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Fin-O-Pedia: Know Your Basics: Purchasing Power Parity
Fin-O-Pedia: Know Your Basics: Purchasing Power Parity
FIN-O-PEDIA
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Where: "S" represents exchange rate of currency 1 to currency 2 "P1" represents the cost of good "x" in currency 1 "P2" represents the cost of good "x" in currency 2
Example: A chocolate bar that sells for C$1.50 in a Canadian city should cost US$1.00 in a U.S. city when the exchange rate between Canada and the U.S. is 1.50 USD/CDN. (Both chocolate bars cost US$1.00.)
Relevance of PPP: The concept of PPP is useful in comparing quality or standard of living in different countries which may not be possible if one just looked at per capita income. A lower income may allow a good quality of life in a country of prices is low. For instance, a haircut may cost lot more in London than in Delhi. The major shortcoming of PPP exchange rates is that these are difficult to measure.
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Example: Suppose Bob holds a 10-year bond issued by company XYZ with a par value of $1,000 and a coupon interest amount of $100 each year. Fearful that XYZ will default on its bond obligations, Bob enters into a CDS with Steve and agrees to pay him income payments of $20 (similar to an insurance premium) each year commensurate with the annual interest payments on the bond. In return, Steve agrees to pay Bob the $1,000 par value of the bond in addition to any remaining interest on the bond ($100 multiplied by the number of years remaining). If XYZ fulfils its obligation on the bond through maturity after 10 years, Steve will make a profit on the annual $20 payments. Why it matters? A credit default swap protects bondholders and lenders against the risk that the borrower will default. The lender's insuring counterparty takes on this risk in return for income payments. In this respect it is important for the insuring counterparty to fully assess the swap's risk/return feature to ensure it is receiving fair compensation vis--vis the level of risk.
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