International Finance

Purchasing Power Parity (PPP):  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. That is, in some years the exchange rate effects may exceed the inflation effects, whereas 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 will vary with each MNCs situation. Even if the subsidiary can raise its prices to match the rising costs, short-term deviations from PPP may occur. The investors who invest in an MNCs 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 their operations in a manner that reduces the volatility in their performance in short-run and long-run periods.
 
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