Discuss about the Sensitivity of Purchasing Power Parity Estimates.
The present study is based on the evaluation and analysis of evidence that the PPP and IFE make unnecessary derivations. The study also covers the ways by which the derivations can be protected when failure arises from purchasing power parity and international Fisher effect.
Under the Purchasing Power Parity, at the equilibrium point, the difference in the percentage of future foreign currency spot rate from the existing spot rate through an amount that balances in percentage with the inflation degree of difference among domestic and foreign countries. When the rate of inflation increases in a country as compared to another country, reduced exports and increased imports further stress the high-inflation currency of country due to the declining trade and balances of current accounts. According to the PPP theory, it tries to quantify the relationship of the exchange rate and inflation[1]. It is suggested by PPP that the customer’s purchasing power will be same as when the purchasing products of a foreign nation or in the domestic nation. In a situation where the inflation with a foreign country is differing from the domestic country’s inflation, the exchange rate will make an adjustment so as to manage the balance between purchasing power. Further, Country currencies with the high-inflation rate will worsen as per the PPP, resulting in the good’s purchasing power in the domestic country against these countries to be the same.
While, in the situation where there is high-inflation in a specified country, the demand for foreign goods in the same country will reduce. Moreover, the demand for foreign goods in the country shall make increment[2]. Hence, the domestic currency of the same country will deteriorate, further this tendency shall be continued unless and until the currency is deteriorated to the point that good of foreign country will not appeal to relative to the goods of domestic country. The differences in inflation are balanced by the changes in exchange rate.
In accordance with the Fisher Effect, an interest which is free of risk will be inclusive of an actual return rate and estimated inflation. In case, the requirements by the investor of the similar actual return on the goods of same risk and date of maturity, it will make a difference in interest rate and might occur due to differences in anticipated inflation. It has to be noted that PPP theory says that movements in the exchange rate are held because of inflation rate differentials.
With the International Fisher Effect, it is said that currencies are having a high rate of interest will be depreciated due to the high nominal rates and suggests high anticipated inflation. Thus, investors willing to exploit on the higher foreign interest rate shall gain no higher return as compared to the earnings made by domestic sources[3]. International Fisher Effect, at the equilibrium point, the difference in the percentage of future foreign currency spot rate from the existing spot rate through an amount that balances in percentage with the nominal interest rate differences among domestic and foreign countries.
In accordance with the IFE, a higher interest rate of a foreign country shall not be appealing to investors, as these rates entail high anticipated inflation rates, which in exchange entail possible depreciates on such currencies. However, some of the investors will still make an investment in foreign countries wherein there are higher nominal interest rates. This might state that it is believed made by investors that the estimated inflation rate rooted in a higher nominal interest rate is overvalued[4]. On the other side, the potential high inflation will not make considerable depreciation of the foreign currency, which can take place if sufficient substitute goods where not accessible elsewhere, or there are other factors that can be balanced the potential inflation impact on the value of foreign currency.
Thus, derivation actually means deriving the value from considering the goods market value, and value derives from and is based on the value of the underlying assets like currency and commodity. While PPP is something different in which the underlying value of assets is determined by the inflation rate of the country. This compares the currency of different countries based on market approach. Both the currencies are in PPP and the market’s commodity and considering exchange rate is charged the same in both countries[5]. If these both approaches are used mutually then this can make derivation unnecessary, as the PPP is a sort of manipulative as it decides the rate of foreign currency by showing difference among inflation in both the countries.
For understanding the relation of inflation to the interest rate, it is essential that the rates must be distinguished in the market. Under the PPP principle, countries having higher inflation rate are willing to look out for currencies in opposition to the currencies of country’s having a lower interest rate. A derivative is a something whose payoffs are depended on future interest rates. However, international Fisher effect clarifies that exchange rate of currency will depreciate versus another currency when there is higher interest rate than those of another country.
The standard interest rate level within the economy is not consistent, but it fluctuates. For instance, the interest rate will convert in relation to the modifications in the expectation of investors regarding the future inflation rates. By considering the seesaw effect, an increase in the interest rate caters the fixed coupon interest payments being less appealing, by making a reduction in the price. Due to this aspect effect of the derivative is nullified by this theory[6]. Thus the PPP is based on the concept of arbitrage throughout commodity markets and the law of one price principle, further value or price calculated by derivates can make it derivation unnecessary. According to the principle of LOP, there should be the same price for the same product in and around the markets. In addition, if the home inflation is lesser than the foreign inflation; as a result, the home currency shall be depreciated.
