550 Part 6 Working Capital Management, Forecasting, and Multinational Financial Management
Note that the spot market exchange rate is expressed as the number of units of
home currency that can be exchanged for one unit of foreign currency ($2 per
pound).
PPP assumes that market forces will eliminate situations in which the same
product sells at a different price overseas. For example, if the tennis shoes cost $90
in the United States, trading companies could purchase them in the United States
for $90, sell them for 50 pounds in Britain, exchange the 50 pounds for $100 in the
foreign exchange market, and earn a pro! t of $10 on every pair of shoes. Ulti-
mately, this trading activity would increase the demand for tennis shoes in the
United States and thus raise Ph, increase the supply of tennis shoes in Britain and
thus reduce Pf, and increase the demand for dollars in the foreign exchange market
and thus reduce the spot rate. Each of those actions works to restore PPP.
Note that PPP assumes that there are no transportation or transactions costs
(or import restrictions) that would limit the ability to ship goods between coun-
tries. In many cases, these assumptions are incorrect, which explains why PPP is
often violated. An additional complication, when empirically testing to see whether
PPP holds, is that products in different countries are rarely identical. Frequently,
there are real or perceived differences in quality, which can lead to price differ-
ences in different countries.
Still, the concepts of interest rate parity and purchasing power parity are criti-
cally important to those engaged in international activities. Companies and inves-
tors must anticipate changes in interest rates, in" ation, and exchange rates; and
they often try to hedge the risks of adverse movements in those factors. The parity
relationships are extremely useful when anticipating future conditions.Ph " Price of the good in the home country ($100, assuming the United States is the
home country)
Pf " Price of the good in the foreign country (50 pounds)SELF^ TEST What is purchasing power parity?
A television set sells for $1,000 U.S. dollars. In the spot market, $1 " 110 Japa-
nese yen. If purchasing power parity holds, what should be the price (in yen)
of the same television set in Japan? (¥110,000)
Price di# erences in “similar” products in di# erent countries often exist. What
can explain those di# erences?17-8 INFLATION, INTEREST RATES, AND EXCHANGE RATES
Relative in" ation rates, or the rates of in" ation in foreign countries compared with
that in the home country, have two key implications for multinational! rms:
(1) Relative in" ation rates in" uence future production costs at home and abroad,
and (2) in" ation has an important effect on relative interest rates and exchange
rates. Both of those factors in" uence multinational corporations’! nancing deci-
sions and the pro! tability of foreign investments.
The currencies of countries with higher in" ation rates than the U.S. in" ation
rate, by de! nition, depreciate over time against the dollar. Countries in which thisHere: