1.Define Purchasing Power Parity (PPP) theory. Based on PPP, would you expect the price of a new car to be the same in China as it is in Brazil? Provide justifications for your answer.
2.The September 2016 inflation rate for China is 1.9% and for Brazil 8.48%. Based on PPP, what would you expect to happen to the foreign currency? Show your calculations and discuss the expected effect.
3.Collect monthly data on the spot exchange rate between the Australian Dollar and Chinese Yuan from July 2012 to June 2015 from the Reserve Bank of Australia (RBA). Plot the data and comment on the factors that influence the exchange rate behaviour (theory and practice) – search for 2 articles in reputable sources to support discussion
4.Compute the forward rate discount or premium for the Brazilian real whose 180 day forward rate is USD3.27 and spot rate is USD3.23. State whether your answer is a discount or premium.
5.Define a currency option, related terms, and pricing factors.
6.How much will Howard pay per option and in total if the MNC wants to hedge the bid with call options?
7.What is the maximum amount necessary to purchase the R$500,000?
8.Would Howard Ltd exercise the call option if the bid is rejected? Explain.
1.Purchasing power parity is one of therories of economics which mentions about the rate of exchange among the currencies in different countries is equal to the currencies ratio in respect of the purchasing power. The main concept behind is that when the price of any particular product is at par in both the countries, the currencies of the countries will be in equilibrium with each other (Lothian 2016)
PPP is denoted by the formula = S = P1/P2, where P1 denotes cost of basket of products in country 1 and P2 denotes cost of basket of products in country 2 and S is the rate of exchange between the two currency of 2 countries. It is determined based on inflation and the cost of living in the given 2 countries.
As per the PPP model, purchase price of a new car in Brazil will be same as it is in China, because the concept of PPP is based one price for all the commodities. Thus if the exchange rate ratio does not alters, the price of the given basket of products will remain same in both the countries. It will also depend on other factors like inflation and interest rates that will affect the price of goods in a particular country.
2.As per the concept of PPP, the rate of inflation is a critical factor that determines the exchange rate ratio. In the given case, the inflation rate for two countries is given. The spot rate for the home currency is 1CNY= 0.48644 BRL.
According to the PPP model, the forward rate will be –
Spot rate (1+Inflation of home currency/ 1+inflation of foreign currency) = 0.5365
Thus, we see that if the inflation of the home currency is more than the inflation of the foreign currency, it will have appositive effect, as there will be an overall increase in value of the home currency. Further, in case the home currency’s inflation is lower than the foreign currency’s inflation, the overall value of the home currency will decrease. In this way the inflation rates of the countries impacts the overall purchasing capacity of the company (Lin & Lee 2016)
3.Post taking into consideration the spot rates of the two given countries namely Australian and Chinese dollar, following are the main factors which impacts these exchange rate-
In the said two countries, we see that the AUD/CNY Exchange Rate is depreciating over the years, that means that one of the currencies is getting strong and one is depreciating, that may be because of the changes in the rate of inflation and the interest rates. The highest was on 29th July 2011 7.567 and the lowest was on 30th September 2015.
If the forward rate of any currency is more than the spot rate of that particular currency it reflects that the currency is at forward premium and if the currency’s forward rate is less than the currency’s spot rate then it is said to be at a discount. In the given case, the forward rate is USD 3.27 and spot rate is USD 3.23, thus the currency is at a forward premium. The main is calculated hereunder-
|
Calculation in annualized percentages of Forward rate Premium or Discount: |
|||||
|
Premium |
= |
(Forward rate – Spot rate) / Spot rate |
x |
12 months |
|
|
N |
|||||
|
forward rate |
USD3.27 |
||||
|
spot rate |
USD3.23 |
||||
|
N |
180 days |
||||
|
Premium |
0.025111799 |
4.A currency option is contract in which the buyer has option to buy or sell any definite currency at any specific price, but there is no obligation to do the same. These are widely used options by corporations to hedge against currency risks. The investors can hedge the currency risk, by either buying or selling the options in various ways. The price of currency option is calculated by numerous factors which includes the currency’s present spot rate, the rate at which the currencies can be deposited in the banks, and the current level of volatility. The two main terms that is related with the cull option and the put option (Habib, Mileva & Stracca 2017)
