exchange rate

Purchasing Power Parity

Purchasing Power Parity is a technique which is used to determine the relative value of different currencies. This whole concept of purchasing power parity allows people to estimate what will be the exchange rate between two countries so that the purchasing power of the two countries remains at par.

Purchasing Power Parity is a technique which is used to determine the relative value of different currencies.

Purchasing power parity exchange rates are helped in minimizing the misleading international comparisons, which can arise due to market exchange rates. The idea of this concept germinated in the 16th century in the School of Salamanca and the concept in its modern form was developed in 1918 by Gustav Cassel. This entire concept of PPP is based on ‘the low of one price.’ This law translates to mean that when official trade barriers and transaction costs are absent, then the prices of identical goods will be same in all the different markets if expressed in one same currency.

When there are deviations in the parity which means that there are differences in the purchasing power in the ‘basket of goods’ of various countries, it become really important that the GDPs and other national income statistics will have to be ‘PPP-adjusted’ so that they are converted into common units, and the comparisons on the international level become easy to measure. The most common and popular purchasing power adjustment is Geary-Khamis Dollar, also known as the international dollar.
PPP exchange rate basically serves two main functions. They are:

• Firstly, purchasing power parity exchange rates are used to make comparisons between different countries, as they remain quite constant day-to-day and week-to-week, and only modest changes occur and that too, over years.
• Secondly, over the years the exchange rate between countries tend to move in the direction of the basic PPP exchange rate, and therefore it will be valuable to know as to in which direction the exchange rate is going to change in the long run.
Thus, it can be said that PPP theory generally states that the exchange rate between the currencies of two countries will be in equilibrium especially when the domestic purchasing power measured at that rate of exchange are equal.

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How does exchange rate affect businesses?

by Kylee Sanders

Financial terms are not easy for everyone to understand. Only those who are adept in the field are the ones who truly understand the meaning of each field. Unless you are some sort of a CA or an economist, you would not know what exchange rate actually means.

Nowadays, international trade is pretty common, and paying and accepting foreign currency is nothing new. Thus, businesses working with foreign companies are at risk as the exchange rate can change at any point (and not necessarily in a way favorable to the company). It is a myth that individual operators and SMEs do not get affected owing to the exchange rate. It affects them as much as it does MNCs. It is also a myth that those businesses not operating at a global level do not get affected. A fluctuation in the exchange rate affects the economy as a whole and there is no escaping it.

How does exchange rate affect businesses?

Business owners and investors receive the hardest hit due to fluctuation in exchange rates

However, it is absolutely true that business owners and investors receive the hardest hit due to fluctuation in exchange rates. From small businesses to sprawling giants, from small investments to millions of dollars, everyone gets affected because of a fall or a rise in the exchange rate.

The economics of the world itself changes when there is a change in the currency value. Business operations are far more vulnerable to these volatilities than anything else. The 3 business areas that are the source of the risk are:

Transaction risks
Translation risks
Economic risks

Transactions bear a risk if a business owner is supposed to pay in foreign currency and the rate has suddenly shot up. This loss can easily be recovered in a short time. Thus, this cannot be deemed as a long term loss and businesses cannot collapse solely on this basis. Only in rare cases will a business totally collapse because of a change in the currency value.

Translations fall into risky positions when there are branches spread out across the globe. A change in the currency value will definitely cause a change in the overall final balance sheet of the company.

Economic risks concerns the situation where the market value is affected by sudden exchange rate fluctuations.

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Exchange Rate Risk

by Ryan Kendall

Also known as ‘currency risk’, exchange rate risk is the possibility of a business’s operation or an investment value being affected by the change in exchange rate. As this is the era of globalization, there is an increasing amount of mobility of currencies between countries. Due to the heightened volatility of currency, the fluctuations in the exchange rates has a great impact on planning of companies’ operations as well as influence on profitability in different ventures.

The exchange rate does not only affect the big companies that are involved in multinational operations. They also have effect on the small and medium enterprises that do not operate outside their home countries. While full understanding of exchange rate risk is obviously crucial for multinational corporations and SMEs, it is also important for investors to be properly familiar with currency risk as; exchange rate risk impacts their investments as well.

How does it work?

Exchange rate is the value of one nation’s currency as compared to the value of a foreign currency. While calculating the exchange rate, the domestic currency and the foreign currency are quoted directly or indirectly in order to measure the exchange rate. Therefore any company or investors holding bonds that make interest and principal payment in a counter currency (foreign) may lose substantial amount of money for reasons that are irrelevant to the issuer’s ability to pay.

Why does the exchange rate risk matter?

One of the most important reasons for finding the exchange rate risk is because at the end, the currency risk affects the cash the investor’s is going to get in the end. This determines the investor’s money’s final rate of return. Exchange rate risk can also create new openings as the interest rates that between two countries which will reflect the possible fluctuations in the exchange rates between them.

What are the types of exchange rate risk?

Business can be exposed to three types of exchange risk rate, that is:

Transaction exposure – caused by the effect of currency risk changes have on business’ commitment to make or receive payments that are denominated by counter currency.
Translation exposure – caused by currency fluctuations’ effect on the organization’s consolidated financial statements.
Economic exposure – caused by the unexpected change of exchange rate risks which may affect the company’s market value and future cash flows.

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