Comparison of purchasing power parity exchange rate and nominal exchange rate
The concept of purchasing power parity maintains that the price levels should be equal across the world when they are expressed in one currency. This implies that a unit of a specific currency should have the same purchasing power across the globe. This concept makes use of the law of national price levels. It does not make use of the individual prices. However, the concept of absolute purchasing power parity is built on a number of assumptions. The commodity that is often used to illustrate the idea of purchasing power parity is Big Mac. Therefore, the purchasing power parity of a Big Mac is the exchange rate that will make the commodity cost the same amount in the United States and other countries. The concept of purchasing power parity is built on a number of assumptions. These assumptions often make the concept of purchasing power parity not hold. For instance, the price of a Big Mac is often affected by a number of factors such as the price of premises in which it is being sold, government taxes, and other services. These factors have a direct impact on the price of the commodity. These factors tend to vary across the globe. Despite the limitations, the idea of purchasing power parity has been instrumental in the past. This is based on the fact a comparison of the purchasing power parity of a commodity in one country and the exchange rate enables an analyst to determine whether the exchange rate of a country is over or undervalued (Mandura 108). Therefore, this section will focus on analyzing the relationship between the purchasing power parity and nominal exchange rate of the three countries.
Data
The table below gives information on the purchasing power parity exchange rate and the nominal exchange rate for the Japanese Yen, British Pound, and the Euro. The data are collected for the period between 2005 and 2015. There are also calculations of over and undervaluation of the currencies.
(Source of data – Organization for Economic Co-operation and Development 1)
The information in the table above indicates that the Japanese Yen was overvalued in all the years apart from in the years 2014 and 2015. In the case of the British Pound, there was a slight overvaluation of the currency throughout the entire period. For the Euro, the currency was also slightly overvalued in all the years apart from the years 2012 and 2015 when there was a slight undervaluation. Generally, it is evident that the exchange rates of the three currencies were overvalued. Overvaluation indicates that the nominal exchange rate is higher than the purchasing power parity exchange rate. This implies that the commodities cost higher in these countries than in the US. Overvaluation can be good or bad for a country depending on whether imports or exports of commodities and services are being analyzed.
Graphs
In this section, the graphs of the purchasing power parity and the nominal exchange rate will be plotted. This will help depict the relationship in the trends of the two data sets. The data for each country will be plotted separately. The graphs are presented below.
Discussion
In the three graphs above, it can be noted that the lines for purchasing power parity exchange rate and the nominal exchange rate tend to follow a similar trend but with some slight variations. It is evident that they move in the same directions. For instance, in the case of the Japanese Yen, the graphs tend to slope downwards. For the British Pound, a slight upward trend can be observed in the two graphs. The graphs for the Euro slope downwards. From a theoretical perspective, it is believed that the concept of the purchasing power theory holds well in the long run but not in the short run. Despite the considerable deviances from the purchasing power parity, the nominal exchange rates of the three currencies have a tendency to move towards the purchasing power parity. The deviations can be explained by a number of reasons. One of the major reasons for the differences is that prices of commodities are sticky especially in the short run. Prices do not respond swiftly to changes in the economy, especially if a country is not experiencing hyperinflation. Therefore, most economies always experience a lag between when there are changes in the economy and when the prices respond to the changes. In such a scenario, law of one price and purchasing power parity is violated. Therefore, the nominal exchange rate will always adjust to the purchasing power parity exchange rate but with a lag. This explains why the nominal exchange rate deviates from the purchasing power parity. Another possible explanation for the deviations is that the effect of different price indices, relative price changes, and commodities not traded are not taken into account when estimating the two exchange rates. These three items may also the deviations that are displayed in the graph above. Also, the exchange rate may deviate from the purchasing power parity during periods of the fixed exchange rate regime. During such periods, the market exchange rate tends to remain static despite changes in the inflation rate. This makes the nominal exchange rate to differ from the purchasing power parity.
