QS1: DISCUSS THE PRACTICAL VALUE OF THE PPP THEORY TO MANAGERS OF MULTI-NATIONAL CORPORATIONS.

The Purchasing Power Parity theory (PPP) relates the exchange rate between any two currencies to the relative price levels in the respective countries. The repercussion is that a country with inflation higher than that of her trading partners will tend to have a disparaging currency. Though at times PPP has often failed to stand empirical tests and its theoretical content of exchange rate determination has been questioned, it has continued to be prevalent in macroeconomic models. PPP is still implicit and also explicit in many models of exchange rate determination, and is also used as a measure of openness of an economy in macroeconomic models. On the policy front, PPP-based benchmarks have been used to assess levels of exchange rates in a bid to establish the need, extent and the direction of adjustment. As illustrated above, the principle of PPP is that the price levels in the respective Countries have an impact on the exchange rate between two currencies. The contemporary theory of the PPP is attributed to Cassel who developed and promoted the experimental version in 1920(Rogoff1996). The Purchasing Power Parity theory is propounded on the basis of the law of one price (LOP). The law posits that once converted to a common currency, the same good should be available for the same price in different countries. In other words, for any good i, Pi = SPi Where, Pi is the domestic price for good i, Pi* is the foreign price for good i, and S is the domestic nominal exchange rate . The LOP assumes that there is perfect competition, there are no tariff or other trade barriers, and no transportation costs but in practice this does not happen due to the existence of trade barriers and transportation costs that drive a wedge between prices in different countries, the law cannot hold accurately (Rogoff, 1996; Froot and Rogoff, 1995).

On the other hand, the Absolute purchasing power parity (APPP) is a generalisation of the law of one price. It proposes that given the same currency, a basket of goods will cost the same in any country. Formally,

P = SP* thus; S= p/p* Where, P and P* are the prices of the identical basket of goods in the domestic and Foreign countries respectively, and S is the exchange rate, or the domestic currency Price of foreign currency. It is easy to see the intuition behind the PPP theory and why in practice it may not appear to hold. One way of avoiding the obstacles that make it impossible for PPP to hold in its absolute version is to resort to the rate of change of both the exchange rates and the national price levels. Despite transport costs and other trade barriers, the change in the exchange rate between two countries currencies is likely to be influenced by the change in the price level of one country relative to the other countrys price level, if indeed PPP is plausible. It is in this context that Relative Purchasing Power Parity, RPPP, another version of PPP was introduced. It states that the rate of growth in the exchange rate offsets the differential between the rate of growth in home and foreign price indices. Formally, this is represented by, P =S.P *. To a certain level, economists have tried to find a weakness in the practice of PPP introduced in studies and have held onto the new developments in testing the accuracy of PPP practice. The first approach that was used was based on a test conducted on the APPP and RPPP where the following two equations were used st = 0+ 1(pt- pt )* + ut

Where S is the nominal exchange rate, P and P* foreign price level and t represents time. According to Frenkel (1981), this approach was employed in hyperinflationary countries in the 1920s with outcomes that supported PPP. On the other hand, the efforts to apply the same approach proved abortive in the Bretton woods era as the theory was rejected. The short comings of this approach is attributed to modern time series techniques, as the equations above involve the use of equations which should have been tested for stationarity in the variables and cointegration analysis. Also, PPP does not outline a direction between the exchange rate and the price level as illustrated in the simulations above and as such any choice of dependent variable will be random and liable to bias. The second approach for testing the PPP theory is built on the following premise; which for various reasons states that the exchange rates fluctuate more than the price levels. Due to this, PPP can hardly hold at any particular instance. The only way that PPP can prove to hold is in its long-run behaviour. This will be manifested by a tendency of a fluctuating exchange rate reverting towards a constant mean. Where the exchange rate is defined as: e= The experiment for PPP can be done indirectly; by testing the mean reversion of the real exchange rate. If the real exchange rate exhibits mean reversion, then we cannot reject the PPP hypothesis. If, on the other hand, the real exchange rate does not exhibit mean reversion, it means that it is not stationary. In this case, PPP is rejected. Given the theories assertion that exchange rates in the long run will move ensure that the purchasing power of currencies are aligned, the theory, if it holds, can give managers useful insights on the likely long run performance of various currencies and this information would be extremely useful in certain long term investment decisions. For example if the difference between the exchange rate as currently derived from PPP and the actual current exchange rate observed in the market suggest that a currency is overvalued, then management would know that an