The call option is a contract amongst the two parties that gives buyer a right to buy any commodity or any stock within a particular time. However, there is no obligation to buy the same. The put option gives buyer a right to sell any commodity, stock or bond within a particular time, but there is no obligation to do the same. It helps the investors in allocating their portfolios without any actual buy or sell. It helps them in hedging the currency risks that are associated with foreign exchange transaction. It helps them to get themselves covered in the stock exchange. Thus, options are widely used. It also helps in generating a large amount of revenues because of the covered call strategy. The investor does not only own the underlying security, but it also owning the right to sell the call option and exercise the put option effectively. It helps in getting an exposure for the stock in very less price. The only cost that the investor will bear will be the cost of the contract. Thus, many factors influence the overall pricing policy and the revenue that a contract may earn. Currency options are very volatile in nature and the major drawback that is associated with such options is that there is large-scale speculation involved, which often leads to loss. Hedging is important because there is a lot of uncertainty involved. The currency rates keeps on fluctuating and that causes a large amount of issues. It is therefore important to make use of the currency options in such a manner that it yields maximum return to the investors (Ahlip, Park & Prodan 2017)
6.In the given case, each option consists of 50,000 Brazilian Real units. Thus total pay per option will be (50000*(0.41+0.004) = AUD 20700. Total amount that the company needs to pay the MNC is (20700*10= AUD207000) this is because total amount need is R$500,000, and each option consists of 50000 Brazilian real units, there 10 such options will be needed to cover the entire amount. Thus, the company would have to pay to the MNC, AUD 207,000.
7.The total amount needed by the company to buy R$500,000 will be (R$500,000*0.41) = 205000AUD. We will not consider the premium price because it is considered only while we purchase the option.
8.In case the bid is rejected, the company will exercise the bid only if the spot rate is less than the AUD 0.41. In case the spot rate is more than this, then the call cannot be exercised. The breakeven point is at AUD0.41. If the spot rate is AUD0.45, then purchase the currency at the spot rate of AUD0.41 and then sell it a profit in AUD0.45. Because the company is paying a premium of 0.004, then company can earn a profit of 0.396. The formula for profit calculation is, Profit = Spot Rate – (Strike Price + Premium).This is the way in which the company will exercise the call option in case the bid cannot be exercised. In any case, the loss will be the premium paid and the gain can be unlimited(Qi & Xie 2016)
Conclusion
Thus after the entire analysis, it can be said that the concept of purchase power parity holds good more on paper then in real life scenario. The exchange rate ratio is affected by so many factors, thus the assumption that the purchasing price of a particular product will stay same in both the countries does not hold good. There is variety of other factors that is to be taken into consideration. (Brooks, Cuthbertson & Mayes 2017)
References
Ahlip, R, Park, AFL & Prodan, A 2017, ‘Pricing currency options in the Heston/CIR double exponential jump-diffusion model’, International Journal of Financial Engineering, vol 4, no. 1.
Bergin, PR, Glick, R & LinWu, J 2017, ‘“Conditional PPP” and real exchange rate convergence in the euro area’, Journal of International Money and Finance, vol 73, pp. 78-92.
Brooks, S, Cuthbertson, K & Mayes, DG 2017, The Exchange Rate Environment, Routledge., NewYork.
Habib, MM, Mileva, E & Stracca, L 2017, ‘The real exchange rate and economic growth: Revisiting the case using external instruments’, Journal of International Money and Finance, vol 73, pp. 386-398.
Horioka, CY & Ford, N 2017, ‘A possible explanation of the ‘Exchange Rate Disconnect Puzzle’: a common solution to three macroeconomic puzzles?’, Applied Economics Letters , vol 24, no. 3.
Lin, L & Lee, CI 2016, ‘Central Bank Intervention, Exchange Rate Regime and the Purchasing Power Parity’, The World Economy, vol 39, no. 8, pp. 1256-1274.
Lothian, JR 2016, ‘Purchasing power parity and the behavior of prices and nominal exchange rates across exchange-rate regimes’, Journal of International Money and Finance, vol 69, pp. 5-21.
Qi, H & Xie, AY 2016, ‘Cost of capital: spot rate or forward rate?’, Applied Economics , vol 48, no. 40, pp. 3804-3811.
Toulaboe, D 2017, ‘Real exchange rate misalignment of Asian currencies’, Asian Pacific Economic Literature, vol 31, no. 1, pp. 39-52.
Yee, S & Ramirez, DM 2016, ‘Purchasing Power Parity: A Time Series Analysis of the U.S. and Mexico, 1995–2007’, International Advances in Economic Research, vol 22, no. 4, pp. 409-419
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