In conclusion, despite the deviations, it can be noted that the nominal exchange rate for the three countries tend to move towards the purchasing power parity. In the short run, the concept of purchasing power parity is less useful as indicated by the deviations. This can be attributed to the uncertainties that create the deviation of nominal exchange rate from the purchasing power exchange rate. However, in the long run, the purchasing power parity can be used as a guide of a given currency because most variables in the economy tend to be stable. In the short run, the purchasing power parity can be an important guide if a country is experiencing episodes of hyperinflation. During periods of hyperinflation, the price level moves rapidly to crowd the effect of relative price changes.
Trend analysis of exchange rate
This section seeks to analyze the trend of purchasing power parity exchange rate for Australian Dollar, Japanese Yen, Korean Won, and British Pounds. This will be achieved by plotting the data of nominal exchange rate and observing whether the graphs display an upward or a downward trend.
Data
The table presented below shows the data for purchasing power parity exchange rate for four countries. The data are collected for the period between 2005 and 2015.
(Source of data – Organization for Economic Co-operation and Development 1)
Graphs
Discussion
The purchasing power parity exchange rate curve for the Australia Dollar was quite volatile during the period. However, it can be observed that there was a slight upward trend in the values of the purchasing power parity. In the case of the Japanese Yen the values of purchasing power parity exchange rate sloped downwards. This shows that there was a decline in the purchasing power parity over time. For Korean Won, there was a general increase in purchasing power parity. The line graph is sloping upwards. Finally, in the case of the British Sterling Pound, there was an increase in purchasing power parity over time as indicated by the upward trend of the slope. A comparison of the four graphs shows that the British Pound had a steeper upward slope than the Australian Dollar and Korean Won. This shows that the values of British Pound grew at a higher rate than for the other two currencies. Therefore, it is apparent that the purchasing power parity of the four countries moved in different directions and at different rates.
The trends displayed by the purchasing power parity of the four currencies can be explained by a number of reasons. Just as mentioned above, absolute purchasing power parity is an equilibrium measure of exchange rate. It is the ratio of overall prices in two countries. Therefore, the PPP shows the purchasing power of the dollar in the United States relative to the purchasing power of the four currencies. Based on this information, the trend displayed in the graphs above can be explained partly by the changes in the purchasing power in the United States and in the four countries. For instance, a drop in the purchasing power parity exchange rate (as in the case of Yen) shows that the price level in Japan is declining or the price level in the US is increasing. For instance, if the price level in the US increases, then the value of the denominator in the calculation of purchasing power parity will increase. This leads to a decline in the estimated value of purchasing power parity. Also, if the purchasing power in Japan declines, then prices will tend to decline. This makes the numerator in the calculation to drop and the overall result is a drop in the estimated value of the purchasing power parity. On the other hand, an increase in the purchasing power parity exchange rates (as in the case of the Australian dollar, won and Pound) shows that the price level in these countries is increasing relative to the prices in the United States. Therefore, a major cause of the trend displayed in the graph above is inflation. This refers to a general increase in the price level. Assume that the inflation rate in the United States is 5%, while the inflation rate in Japan is 2%. Then the dollar value of the Japanese Yen needs to grow by approximately 3% so as to equalize the price in the two countries in dollars. This will result in a decline of the purchasing power exchange rate. Thus, based on the concept of inflation differential currencies with high rates of inflation should depreciate relative to currencies with lower inflation rate. If the US dollar depreciates relative to the Japanese Yen due to inflation, then the purchasing power parity exchange rate of the two countries will tend to decrease. Therefore, inflation rates play a significant role in explaining the trend displayed in the graphs above. The price of commodities in different time periods can be compared after adjusting for the effect of inflation. The analysis above shows the importance of managing inflation in a country. It shows that expansionary monetary policies in a country can be detrimental to an economy. A country should focus on maintaining stable monetary policies that will ensure that prices are stable (Shapiro 155).
Yield differentials
Interest rate differential measures the differences in interest rate between similar assets that have same maturity. The concept is quite important when coming up with pricing for the forward exchange rates. It allows a trader to estimate the value of a premium or a discount on the exchange rate for future contracts. In most cases, it is anticipated that the difference in interest rate between two countries will be the same as the difference in inflation rates of the two currencies. This is the concept is known as the Fisher Effect. According to the international fisher effect, it is expected that the currencies that have low interest rates will strengthen relative to currencies that have high levels of interest rates. This concept will be significant when evaluating the forward exchange rates between the currencies (Shapiro 164). This section will focus on analyzing the relationship between interest rate differentials and the forward exchange rate.
Data
The table presented below shows the 90 day interest rates, the interest rate differential (between the US dollar and other currencies) and forward exchange rates.
(Source of data – The Financial Times Limited 1; Trading Economics 1)
The 90 day interest rate for US dollar stands at 0.23%, 0.17% for the Japanese Yen, -0.02% in the Euro region, 1.74% for the Polish Zloty, 14.76% for Russian Rubble and 0.55% for the British Pound. It can be noted that the Euro has the least interest rate. This can be attributed to the fact that the interest rate is an average of 19 countries that are members of the European region. This is followed by the Japanese Yen that has an interest rate of 0.17% and the US dollar that has an interest rate of 0.23%. The Russian Ruble has the highest 90 day interest rate. This is followed by Polish Zloty at 1.74%. When it comes to the interest rate differential, the Russian Rubble has the highest value that stands 14.53% followed by Polish Zloty at 1.51%. On the other hand, the Japanese Yen has the least value of interest differential that stands at -0.06% followed by the Euro at -0.25%. A review of the forward rates shows that the Russian Rubble has the highest value of forward exchange rate (16,120) followed by Polish Zloty (36.46). On the other hand, the Japanese Yen has the least value of forward exchange rate (-29.44). Therefore, some consistencies can be observed between the value of interest rate differential and the forward exchange rate. For currencies that have a high interest rate differential, the corresponding forward exchange rate is also high. On the other hand, in scenarios where the differential is low, the corresponding forward exchange rates are also low. Therefore, the data used above indicates that there is a direct relationship between the interest rate differentials and the forward exchange rate. This is evident in all the currencies apart from the Euro. The inconsistency that is observed in the case of the Euro can be explained by a number of factors (Shapiro 151).
From a theoretical point of view, the concept of interest rate arbitrage suggests equality between the interest rate differentials and the forward premium. However, the theory does not give detailed explanations about the size of the interest rate differential and of the premium. Studies that have been carried out indicates that the size of the two variables can be determined using the values of anticipated inflation of the two countries. It is worth mentioning that if the theory of interest rate arbitrage does not hold, then it implies that the interest rate differential does not equal the forward premium or discount. This makes it possible to borrow money in one country and lend it in another country thus creating arbitrage profit. The theory of interest rate arbitrage is based on a number of unrealistic assumptions. Examples are lack of transaction cost and that the markets are perfectly competitive. Therefore, the theory of interest party requires that the premium/discount on the forward exchange rate should be adjusted to the short term interest rate differential between two countries. For instance, if the 90-day interest rate in the foreign country exceeds the home country’s exchange rate, then it will be profitable to invest abroad. This should continue until the point where the forward discount is approximately is equal to the differences in the interest rate between the two countries is reached. When transferring funds abroad, it is important to cover the currency against fluctuations in exchange rate between the two countries. This can be done through hedging. Thus, the capital flow will ensure that the interest rate differential is an unbiased estimator of future variations of the exchange rate (Shapiro 131).
The information in the table above shows some consistencies between the interest rate differential and forward rates apart from the case of the Euro. The consistency indicates that the high interest rate should be offset by the forward discount while low interest rate should be offset by forward premium if the theory of interest rate parity holds. In the case of the Euro, it is evident that theory does not hold. This can partly be explained by the fact that the Euro is a representative of 19 countries unlike the other currencies. Some of the other reasons that may cause the inconsistency are existence of transaction costs, capital controls that are available in the regions, and the taxes that are imposed on the interest payments. However, the inconsistency is expected to last over a short period since the market is self-adjusting.
Currency forecasts
Currency forecasting is often considered a complex process and in most cases it is always difficult to predict currency of a country accurately. In order to forecast a currency, then an analyst needs to use a proper forecasting model. Besides, there is need to have consistent access to information. Finally, an analyst needs to be able to predict the form of government intervention. In a fixed exchange regime, an analyst should be able to predict the decision making model of a government with regard to devaluation and revaluation of a currency. Various traders often pay forecasters to give them accurate estimates of future values for various currencies. The traders use the information for a number of reasons. However, some of the traders often want to use this information for making profits (Shapiro 149). This section will focus on analyzing the relationship between actual exchange rates, currency forecasts, and forward rates.
Data
The table presented below show a summary of forecasts for the year 2016 and the year 2020.
(Source of data – The Financial Times Limited 1; Trading Economics 1)
The current exchange rate for Euro/USD is 1.1311. The exchange rate is predicted to drop to 1.06 in the first quarter of 2016, 1.04 in the second quarter, 1.03 in the third quarter, and 1.02 in the fourth quarter. In 2020, the exchange rate is expected to increase to 1.28. Therefore, in 2016, the currency is expected to appreciate throughout the year. This indicates that the Euro will become stronger against the dollar. However, in 2020, the currency is expected to depreciate. It will become weaker against the dollar. In the case of the British Pound, the current exchange rate is 1.4472. In the first quarter, the exchange rate is expected to be 1.45. The value will drop to 1.42 in the second quarter, and a further drop to 1.39 in the fourth quarter. In 2020, the exchange rate is expected to grow to 1.75. Thus, the British Pound will appreciate against the dollar in the year 2016. However, in 2020, the currency will depreciate. Therefore, the British Pound will become weaker against the dollar. In the case of the Japanese Yen, the current exchange rate against the dollar is 111.44. The value is expected to increase to 120 by the end of the first quarter. It will increase further to 122 in the second quarter, 123 in the third quarter and 125 in the fourth quarter. In 2020, the value of the exchange rate is expected to drop to 94.9. Thus, it can be noted that an increasing number of units of the Japanese Yen will be required to buy a unit of the USD. This shows that the currency is depreciating. Thus, in the year 2016, the currency is expected to depreciate against the dollar. However, in 2020, 94.9 of the Japanese Yen will be required to buy a dollar. This shows that it will take less number of Yen to get a unit of the USD (Eun and Resnick 139). This shows that the currency will appreciate in 2020. Finally, in the case of Russian Ruble, the current exchange rate is 67.88. At the end of the first quarter, the exchange rate is expected to increase to 75.09. The value of the exchange rate is expected to increase further to 76.58 in the second quarter of 2016, 77.32 in the third quarter and finally to 78.07 in the fourth quarter. In 2020, the exchange rate is expected to drop to 59.48. In 2016, it can be noted that more number of the Russian Ruble units will be required to buy a unit of the US dollar. This shows that the currency will weaken against the dollar. This shows that the Russian Ruble will depreciate. In 2020, the number of units that will be required to purchase one USD is 59.48. It shows that less number of Russian Ruble units will be required to get a unit of the USD. Thus, the currency will appreciate. The comparisons above show that the Euro and the British Pound will appreciate in the short run and depreciate in the long run. However, in the case of Japanese Yen and the Russian Ruble, the currencies will depreciate in the short run and appreciate in the long run (Shapiro 159).
As mentioned above, there are several approaches that can be used to forecast the exchange rate of a currency. However, it is worth mentioning that these forecasts are not consistent with the efficient market hypothesis. This is based on the fact that the hypothesis maintains the view that exchange rate should reflect all information that is available publicly. It is expected that the exchange rates will follow random walk and the efficient market hypothesis. Thus, future exchange rates are expected to fluctuate randomly as they react to new available information in the market. Thus, based on these two hypotheses, the exchange rate of currencies cannot be predicted. Otherwise, traders will be able to make arbitrage profit. The arbitrage profits are not possible in a foreign exchange market because the market is characterized by free entry and exit of an unconstrained amount of money and other resources. This limits the ability to forecast the future exchange rate and use the information to make a profit (Eun and Resnick 145).
