2016-ag-514 M.COM (4TH SMESTER) ASSIGNMENT 2 (INTERNATIONAL FINANCE) AGRICULTURE UNI FAISALABAD QUESTION 1 IN WHAT SENSE IS PURCHASING POWER PARITY RELEVENT TO THE BUSSINESS OPERATIONS Macroeconomic analysis relies on several different metrics to compare economic productivity and standards of living between countries and across time. One popular metric is purchasing power parity (PPP). HYPERLINK https//www.investopedia.com/video/play/purchasing-power-parity-ppp/ Purchasing power parity(PPP) is an economic theory that compares different countries currencies through a basket of goods approach. According to this concept, two currencies are in equilibrium or at par when abasket of goods (taking into account the exchange rate) is priced the same in both countries How to Calculate Purchasing Power Parity The relative version of PPP is calculated with the following formula INCLUDEPICTURE https//lh6.googleusercontent.com/d0uqII6g8QrBnJuRVYBqcwdwJqkPRW2cr64U5-bkmmOs6eu0NOcSp4IHLFC2SpUU5kavFtOXDrjOHIHGr6jvne52LrrExZvTv6z9HuKak2jcT9KcTPd91DVb1RBONT7_auggni5TcY6LqA05ng MERGEFORMATINET Where Srepresents HYPERLINK https//www.investopedia.com/terms/e/exchangerate.asp exchange rateof currency 1 to currency 2 P1represents the cost of good xin currency 1 P2represents the cost of good xin currency 2 P2represents the cost of good xin currency 2 How PPP Is Used To make a comparison of prices across countries that hold any type of meaning, a wide range of goods and services must be considered. The amount of data that must be collectedand the complexity of drawing comparisons make this process difficult. To facilitate this, the International Comparisons Program (ICP) was established in 1968 by the University of Pennsylvania and the HYPERLINK https//www.investopedia.com/terms/u/united-nations-un.asp United Nations. Purchasing power parities generated by the ICP are based on a worldwide price survey comparingthe prices of hundreds of various goods. This data, in turn, helps international macroeconomists come up with estimates of global productivity and growth. HighestPurchasing Power The five nations with the highest GDP in market exchange terms are the U.S., China, India, Japanand Germany. This comparison changes when PPP is used. According to 2017data from the International Monetary Fund (IMF), China has overtaken the U.S. as the worlds largest economy based on purchasing power with 23,122 billion current international dollars. The U.S. comes in second with 19,362 billion. India, Japanand Germany follow with 9,447 billion, 5,405 billion, and 4,150 billion,respectively. QUESTION 2 What is interest parity Interest rate parity is a theory in which the HYPERLINK https//www.investopedia.com/terms/i/interest-rate-differential.asp interest rate differentialbetween two countries is equal to the differential between the forward HYPERLINK https//www.investopedia.com/terms/e/exchangerate.asp exchange rateand the HYPERLINK https//www.investopedia.com/terms/s/spotexchangerate.asp spot exchange rate. Interest rate parity plays an essential role in HYPERLINK https//www.investopedia.com/terms/forex/f/foreign-exchange-markets.asp foreign exchange markets, connecting interest rates, spot exchange rates and foreign exchange rates. BREAKING DOWN Interest Rate Parity If one country offers a higher risk-free rate of return in one currency than that of another, the country that offers the higher risk-free rate of return will be exchanged at a more expensive future price than the current spot price. In other words, the interest rate parity presents an idea that there is no arbitrage in the foreign exchange markets. Investors cannot lock in the current exchange rate in one currency for a lower price and then purchase another currency from a country offering a higher interest rate. Covered vs. Uncovered Interest Rate Parity The interest rate parity is said to be covered when the no-arbitrage condition could be satisfied through the use of forward contracts in an attempt to hedge against foreign exchange risk. Conversely, the interest rate parity is said to be uncovered when the no-arbitrage condition could be satisfied without the use of forward contracts to hedge against foreign exchange risk. Options of Converting Currencies The relationship can be seen in the two methods an investor may take to convert foreign currency into U.S. dollars. One option an investor may take would be to invest the foreign currency locally at the foreign risk-free rate for a specific time period. The investor would then simultaneously enter into a HYPERLINK https//www.investopedia.com/terms/f/fra.asp forward rate agreementto convert the proceeds from the investment into U.S. dollars, using a forward exchange rate, at the end of the investing period. The second option would be to convert the foreign currency to U.S. dollars at the spot exchange rate, then invest the dollars for the same amount of time as in option A, at the local (U.S.) risk-free rate. When no HYPERLINK https//www.investopedia.com/terms/a/arbitrage.asp arbitrageopportunities exist, the HYPERLINK https//www.investopedia.com/terms/c/cashflow.asp cash flowsfrom both options are equal. Covered Interest Rate Parity Example For example, assume Australian Treasury bills are offering an annual interest rate of 1.75, while U.S. Treasury bills are offering an annual interest rate of 0.5. If an investor in the United States seeks to take advantage of the interest rates in Australia, the investor would have to translate U.S. dollars to Australian dollars to purchase the Treasury bill. Thereafter, the investor would have to sell a one-year forward contract on the Australian dollar. However, under the covered interest rate parity, the transaction would only have a return of 0.5, or else the no-arbitrage condition would be violated. QUESTION 3 What is arbitrage in foreign exchange market Definition Arbitrageis the process of a simultaneous sale and purchase of currencies in two or more foreign exchange markets with an objective to make profits by capitalizing on theexchange-rate differentialsin various markets. The arbitrage opportunities exist due to theinefficiencies of the market. While dealing in the arbitrage trade, an individual can make profits only out of price differences of similar or identical financial instruments traded on different exchange markets. Thus, theprice differential is captured as a trades net payoff.This payoff should be large enough to cover the expenses incurred in executing the trade. For exampleSuppose the stock of company A is trading at Rest 2000 on BSE while the same stock is trading on NSE at Rest 2500. A trader can earn a profit of Rest 500 by buying the stock on BSE and immediately selling the same shares on NSE. This arbitrage opportunity can be availed until BSE runs out of shares of company A or until BSE and NSE adjusts the price differences so as to wipe out the arbitraging opportunity. The importance of arbitrage lies in its ability to correspond foreign exchange rates in all the major foreign exchange markets. The arbitraging involves the transfer of foreign exchange from the market with a lower exchange rate to the market with a higher exchange rate. Hence, arbitraging equates the demand for foreign exchange with its supply, thereby acting as a stabilizing factor in the exchange markets. The arbitrage opportunity can be availed only where the foreign exchange isfree from controls, and if any, controls should be of limited significance. If the sale and purchase of foreign exchange are under severe control and regulation, then the arbitrage is not possible. Practically, the arbitrage opportunity exists for avery brief periodsince in the mature markets the most of the trading has been taken bytealgorithm-based trading(a trading system that relies heavily on mathematical formulas and computer programs to determine the trading strategies).These algorithm-based trading is quick to spot and is quite easy for a trader to keep track..