PPP and IFE Theories
Introduction
According to Eun and Resnick (2010), the theory of Purchasing Power Parity (PPP), as described in economic study, compares the purchasing power of multiple currencies over the globe. PPP is the rate of exchange, which permits a person to buy a similar basket of commodities and services around the world. It refers to a pointer of how much a product is likely to cost when a US dollar is utilized in purchasing the same good. International Fisher Effect (IFE) is a model of an exchange rate that incorporates rates of nominal interest both in the present and future. It is free from risks. Irving Fisher developed the model in the year 1930. It was created to assist in forecasting both current and future prices of movements in currency prices. Contrastingly, the derivatives that are financial pacts stand for the position in which buyers agree to buy assets at a particular price and time via deriving value from original assets. Derivatives application is seen currency changes when purchasing products using like oil using US dollars.
Explain why PPP and IFE, in theory, make derivatives unnecessary
As illustrated by Madura (2020), derivatives, just like financial instruments employed in monetary marketplaces, reduces market risks via hedging process. The threats incorporate currency fluctuations due to rates of exchange, movements in interest rates, inflation, and others. As they are intrinsic risks within securities, derivatives help in the reduction of spending on expensive products. Due to increasing rates of inflation in some states relative to the other, there is always a reduction in exports as imports surge. Consequently, the currency of such countries goes down. For example, suppose there exist more incidences of inflation USA than the UK, and then all products sold in the UK would become extremely expensive to buy (Madura, 2020).
The theory of PPP stipulates that as a result of inflation happening in different states, the price of a similar basket of commodities within a single state would be comparatively higher when matched with another state. For example, when there is inflation in the USA, then this is likely to cause a change in commodity prices. Suppose a product is a value of £4 in London and the USA, the same good retails at $8. As a result of inflation, the same product’s price will shift to $10 in the USA for every item. An increment of inflation within the USA comparable to that Of the UK would make the US raise its imports from the UK when they matched to the value of exports. This would make the rate of sterling pound appreciation to be equivalent to that of US dollars. In such scenarios, the USA dollars will get depressed as a result of worsening trade in addition to present account balances of the country (Madura, 2020).
At the equilibrium point, the future spot rate of the foreign currencies appears not to be the same as that of the current rate of the spot in terms of percentage. Such difference gets revealed by the differences in the inflation between home and external currencies. As the outright Purchasing Power Parity that holds prices of basket commodities within various states ought to be similar when quantified using similar currencies (Pirie, 2017). This is not taking into account marketplace imperfections like tariffs, and as with such, the arbitrate likelihood would be higher. However, comparative PPP considers market imperfections. Consequently, the relative PPP hypothesizes that the changes in future prices on the basket of commodities from one state to another should be the same. For that matter, it forecasts that future price of products, through eliminating the needs to use derivatives like forwarding rates; swaps and options assist in mitigating risks which can arise due to subsequent changes in prices (Pirie, 2017).
The PPP assists in recognizing imbalances in trade, which set in due to purchase parity imbalance. The notion that similar products should have the same prices from any state is due to either overvaluation or undervaluation of these commodities. In such instance, Purchasing Power Parity aids in recognizing anomalies within an economy then do appropriate correction of such stance in the long run. For that matter, this is rendering derivative use as unnecessary because derivatives become risky as a result of their higher rates of volatility. When an institution has high leverage positions, then the possibility of getting losses is higher, particularly for the cases in which derivatives are drawn against them. A scenario like that when happens, then the contract valuation becomes incredibly impossible. Thus, it bears higher inherent risks. Subsequently, derivatives are known to work excellently in cases where the process of due diligence needs to be followed to prevent counterparty risk instances.
According to Pirie (2017), International Fisher Effect (IFE) portrays that there are differences in exchange rates in one country to another. That such differences only changes when there are inflation and variance in interest rates. IFE theory postulates that for any state having higher rates of interest, their currency automatically would depreciate since higher nominal rates reflect the anticipated inflation rates in a nation. For that matter, the differential interest rates lead to arbitrate. In such cases, at the point of equilibrium, the percentage rate of the spot in the future of a foreign state differs with the current percentage spot rate amount, which is the equivalent rate of nominal interest between foreign and home countries. For example, when the rate of interest in the USA was assumed to be at 8 percent and that of the UK at 4%, then the interest rate of the US can be reduced to 6%. The rate of foreign exchange would adopt similar movements.
Monitoring changes of future for the current spot exchange due to an increase or decrease in the rates of nominal interest assist in making decisions on investment matters. Consequently, investors get in a position where they are capable of mitigating risks that come from fluctuations of foreign currencies. For that matter, future and current nominal rates are forming the foundation predicting current and future movements of currency and spots. Unlike IFE, which is deemed to be independent, derivatives depend on the underlying assets like stock. In the exact sense of the word, the derivative values are driven through fundamental assets.
The IFE and PPP hold postulation that rates of exchange and adjustments automatically get equalized. Consequently, derivatives are applicable in case of speculations and obstinate arbitrage in which investors do exploitation of differential prices. Besides, both International Fisher Effects and Purchasing Power Parity undertake their operational marketplaces inefficiently (Kallianiotis, 2015). For that matter, there exists no need for derivatives since each investor shall be holding important information about an investment available which drives movements on exchange rates.
