Chapter 15 • International aspects of business finance
Some theoretical explanations of relative exchange rates
Various attempts have been made to explain and predict relationships between two
national currencies. We shall now briefly review these and the research evidence of
their existence in real life.The law of one price
The theories explaining relative exchange rates are underpinned by the general notion
that if there are lots of wealth-maximising buyers and sellers with access to informa-
tion, then the prices of identical goods and services in two different countries (each
with its own currency) must logically be the same, when expressed in the same cur-
rency, and the exchange rate will adjust to make sure that this is true. This is known
as the law of one price.
For example, if the exchange rate were $1.95 =£1, then a product or service costing
$19.50 in the USA should cost £10 in the UK. Were this temporarily not true, market
forces would force it to be true. Suppose that a particular product costs £11 in the UK
and $19.50 in the USA. Then traders would seek to make a profit by buying the prod-
uct in the USA and selling it in the UK. This would have several effects simultane-
ously. It would create additional demand in the USA, which would force up the price
of the product there. In the UK it would create additional supply, which would force
down the price there. The action of selling a US-derived product in the UK market
would also lead to the conversion of sterling into dollars, that is, increase the demand
for dollars and increase the supply of sterling. This would have the effect of strength-
ening the dollar against sterling. These adjustments in the supply and demand, both
of the product and of the two currencies, should drive the effective cost of the product
to be the same on both sides of the Atlantic.
The law of one price should, in theory, extend to financial assets – loans, shares and
so forth.
In practice, the law of one price does not always work as theory would suggest.
This is for several reasons:l There are currency conversion costs. This means that it would not be worth traders
exploiting a very small pricing difference; after meeting the costs of converting
the currency, there would be no gain. This point is not a major one in economic
terms.
l There may be some legal restriction on importing the particular product from the
foreign country.
l Transport costs mean that buying a product in one country and selling in the other
will not completely equalise the price in the two countries.
l The exchange rate, as we have seen, is not always entirely determined by independ-
ent traders in goods and services. Governments are often major interveners in the
foreign exchange market.
From the law of one price come several subsidiary relationships.Purchasing power parity
If an identical product has, in effect, the same price in two different countries, as the
law of one price predicts, then differential inflation rates between the two countries
must, in theory, affect the exchange rate.‘