CFM12090 - Understanding corporate finance: foreign exchange: purchasing power parity and hyperinflationary currencies

What influences exchange rates: purchasing power parity

How do the markets determine at what particular spot rate a currency will trade?

One hypothesis is ‘purchasing power parity’. For example, suppose that the same CD can be bought in the UK for £8 and in the USA for $12. It seems reasonable to believe that £8 should be equal in value to $12 (or £1 to $1.50). If the £/US $ exchange rate deviates from this level, consumers would rush to buy CDs in the cheaper country (perhaps over the internet), thus exerting pressure to return the exchange rate to its equilibrium level.

Experience tells us that purchasing power parity, at least in this simple form, rarely works. People and companies take factors other than relative prices into account when deciding where to buy goods and services. The costs, risks and feasibility of making the purchase in an overseas territory, indirect taxes such as VAT, and import duties all enter the equation.

Hyperinflationary currencies

In very general terms, however, it does tend to be case that ‘hyperinflationary’ currencies, that is to say the currencies of countries with a high rate of inflation, will have a currency that depreciates in value compared to that of a currency with stable and modest rates of inflation. This is particularly the case over the longer term.

For instance, persistent hyperinflation in Argentina had a massive impact on the value of the Argentina Peso relative to the US dollar over an entire century. At the end of 1917 one US dollar was equivalent to about 2.1 Argentine pesos. At the end of 2017 one US dollar was equivalent to about 18 pesos, but the definition of the Peso changed several time during the century such that one 2017 peso was the equivalent of 10,000,000,000,000 1917 pesos, so over the century, the relative value of the Argentine currency had been reduced by a factor exceeding 100 trillion - a fall in value averaging more than 30% per year. Interest rates for Argentine Peso borrowing have tended to be correspondingly high.

But, small differences in expected inflation are not reliable predictors of future spot exchange rate movements, nor do they in any direct sense determine forward exchange rates. The ‘random walk’ of the spot rate in response to economic and political news and other factors affecting market sentiment can swamp any systematic trend.