Evaluate the differing ways in which derivatives can protect against the failings of IFE and PPP
International Fisher Effects and Purchase Power Parity have their arguments anchored on assumptions that have been outlining above. In the short term, the theories often portray errors that, when depended on, would misinform customers in the decision making about the investments. So, the two theories can operate within an environment of exchange rate volatility. Within various states where exchange volatility becomes higher, there are calls to utilize derivatives when it comes to mitigating risks, which can arise due to exchange rate volatilities. For that matter, developing states whose key trades entail exporting and importing are possibly going to experience recurrent swings on the movements of exchange rates. As indicated by MacDonald (2008), there would subsequently need hedging in safeguarding investors from losses that arise from trading in multiple currencies apart from that of home states.
International Fisher Effect and Purchasing Power Parity state that in the long-run, contrary to the short term measures, multiple frequent swings would be experienced. These recurrent swings clear way profits as well as gains which a business might experience. Therefore, derivative applications become quite imperative when it comes to alleviating and hedging possible losses, which have been accessioned exchange rate fluctuations. IFE, which hinges heavily on the fluctuation of interest rates to emphasize the movements of exchange rates, might never hold when interest rates are volatile. IFE theory is used by various developing states borrowing loans for development from the IMF and World Bank.
In several cases, the loans borrowed from the IMF and World Bank get determined in US dollars. For that matter, when the home currency for the country that is borrowing differs from the US dollars, then in case of an increment in the rate of interest as backed by IFE would bring about exchange rate swings. In various instances, the country which is borrowing for a development loan shall expensively repay the loan. In such a case, they are supposed to get means through which they can cushion themselves from such prospects. If there are changes in US federal rates, then the home country currency is likely going to be weaker hence likely to depreciate against the US dollars. As the International Fisher Effect lack possible remedies within the short run, the involved states have to look for strategies of mitigating such risks like the use of derivatives. By using swaps, forward rates and options would ensure that the home country borrowing gets cushioned against fluctuations in the exchange rates of currencies. Thus, it would make loan servicing to be inexpensive, as explained by Pirie (2017). Additionally, at times of political turbulences within countries that are developing. Several investors make decisions of withdrawing their investments within such states as a result of fear of making massive losses in return. Essentially, withdrawing investments impacts home currency strengths. Home currency depreciation makes operations of the business to be expensive (Shaik, 2014). As a result, the local businesses doing their borrowing do so expensively. For that matter, to cushion such repercussions, firms could utilize derivatives in eradicating prospective risks, which might be experienced due to the local currency depreciation. Businesses borrowing through the use of foreign currencies might enter into forward contracts with various lending institutions. Thus, this is likely going to hedge opportunities of incurring losses which crop due to interest rate changes. In such instances, IFE might never bear predictable pattern concerning movements of future currency as outline by Kallianiotis (2015)
PPP has shortcomings like it does not put into consideration other factors that impact the country’s exports and imports. These factors may incorporate government restrictions on doing businesses that vary from one state to the other. There could similarly be limitations involving currency exchange rates within different countries. Besides, the fluctuation in future currency becomes affected through other elements in addition to marketplace imperfections. Factors such as supply and demand for foreign currencies within home states have an impact on the fluctuations of foreign currency. The derivatives take into considerations all these factors. They can be used in accurately determining the movements of future exchange rates, thus leading to the mitigation of possible risks that can be experienced (MacDonald, 2008).
The calculations of PPP are done using samples of commodities that have been chosen. Thus, the attained figure is not a representation of actual positions. Therefore, to some extent, by adopting the use of PPP, investors get misinformation concerning exchange movements of the future currency. Then again, derivatives aim to increase returns on investments via risk exposure reduction. As a result of PPP and IFE uncertainties, there are possibilities of rising chances of arbitrage. Such opportunities encourage conscientious investors to exploit their positions in the market to gain maximum profits (Shaik, 2014). The use of derivatives within such scenarios eradicates exploitation tendencies hence leading to an appropriate predictor of exchange movements for future currencies. Thus, this tendency acts like a market efficiency booster.
Conclusion
International Fisher Effect, Purchase Power Parity, and derivatives are essential in mitigating businesses from being exposed to risk coming as a result of the movement of currency exchanges. Consequently, firms should use both derivatives and theories to forecast price movements accurately in the future. The movements witnessed in prices can either have an impact on business operations negatively or positively. As indicated within the paper, there are cases where IFE and PPP applications eradicate the need to use derivatives. Then again, using derivatives assist in bridging the gap in the case the two theories fail to provide appropriate outcomes.
References
Eun, C. S., & Resnick, B. G. (2010). International Financial Mgmt 4E. Tata McGraw-Hill Education.
Kallianiotis, I., 2015. International financial transactions and exchange rates: trade, investment, and parities. Place of publication not identified: Palgrave Macmillan.
MacDonald, R., 2008. Exchange rate economics theories and evidence. London: Routledge.
Madura, J. (2020). International financial management. Cengage Learning.
Pirie, W. L., 2017. Derivatives. Hoboken, NJ: John Wiley & Sons, Inc.
Shaik, K., 2014. Managing Derivatives Contracts A Guide to Derivatives Market Structure, Contract Life Cycle, Operations, and Systems. Berkeley, CA: Apress