Question

1) Please discuss what is meant by the law of one price in international finance.   How would you go about modeling the factors that affect exchange rates? What are some of the difficulties related to modeling exchange rates?

Answer 1

1. Law of one price states that the price of similar asset or commodity will be same globally instead of location when certain factors are considered. This law takes into account a frictionless market i.e. when there is no transaction cost, transportation cost or legal restrictions, then the currency exchange rate will be same and then there will be no price manipulation by buyers and sellers. Law of one price exists because of the elimination of price difference in different locations.

Purchasing power parity approach model offset the price changes due to inflation based on the underlying principle.

Relative economic strength approach model look at the strength of economic growth in different countries i.e. this approach is based on the idea that a strong economic environment and potentially high growth attracts more investment from foreign country and in order to purchase investment of the desired country one has to purchase country's currency which increase demand of the currency and the currency of that country appreciate.

Another model is econometric model which consider various factors like interest rate differential between the countries, difference in GDP growth rate between the countries and income growth rate difference between countries etc.

Difficulties related to modeling exchange rates are transaction risk which influence receivables (Export contract), payables (import contract), translation risk (exchange rate moves to the valuation of foreign subsidiary and in return it affects parent company balance sheet and economic risk (it is the risk to the firm present value of future operating cash flows from exchange rate movement)