investment in that currency at this stage would not be such a wise idea. The reverse to this is also clearly true. One other area in which PPP is useful to multinational companies is in assessing compensation packages for employees at similar levels within the company but who work in different countries. A useful example is the situation in which a company, like McKinsey & Company, employs two Harvard Business School graduates: one into their Johannesburg office and the other into their New York office. In this case, the PPP framework provides a useful tool through which the company can set the compensation levels of the two graduates given that they are living in different countries and will have differing costs of living. The tool will ensure that although the nominal salaries may differ, the purchasing power of their salaries would be comparable. Other entities, including governments, would also be able to make better policy decisions if they had a better sense of the long term Performance of their currencies as predicted by the theory of PPP. Furthermore, multinationals have substantial amount of excess cash which is available for a short time period which will exhibit a high interest rate and strengthen in value over the investment period. An example is Lafayette and co which has excess cash and is deciding whether to deposit the cash into a British bank account. If the appreciates against the dollar by the end of the deposit period when the will be exchanged for US dollars more dollars will be received. Therefore, the firm can use forecasts from the pounds exchange rate when deciding whether to invest the short term cash in a British or US account (Madura, 2006:267). It is also valuable to Managers in terms of capital budgeting where MNCs assess whether to invest in funds in a foreign project, which may periodically require the exchange of currencies. Analysis of capital budgeting can only be completed when all estimated cash flows are measured in the parents local currency. For instance, Evansville Co is thinking of creating a subsidiary in Thailand. Forecast of the future cash flows used in the capital budgeting process will be reliant on the future exchange rate of Thailand against the dollar which could be as a result of future inflows denominated in Baht which will require conversion to dollars or the influence of future exchange rates on demand for the subsidiaries product (ibid).

Multinationals continually face the decision of either hedging future payables or receivables in foreign currencies. Laredo Co. based in the US plans to pay for clothing imported from Mexico in 90 days. If the estimated 90 days is appropriately below the 90 day forward rate, the company may choose not to hedge in order to reduce the risk in price movement.

QUESTION2: THE EXPECTATION HYPOTHESIS SUGGESTS THAT THE FORWARD RATE IS A VALID PREDICTOR OF THE FUTURE SPOT RATE (E.G. THE SUGGESTION IS THAT A 90 DAY GBP/EUR FORWARD RATE IS A VALID PREDICTOR OF THE GBP/EUR SPOT RATE IN 90 DAYS TIME). USING APPROPRIATE EVIDENCE, DISCUSS WHETHER THIS SUGGESTION IS TRUE. The expectations theory articulated by Fisher (1930), Keynes (1930) and Hicks (1953) provides a good explanation of the determination of long term interest rates and this theory states that long-term interest rates are determined by the expectations on the future short-term interest rate. According to the expectations hypothesis theory (EHT) of the term structure forward rates are useful predictors of future spot interest rates. Fama (1984) discovered that forward rates can predict spot rates one month ahead. However, most of the experimental evidence suggests that the relationship between forward rates and expected returns is stronger than the relation between forward rates and future spot rates. On the other hand, Davis (2000) provides an update of Famas (1984) results, showing that there is more information in the term structure about expected returns than there is about future interest rates. This means that forward interest rates cannot predict future interest rates but may provide information on expected returns of fixed income instruments.