Purchasing Power Parity and Arbitrage Purchasing Power Parity: "is an economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power".(1)
PPP is calculated using the formula: S=P1/P2
S= the exchange rate between currency 1 and currency 2
P1= cost of good x in currency 1
P2= cost of good x in currency 2
e.g Escalade in Canada = 80210, in US= 63170, to check if they are at ppp; 80210/63170 = 1.27 (canada/us are not at ppp) Arbitrage can make profit from the discrepancy in this two currency value. Arbitrage causes purchasing power to equalize.
Arbitrage: "is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time."(2)
Arbitrage is a concept best explained with an example. Lets assume that in the USA it costs $50,000 to buy a new BMW, but for the exact same care it is $100,000 in Canada. With the current exchange rates at nearly par this is most definitely not at purchasing power parity. In this situation people would go across the boarder to buy the car, bring is pack, and sell it for a profit at $75,000. With enough people doing this it would eventually raise the US price because of the increased demand while lowering the Canadian price due to decreased demand.(3)
Purchasing Power Parity: "is an economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power".(1)
PPP is calculated using the formula: S=P1/P2
S= the exchange rate between currency 1 and currency 2
P1= cost of good x in currency 1
P2= cost of good x in currency 2
e.g Escalade in Canada = 80210, in US= 63170, to check if they are at ppp; 80210/63170 = 1.27 (canada/us are not at ppp) Arbitrage can make profit from the discrepancy in this two currency value. Arbitrage causes purchasing power to equalize.
Arbitrage: "is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time."(2)
Arbitrage is a concept best explained with an example. Lets assume that in the USA it costs $50,000 to buy a new BMW, but for the exact same care it is $100,000 in Canada. With the current exchange rates at nearly par this is most definitely not at purchasing power parity. In this situation people would go across the boarder to buy the car, bring is pack, and sell it for a profit at $75,000. With enough people doing this it would eventually raise the US price because of the increased demand while lowering the Canadian price due to decreased demand.(3)
Endnotes:
(1) "Purchasing Power Parity", www.investopedia.com, accessed April 13, 2012,
http://www.investopedia.com/terms/p/ppp.asp#axzz1ru24v71l.
(2) "Arbitrage", www.investopedia.com, accessed April 13,2012,
http://www.investopedia.com/terms/a/arbitrage.asp#axzz1ru24v71l.
(3) Dr. Stephanie Powers, "Exchange rate", Intro to Macroeconomics.(Lecture, Donald School of Business, Red Deer Alberta, Winter 2012)