Does PPP Eliminate Concerns about Long-Term Exchange Rate Risk? POINT: Yes. Stud

Question

Does PPP Eliminate Concerns about Long-Term Exchange Rate Risk?

POINT: Yes. Studies have shown that exchange rate movements are related to inflation differentials in the long run. Based on PPP, the currency of a high-inflation country will depreciate against the dollar. A subsidiary in that country should generate inflated revenue from the inflation, which will help offset the adverse exchange effects when its earnings are remitted to the parent. If a firm is focused on long-term performance, the deviations from PPP will offset over time. In some years, the exchange rate effects may exceed the inflation effects, and in other years the inflation effects will exceed the exchange rate effects. COUNTER-POINT: No. Even if the relationship between inflation and exchange rate effects is consistent, this does not guarantee that the effects on the firm will be offsetting. A subsidiary in a high-inflation country will not necessarily be able to adjust its price level to keep up with the increased costs of doing business there. The effects vary with each MNC’s situation. Even if the subsidiary can raise its prices to match the rising costs, there are short-term deviations from PPP. The investors who invest in an MNC’s stock may be concerned about short-term deviations from PPP, because they will not necessarily hold the stock for the long term. Thus, investors may prefer that firms manage in a manner that reduces the volatility in their performance in short-run and long-run periods. WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

Explanation / Answer

Solution:

According to me PPP Eliminate Concerns about Long-Term Exchange Rate Risk. So I would go for the statement.

It may be possible that inflation and exchange rate effects might balance in long run. However, many investors might not be satisfied because they will not invest in the firm for long term. They may invest for shorter period. In which case they would be prefer that the MNCs would assess the exposure which they will face to exchange rate risk and attempt to limit the risk. According to the PPP Principle, the currency of a country will depreciate in relation to the currency of another country on the basis of inconsistency in the rates of inflation between them. The rate of depreciation in the currency of a country would roughly be equal to the excess inflation rate in the country over the other country. This theory maintains that free international trade even out the prices of tradable goods in different countries. So, a product will sell for the same price in common currency in all countries. Different rates of changes in prices i.e. different inflation rates must eventually encourage off-setting changes in exchange rates in order to restore approximate price equality. If we try to understand it mathematically, the rate (or the expected rate) of change of the exchange rate should equal the rate (or the expected rate) of change of the inflation rate. Evidence shows that there do exist disparities between changes in observed exchange rates and those in inflation rates in the short-run. But, the theory should hold in the long-run.

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