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 iss

Answer 1

The second argument.The theory of purchase power parity states that the purchasing power of an individual will remain the same regardless of where the place of the purchase(home or foreign country)is.The theory assumes that the exchange rate will adjust to ensure the purchasing power parity in the event of inflation in one country.PPP states that the currency of a country with higher inflation will depreciate.As a result the earnings they post will be inflated and thereby will offset the exchange rate difference.So the deviations from Purchase Power parity will offset in the long run.This does hold true for the long run.But not all investors make investments for a longer period of time.Some investors may make make investments for a shorter period of time.Such investors would prefer the management of the firm to take steps that would mitigate the exchange rate risk subsequent to evaluating it, rather than waiting for it's effects to be offset in the long run.