Purchasing Power Parity-Pros And Cons
How does the price of a cup of coffee in two different countries affect the Forex market? One way to respond to this is by exploring the concept of a basket of goods, a commonly used microeconomics metric also known as the purchasing power of parity. Today we will discover everything you need to know about PPP-based currency trading.
What is the purchasing power of parity
The purchasing power parity was originally designed as an attempt to find a unified unit of measurement to compare currency values around the world. The initial concept focused on the idea that a collection of similar retail items should cost the same amount of money everywhere in the world. This way, essentially, if a person from London were shopping with the same shopping list as someone in Tokyo, they would end up spending an equivalent amount in their local currency.
However, this theory really did not live up to expectations. Mainly because the amount of data to be considered was overwhelmingly difficult to organize. To simplify the process, the United Nations together with the University of Pennsylvania established the international comparison program (ICP). ICP’s main goal is to build a unified power purchasing parity portfolio by surveying the costs of hundreds of diverse services and goods.
Once every three years, the report is published by the World Bank, in which the growth and productivity of all countries are assessed against their purchasing power. The IMF (International Monetary Fund) and the OECD (Organization for Economic Cooperation and development) use PPA metrics to forecast and recommend economic policies. Policy recommendations sometimes have a short – term but powerful effect on the foreign exchange market, making them an important factor to consider during the analysis.
Since the concept of purchasing power parity is based on the law of a price, the two are often confused. Let’s take a few moments defining the law of a price, to make sure that there is no more uncertainty.
The law of a price
A concept known as the law of a price dictates that a particular item sold in one country must cost the equivalent amount in local currency elsewhere in the world. This way, if we buy a pound of apples in New York for $ 2.50 and the USD / GBP rate is 0.7844 (or approximately 0.78), we should expect a pound of apples in London to cost £ 1.96.
However, if the actual price of a pound of apples is higher or lower, it creates a set of arbitrage opportunities. For example, if the price is lower in the United States, it would make sense to buy there in bulk and sell in the United Kingdom for profit. Such opportunities are running out quickly, as more and more entrepreneurs pick up a profitable idea. Eventually, this leads prices to match, which points to the law of a price in action.
Now, you might think that international Apple trading has very little to do with Forex currency trading. But in fact, there is a complete way to analyze the market based on similar principles. It’s called fundamental analysis.
Why purchasing power matters
How does a trader make decisions? You probably already know there’s no one-size-fits-all answer. Some approach the negotiation process as if it were a lottery and just guess their way through. Needless to say, this quickly results in a miserable failure. Forex, like any other market, is a complex mechanism that must be treated with respect and consideration.
Then, to better understand the overall complexity, operators adopted two main approaches: technical and fundamental. Technical analysis considers purely numerical factors: price, date, level, difference, etc. by studying the current chart and comparing it with similar charts of the past, a trader can predict several ways for the situation to unravel. Then, based on this prediction, the trading strategy is chosen or developed to benefit from the situation.
Now, the fundamental analysis is much more abstract. It involves studying and considering various trends in economics, politics and sociology. For example, the participation of an election can have a very noticeable effect on the way business decisions are made, depending on the expectations of the majority. In this way, if a particular party in power has a radical view on trade policies, it will ultimately reflect on its international relations, trade and, of course, the value of the national currency.
The task of any trader who considers fundamental factors is to reduce their outlook. It is impossible to keep a hand in the pulse of absolutely every government, company or organization in the world. In addition, not all governments, companies or organizations have the same importance of influence on Forex.
When choosing which factors to include in your own fundamental analysis, start by choosing one or two currency pairs to analyze. More than that, and your investigation could become complicated, contradictory and confusing. In addition, it should be known that the currencies it analyzes change under the pressure of fundamental factors. For example, while the US dollar is incredibly policy-driven, the Australian dollar fluctuates according to seasonal exports of goods.
Once you have your eyes on the particular pair, gather all the information you may need. This will include the list of institutions and companies that have the most effect on the selected currency, the times when the most trades and the geography of the traders involved in the process. You can use this foreign currency guide to get a general understanding.
