Question: CFA question: 1997, Level 3.

A. Explain the following three concepts of purchasing power parity (PPP):

a. The law of one price.

b. Absolute PPP.

c. Relative PPP.

B. Evaluate the usefulness of relative PPP in predicting movements in foreign exchange rates on:

a. Short-term basis (for example, three months)

b. Long-term basis (for example, six years)

Solution:

A. a. The law of one price (LOP) refers to the international arbitrage condition for the standard consumption basket. LOP requires that the consumption basket should be selling for the same price in a given currency across countries.

A. b. Absolute PPP holds that the price level in a country is equal to the price level in another country

times the exchange rate between the two countries.

A. c. Relative PPP holds that the rate of exchange rate change between a pair of countries is about equal

to the difference in inflation rates of the two countries.

B. a. PPP is not useful for predicting exchange rates on the short-term basis mainly because

international commodity arbitrage is a time-consuming process.

B. b. PPP is useful for predicting exchange rates on the long-term basis.
1. Suppose that the treasurer of IBM has an extra cash reserve of $1,000,000 to invest for six months. The six-month interest rate is 8% per annum in the U.S. and 6% per annum in Germany. Currently, the spot exchange rate is DM1.60 per dollar and the six-month forward exchange rate is DM1.56 per dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should he/she invest to maximize the return?