The derivative is an agreement among two parties which grants the right and at some point the responsibility to purchase or sell an asset based on underlying aspects, wherein the payment is required to be made among the participants. Some of the financial risks could be pooled by financial tools called derivatives; these are put in use in various factors in financial transactions inclusive of interest rate swaps in order to manage exchange rate movements to change variable rate debt into fixed rate debt used in several facts, also in currency swaps and commodity derivatives to do fixation at the commodities price over time[7]. Future market prices are based on the ongoing information flow in and around the globe and demand a high level of transparency. A range of factors influence demand and supply of goods, and thereby the present and future prices of underlying asset whereby there is the basis of the derivative contract. This information and by which it is amended by individuals continuously coverts commodity prices. The transactions of derivations cover a variety of underlying exchange rate, commodities and interest rates.
With some of the futures markets, the assets can be dispersed geographically, having various spot prices in its presence. If the theory of PPP fails then derivative assist in the contract price with the minimal time to maturity generally caters as a proxy for the core asset. Next, the future contract prices cater as prices which are acceptable by those trading the contracts in lieu of experiencing the risk of uncertainty in future prices. These options also facilitate in price detection, not in terms of absolute price, but in terms of the perspectives of market participants with the market volatility[8]. It is because options are considered as the diverse form of hedging in that secures investors from losses while agreeing on them to do participate in the gains of the asset. In the situation where the investors believe that there is volatility in the market, the options of prices will be increased.
With the failure of PPP, risk management will act as one of the most significant aspects of the derivatives market. Further, the risk management is the procedures for determining the expected risk level, determining the actual risk level and managing the latter to balance the former. This procedure can be categorized into hedging and speculation.
Hedging has been defined as the strategy for decreasing the risk of retaining a market position whereas speculation means a position in terms of the movement of the market. At present, both these strategies and derivatives are said as helpful tools that allow companies to manage risk in an effective manner[9]. This will develop market efficiency meant for the underlying asset. For instance, investors hoping to get exposure to the S&P and can purchase S&P with the stock index fund or can imitate the fund by purchasing S&P futures and make investments in free of risk bonds. These methods can provide index exposure with no expense of making the purchase of the underlying assets.
In the situation where the implementing cost, both these strategies are similar to each other; investors will act as neutral while choosing the same. In case, there is the presence of
the discrepancy among prices, investors will be willing to put the richer asset in the sale and purchase the inexpensive asset unless and until the prices reach the equilibrium point. In regards to this, derivatives can form market efficiency[10]. Moreover, derivatives can also assist in reducing costs of market transactions, it is because derivatives are the type of insurance or a sort of risk management, the trading cost within it must be low, or investors will not consider it economically to buy this type of positions for their respective positions.
Under the IFE theory, it is anticipated that the risk-free factors of capital that must be enabled to free flow among countries that includes a specified currency pair. Exchange rate balance interest rate discrepancy; however, the estimation errors generally take place when the result is attempting to forecast the spot rate in the near future. The main problem impacting consumers and the global economy is the fluctuation in exchange rate and interest rate differences. In an expansion of the preservation of capital, information might be used to make a decision on hedging the derivative securities like futures and options so as to mitigate risks taking place from exchange rate movements[11]. Moreover, investors, as well as financial managers, make use of such tools to make speculation as well, willing to gain profit from exchange rate fluctuations and movements.
In a situation where the assets in a foreign firm and the home currency rise in percentage, the value of the investment also rises up from the same percentage also when there are no changes in the prices. Further, in this case, the International Fisher Effect will be highly appealing as it is based on the relation between interest rate and exchange rate. The aspects of derivation which are hedging and speculation help in mitigating the risks occurring from the factors and aspects besides inflation discrepancy that impacts exchange rate fluctuations, Hence the exchange rate fluctuations will not essentially match to the differential of inflation, and thereby PPP will not essentially retain[12]. There are various hedging tools such that can be implemented to make a reduction in risk. Alternatives to hedging risk are inclusive of; forward, future, options and swaps.
Conclusion
In accordance with the present study, the conclusion can be drawn that the derivatives are the most advanced guard tools that can occur in the portfolio of investors. In regards to this, these contracts can satisfy the specialized requirements that take place in the existing terms of the international financial system. Therefore, it enables individuals and companies to get secured from potential risks while accepting the same in an effective manner.
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