From what we have covered so far, it can be concluded that PPP is a kind of child of both worlds. Because while the purchasing power of parity is expressed as a coefficient, which makes it a piece of technical data, it is the result of complex procedures, both external and Internal, in any specific government. In addition, PPA measures are constantly used by major institutions that dictate monetary value, such as the World Bank, the United Nations, the International Monetary Fund and the European Union. Understanding this can become a big asset later along the way when practicing purchasing power parity trading.
So far we know that purchasing power parity is an economic theory, which can be reduced to this: if a can of coke costs the same in New York and Berlin, we should essentially be able to exchange one can for another without any difference in value. And we also know that due to a variety of factors, such as employment rates, for example, this is not really a concept of work.
However, the mathematics behind power purchasing parity is incredibly useful for a set of trading and policy-making institutions, making it a solid decision-making tool for Forex traders. Before going into the details of purchasing parity power trading strategies, let’s first differentiate two types of PPP, which can be used both separately and as a combo.
Absolute purchasing power parity
Absolute parity purchasing power (appp) is basically the original PPP theory about two baskets of products from different countries that cost the same amount. Most of the time, this concept is linked to the exchange of any specific currency for USD. Going back to the example of buying apples, if we buy a pound for $ 2.50 in Los Angeles, theoretically the price will remain the equivalent of $ 2.50 in Sydney.
And if that’s not the case, according to theory, continuous arbitrage will eventually lead to two currency values balancing the way the pound of apples costs $ 2.50 everywhere. The problem with this approach is the disregard of several heavy factors such as inflation, consumer spending behavior, transportation costs, etc., which means that the real power of the currency is underrepresented.
Relative purchasing power parity
The relative purchasing power parity (rppp) solves this problem. While continuing to consider that two baskets of goods from different countries should cost the same amount, RPPP suggests that inflation plays an important role in the formation of foreign exchange rates. For example, if the annual inflation rate is 5%, it means that the same amount of money will be able to buy 5% less each new year.
Therefore, the purchasing power of relative parity takes this into consideration and simply includes inflation in the calculation process. The formula for APPP, which is dividing the cost of good X in currency a by the cost of good X in currency B, serves as the basis. The aforementioned division gives us the spot exchange rate, described by purchasing power parity.
And since the relative power purchase parity is essentially the estimate of how the spot rate will change under the influence of inflation, it can be calculated by dividing inflation a plus one by inflation B plus one, Squared by the required amount of periods and then multiplied by the spot exchange rate calculated through the formula
Big Mac Index
Economists have come up with a variety of ways to measure purchasing power parity, from the highly professional OECD comparative price index to something a little more fun, for example, The Big Mac Index.
The Big Mac Index is one of the most recognized ways to measure PPP and is based on the calculation of the amount of monetary units you will need to buy the famous fast food sandwich. This theory originated from McDonald’s unprecedented global reach of more than 34,000 locations in 118 countries. And since the burger is supposed to be the same in all countries, knowing its price in all countries we can successfully calculate the exchange rates.
It is worth noting that due to differences in the cost of ingredients, labor practices, etc., the price of the burger is still not an ideal representation of parity purchasing power. In addition, in some countries, Big Mac is not even the measuring point for the index, despite its name. In India, a predominantly Hindu Country, Meat burgers are not available, so a chicken burger serves as a substitute. However, it remains effective to some extent. Here’s an example.
Imagine that we want to compare the purchasing power of the pound sterling and the Canadian dollar, applying the Big Mac Index. In the second quarter of 2020, the cost of the sandwich in London was 3.19 GBP, and in Toronto-4.99 CAD. The implicit purchasing power of parity is reduced to 1.56, however, in reality the rate is actually 1.76. From which we conclude that the pound is overvalued against the Canadian dollar by 12.8%, which in the world of theory will lead to the proportional decrease in the value of the GBP.
