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 domain of international finance

The concept of purchasing power parity (PPP) finds an instrumental place as a subject
in the domain of international finance. The most elemental assumption underpinning the
concept of PPP is that the prices in different countries for a standardized basket of goods
must be equal when expressed in terms of same currency. The in-principle idea anchoring
this long-run theory is differences in domestic and foreign currencies serve as a determinant
of the cross-country exchange rates. This implies that for any two given countries,
equilibrium exchange rate condition is satisfied when the purchasing power remains same in
both countries (Rogoff, 1996).

Literature Review

Historical Perspective on Purchasing Power Parity

The origins of purchasing power parity can be traced back to the then burning
question as to how to restore the financial system of the world post World-War I era. Pre-war
era operated on gold standards wherein the currencies of countries were convertible to gold
following fixed parities. Cross-currency exchange rate then, in the simplest terms, reflected
their comparative gold values. However, in the aftermath of world war, speculators thought
that countries would devalue their currencies for want of seigniorage revenues and soon gold
system was abolished which posited an incumbent need to reset the exchange rates in a
manner that would cause minimal disruption to government finances and prices. Since,
inflation had substantially altered prices during the period of was, continuing with the pre-
war exchange rates was not feasible without disrupting prices (Rogoff, 1996).
Gustav Cassel (1921) a Swedish economist professed the use of purchasing power
parity as means of settling gold parities through determination of cross-country exchange
rates needed to achieve and maintain PPP. His fundamental proposition was to compute

cumulative inflation rates since 1914 to arrive at inflation differential which could then be
utilised towards arriving at exchange rates (Cassel, 1921).
Synthesis of Purchasing Power Parity

The theory takes into account the possibility of short-term deviations in the exchange
rates between the countries which forays a possibility of arbitrage in cross-country
commodity market. Market participants exploiting this arbitrage opportunity forces the
exchange rates to move in the direction of PPP equilibrium which exhausts any existing
arbitrage. Policymakers and market participants rely on the assumption that parity in
purchasing power holds to enable them study/predict the behaviour of exchange rates in the
long-run (Arize, Malindretos, and Ghosh, 2015).
PPP also finds its application in the foreign exchange rate market where financial
authorities depend on it to probe evidence in support of undervaluation or overvaluation of
exchange rate relative to equilibrium value as indicated by PPP. Additionally, financial
analysts invariably rely on PPP as a measure of policy analysis to achieve comparison of real
purchasing power among countries. PPP also finds practical application where the level of
trade integration between countries or bilateral or multilateral trade agreements and
liberalization is the locus standi of policymakers (Arize, Malindretos, & Nippani, 2004).
Due to the conspicuous and still unclear relationship between the PPP and the real
exchange rates for lack of sufficient empirical evidence, PPP has ever since been a stock of
frequent empirical studies that has led to accretion of enormous amounts of literature
available today. An increasing number of past studies provide empirical evidence at least to
the effect that real exchange rates (RER) converge towards purchasing power parity in the
very long run. Real exchange rates are arrived at post adjusting the nominal exchange rates
for differences in the levels of national prices. Such differences arise due to differing levels of

inflation as also several other factors. RER reflects higher deviations and volatility from PPP
in the shorter run (Taylor, 2003).
Past studies concertedly echo the fact that speed at which RER converges to PPP is
rather very slow and the deviations of RER from PPP damp out at the rate of 15 % per year
with a half-life of 3-5 years. As a matter of fact, the magnitude of monthly real exchange rate
conditional volatility (the volatility of deviations from PPP) is of same order to that of
conditional volatility of nominal exchange rates. Even in case of a homogenous basket of
goods, price differential volatility tends to large.

Aims of Study

The intent of this study is to provide a synthesis of past literature available in
connection with PPP as also empirical testing of data and its applicability in determination of
real exchange rates in the longer run. The subsequent section will detail the historical origins
of PPP along with the rationale for its relevance in determination of exchange rates which is a
management function in proprietary trading firms so and such an analysis enables the firm to
assume appropriate positions LONG or SHORT in the futures market.

Research Problem and Methodology

The research problem can defined as “whether real-exchange rates converge to
purchasing power parity in the long-run or not”.
As for the methodology, the study endeavours to probe for empirical evidence in
support of the research problem through systematic statistical testing of historical time series
data of exchange rates. This study is by its very nature is desk research which involves data
collection from published secondary sources of information. Also, since it is endeavoured to
probe for empirical evidence to the effect of afore-stated research problem, qualitative data