Forward rates
The forward rates are used to exchange the currency for some days in the future. This is different from the spot rate, which is used to exchange currency immediately. In most cases, the forward rates are used as insurance against risks that are associated with exchange rate fluctuations (hedging). It is worth mentioning that the forward rate cannot be used to predict the future spot rate of a currency. It cannot even give a prediction of the direction that a currency will take in the future (Shapiro 165). The table presented below shows a summary the current exchange rate (spot rate), forecasted exchange rate in 2020 and forward rates.
(Source of data – The Financial Times Limited 1; Trading Economics 1)
For the Euro/USD, the actual exchange rate is 1.1311 while the forecasted exchange rate is 1.28. The forward rate is 852.00. Thus, it can be observed that the forward rate is greater than the forecasted exchange rate. In the case of the GBP/USD, the actual exchange rate is 1.4472. The forecasted exchange rate is 1.75 while the forward rate is 252.18. In this case, the forward rate is higher than the forecasted exchange rate. For the Japanese Yen, the actual rate is 111.44. The forecasted exchange rate is 94.9 while the forward rate is -963.5. Thus, the forward rate is less than the forecasted rate. Finally, for the Russian Ruble, the actual rate is 67.88. The forecasted rate is 59.48 while the forward exchange rate is 100,000. Thus, the forecasted exchange rate is less than the forward rate.
Accuracy of the forecasts
The accuracy of the forecasts will be evaluated by analyzing the forecasting error of the exchange rates. Forecasting error is estimated by taking the difference between the actual exchange rate and the forecasted rate. The accuracy of the forecasts focuses on the deviations between the actual and forecasted exchange rate. It is worth mentioning that accurate forecasts may not be correct in predicting the direction of change. Thus, when predicting the direction of change, it is important to use correct and not accurate forecast (Shapiro 165). The forecasting errors for the four currencies are presented in the table below.
(Source of data – The Financial Times Limited 1; Trading Economics 1)
In the case of the Euro, it can be noted that the actual exchange rate is 1.1311 while the forecasted rate for 2020 is 1.28. Thus, the forecasted amount is greater than the actual amount. The same is observed in the case of the British Pound. The forecasted exchange rate exceeds the actual exchange rate by 0.3028. In the case of the Japanese Yen, it can be noted that the actual exchange rate exceeds the forecasted rate by 16.64. The same is observed in the case of the Russian Ruble where the actual exchange rate exceeds the forecasted rate by 8.4. The calculated forecasting errors give dismal information on the ability to use econometric models to make profits or losses. Thus, apart from determining arbitrage profit, the forecasting errors can help in determining whether to hedge or not with forward contracts. For instance, in the case of the Euro and The British Pound, it can be noted that the forecasted exchange rate falls below the forward exchange rate. In this case, the currency should be sold forward. However, in the case of Japanese Yen and the Russian Ruble, the forecasted rate exceeds the forward rate, therefore the two currencies should be purchased forward (Shapiro 169).
Works Cited
Eun, Cheol and Bruce Resnick. International financial management, Boston: McGraw-Hill Irwin, 2015. Print.
Mandura, Jeff. Financial Management Theory and Practice, Boston: South-Western Cengage Learning, 2011. Print.
Organization for Economic Co-operation and Development. Monthly Monetary and Financial Statistics (MEI): Exchange Rates (USD Monthly Averages). 2016. Web.
Shapiro, Allan. Foundation of Multinational Financial Management, New York: John Wiley and Sons, Inc., 2014. Print.
The Financial Times Limited. Currency Performance. 2016.
Trading Economics. Currency Forecasts 2016-2020. 2016.