PPP and GDP
Returning to the key factors used in the analysis of most major currency pairs, GDP (Gross Domestic Product) is often calculated taking into account parity purchasing power metrics. GDP is an important economic measure, as it reflects the aggregate value of services and goods produced by the country in question, over a specific period of time. These data ultimately serve as an indicator of economic growth and stability, which is then reflected in the value of the national currency. Each country has to collect and report its own data, which will then be compared with data from all other countries.
Another way to approach GDP in addition to using purchasing parity power is the so-called nominal GDP. This method is essentially a process of translating exchange rates into gross domestic product data. There are two main problems with this technique. First, nominal GDP does not explain volatility, which is a very common feature of most forex pairs. The fact that the currency fluctuates in value, no matter how dramatic, does not always change the standard of living in that country. This means that nominal GDP does not really show the country’s gross domestic product.
The second problem is that GDP only looks at the
How to use PPP in Forex Trading
Power purchase parity is commonly used by Forex traders as it can serve as an instrument for predicting the next price direction. It is worth noting that such predictions are mostly long-term as factors such as PPP do not tend to change dramatically overnight.
While traders actively use power purchase parity to analyze the market and determine possible entry and exit points for their operations, PPP should not be the only measurement tool involved. Any economic theory is first and foremost an idea that will not always be developed according to the textbook. That is why no matter how meticulously you approach fundamental analysis, it is always important to keep abreast of technical indicators. Because when the theory says that the price should rise, but the chart strongly suggests otherwise, it would be prudent to minimize the long positions, until the technical situation is reversed in their favor.
The most common approach to Trading Forex using power purchase parity is to go from the rates published by the OECD. Fees are issued annually at the beginning of the year. You might ask yourself: Does this not mean that the rates in the report will not remain true for such a long period of time? For a clearer picture, you may want to account for inflation rates from time to time.
Once you have obtained the OECD report numbers, please note that all information is presented with USD as the base currency. Therefore, if your chosen pairs do not include the dollar, additional math will have to be done. We then compare the PPP shown in the report with the actual exchange rate at this time and get the actual exchange rate (RER). RER ultimately serves as the baseline for the next trading process: if it is more than 1, the base currency is overvalued, and when it is below 1, undervalued.
After sorting the report data according to RER, you will be able to identify the cheapest and most expensive currency. From there, the most intuitive approach is to shorten the most expensive and then go long the cheapest. This can be summed up basically in the very essence of foreign exchange trading, which is relative value speculation.
Advantages and disadvantages of purchasing power of parity
From what we have learned today, we can sum up several pros and cons of trading with power purchase parity. The main advantage is that the concept of PPP is relatively easy to understand, but at the same time it serves as the basis for a number of significant fundamental measurements, such as GDP, for example.
In addition, the mathematics behind purchasing parity power is quite simple, which makes the trading process faster than many other approaches. Once you’ve mastered incorporating PPP into your strategies, you’ll know what to look for and how to use data most effectively.
On the other hand, we have already discussed that PPP is not an ideal representation of the value of the currency. Theoretical arbitrage, which is expected to level monetary values, hits the wall of reality, consisting of transport costs and tariffs, as well as other factors.
In addition, the concept of the identical basket of goods in two separate countries works best on paper. Especially since it is almost impossible to collect goods and services that are completely interchangeable across borders. In addition, due to the fact that the amount of data to be considered is incredibly large, the calculator process often becomes complex and self-contradictory. Therefore, trade with PPPs must always be as conscious as possible, with the incorporation of other analytical factors.
Buy Parity Power: Overview
Let’s briefly summarize today’s publication, drawing out the most noteworthy information on the purchasing power of parity.
PPP is a way of measuring exchange rates between currencies, judging by the differences in the value of goods and services in each country.
According to the purchasing power theory of parity, the pound of apples should cost the same amount in equivalent currencies in New York and London.
When the actual values do not match, the arbitration process must match them. This does not always work due to a number of factors, not considered in theory.
Currency traders use purchasing parity power to forecast long-term fluctuations in selected currency pairs and build their trading strategies accordingly.
Due to some of the limitations of purchasing power parity, it should be used in combination with other fundamental and technical factors.