9.

14 STRATEGIC FINANCIAL MANAGEMENT

PF = is the price level in the foreign market, the US in this case.

α = Sectoral price and sectoral shares constant.
For example, A cricket bat sells for ` 1000 in India. The transportation cost of one bat from
Ludhiana to New York costs ` 100 and the import duty levied by the US on cricket bats is
` 200 per bat. Then the sectoral constant for adjustment would be 1000/1300 = 0.7692.
It becomes extremely messy if one were to deal with millions of products and millions of constants.
One way to overcome this is to use a weighted basket of goods in the two countries represented
by an index such as Consumer Price Index. However, even this could break down because the
basket of goods consumed in a country like Finland would vary with the consumption pattern in a
country such as Malaysia making the aggregation an extremely complicated exercise.
The RELATIVE FORM of the Purchasing Power Parity tries to overcome the problems of market
imperfections and consumption patterns between different countries. A simple explanation of the
Relative Purchase Power Parity is given below:
Assume the current exchange rate between INR and USD is ` 50 / $1. The inflation rates are 12%
in India and 4% in the US. Therefore, a basket of goods in India, let us say costing now ` 50 will
cost one year hence ` 50 x 1.12 = ` 56.00.A similar basket of goods in the US will cost USD 1.04
one year from now. If PPP holds, the exchange rate between USD and INR, one year hence,
would be ` 56.00 = $1.04. This means, the exchange rate would be ` 53.8462 / $1, one year from
now. This can also be worked backwards to say what should have been the exchange rate one
year before, taking into account the inflation rates during last year and the current spot rate.
Expected spot rate = Current Spot Rate x expected difference in inflation rates
(1 + Id )
E(S1) = S0 x
(1 + 1f )
Where
E(S1) is the expected Spot rate in time period 1
S0 is the current spot rate (Direct Quote)
Id is the inflation in the domestic country (home country)
If is the inflation in the foreign country
According to Relative PPP, any differential exchange rate to the one propounded by the theory is
the ‘real appreciation’ or ‘real depreciation’ of one currency over the other. For example, if the
exchange rate between INR and USD one year ago was ` 45.00. If the rates of inflation in India
and USA during the last one year were 10% and 2% respectively, the spot exchange rate between
the two currencies today should be
S0 = 45.00 x (1+10%)/(1+2%) = ` 48.53

© The Institute of Chartered Accountants of India