Question

1. Answer the short Question:
a. What is the "law of one price"?
b. Write down the absolute form of PPP and interpret it.
c. Write down the relative form of PPP and interpret it.
d. What is a "Spot Exchange Rate " ?

Answer 1

1. Law of one price: according to law of one price, the identical products must sell for the same price everywhere; this will hold as long as there is possibility for arbitrage. There is a exception that a higher price is offset by superior or by providing more reliable services to the consumers.
2. Absolute form of purchasing power parity: this is a theory which states which states that prices of products of two different countries should be the same when measured by a common currency. For example, if one pound is equal to two dollars & a widget costs one pound in England then the absolute form of PPP would state that the same widget would cost two dollars in US. In securities the absolute form of PPP would create opportunities for arbitrage.
3. Relative form of PPP is an economic theory which predicts the relationship between inflation rates of two countries in a specific period & the movement in the exchange rate between the two currencies over the same period. This is considered to be the dynamic version of absolute PPP.

Suppose that the currency of Country A is called the A$ (A-dollar) and the currency of country B is called the B$.

The theory states that if the price P in country A of a basket of commodities and services is P A-dollars, then the price Q of the same basket in country B will be C×P A-dollars, where C is a constant which does not vary over time, or, equivalently, C×P×S B-dollars, where S is the (variable) number of B-dollars required to buy one A-dollar, i.e. the exchange rate.

4. Spot exchange rate:

A foreign exchange spot transaction is an agreement between two parties to purchase one currency against the sale of another at an agreed price for settlement on the spot date. The exchange rate at which the transaction is completed is called as the spot exchange rate.