714 Part Eight Risk Management
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manager; it means that a company that always uses the forward market to protect against
exchange rate movements does not pay any extra for this insurance.
That’s the good news. The bad news is that the forward rate is a fairly awful forecaster of
the spot rate. For example, in Figure 27.1 the large error in 1985 reflects the total failure of the
forward rate to anticipate the 34% rise in the value of sterling.- Purchasing Power Parity Theory What about the third side of our quadrilateral—
purchasing power parity theory? No one who has compared prices in foreign stores with
prices at home really believes that prices are the same throughout the world. Look, for example,
at Table 27.2, which shows the price of a Big Mac in different countries. Notice that at current
rates of exchange a Big Mac costs $7.54 in Switzerland but only $4.79 in the United States. To
equalize prices in the two countries, the number of Swiss francs that you could buy for your
dollar would need to increase by 7.54/4.79 − 1 = .57, or 57%.
This suggests a possible way to make a quick buck. Why don’t you buy a hamburger to-go
in (say) Ukraine for the equivalent of $1.20 and take it for resale in Switzerland, where the
price in dollars is $7.54? The answer, of course, is that the gain would not cover the costs.
The same good can be sold for different prices in different countries because transportation is
costly and inconvenient.^12
On the other hand, there is clearly some relationship between inflation and changes in
exchange rates. For example, prices in Venezuela rose by 266% in the period 2010 to 2014.
Or, to put it another way, you could say that the purchasing power of money in Venezuela
declined by almost three-quarters. If exchange rates had not adjusted, Venezuelan exporters
would have found it impossible to sell their goods. But, of course, exchange rates did adjust.
In fact, the value of the Venezuelan bolivar fell by nearly 60% relative to other currencies.
In Figure 27.2 we have plotted the relative change in purchasing power for a sample of countries
against the change in the exchange rate. Venezuela is tucked in the bottom left-hand corner; Swit-
zerland is at the top right. You can see that although the relationship is far from exact, large differ-
ences in inflation rates are generally accompanied by an offsetting change in the exchange rate.^13
(^13) Note that some of the countries represented in Figure 27.2 have highly controlled economies, so that their exchange rates are not
those that would exist in an unrestricted market. The interest rates shown in Figure 27.4 are subject to a similar caveat.
(^12) Of course, even within a currency area there may be considerable price variations. The price of a Big Mac, for example, differs
substantially from one part of the United States to another.
Country
Local Price Converted to
U.S. Dollars ($)
Brazil 5.21
Canada 4.64
China 2.77
Euro area 4.26
India 1.89
Japan 3.14
Norway 6.30
Russia 1.36
South Africa 2.33
Switzerland 7.54
Ukraine 1.20
United Kingdom 4.37
United States 4.79
❱ TABLE 27.2^ Price of Big
Mac hamburgers in different
countries.
Source: “The Big Mac Index,” The Economist,
January 22, 2015. http://www.economist.com/
content/big-mac-index