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is transacting business in his/her home currency, also known as interest rate parity.
Interest rate parity is the relationship between spot and forward exchange rates and
interest rates. It also shows why a currency might be sold or bought at forward premium
or discount. If the spot rate is greater than the forward rate, thus constituting a forward
premium, or whenever domestic interests are higher than foreign interest rates. Forward
discount, on the other hand, is vice versa to forward premium.
Purchasing Power Parity (PPP) is the relationship in which the same products
cost roughly the same amount in different countries after taking into account the
exchange rate. PPP referred to as the law of one price, implies that the level of
exchange rates adjusts so as to cause identical goods to cost the same amount in
different countries. The equation for PPP is Ph= (Pf) (Spot rate) Or Spot rate=
Where:Ph = Price of the good in the home country and Pf = Price of the good in the
foreign country PPP eliminate situations in which the same product sells at a different
price overseas. It also assumes that there are no transportation or transactions cost (or
import restrictions) that would limit the ability to ship goods between countries.
According to Merriam-Webster Dictionary, Investing is to commit (money) in order
to earn a financial return. This is one of the important factors that a company must focus
on in order to attain that life-long success in the business world. Risk highly affects the
investment which is the reason why investors tend to be more meticulous in handling
their investments. In investing overseas it is important for the investors to consider
additional risk factors. This risk factor includes country risk, risk that arises when
investors invest or do some business in a particular country, and the exchange rate risk,
risk that exchange rate changes will reduce the number of home currency provided by a
given amount of foreign currency. We should keep in mind that returns on investment
depend on what happens to exchange rate and the performance the country where you
invest.
Reference:
Block, S.B. & Hirt, G.A. (2006) Foundations of Financial Management (11th
ed.).Philippines: McGraw-Hill Education (Asia)
Brigham, E., & Houston, J. F. (2013). Fundamentals of Financial Management (13th
ed.). Philippines: Cengage Learning Asia.
International Arbitrage And Interest Rate Parity. (n.d.). Retrieved November 3, 2016,
from http://maysweb.tamu.edu/cibs/wp-content/uploads/sites/4/2015/05/Chapter07.pdf
R. (2016). Currency Option. Retrieved November 3, 2016, from
http://www.investopedia.com/terms/c/currencyoption.asp
What Is a Purchasing Power Parity? - World Bank. (n.d.). Retrieved November 15,
2016, from http://siteresources.worldbank.org/ICPINT/Resources/2700561255977254560/6483625-1338834270350/FVogel_WhatisPurchasing
PowerParity.pdf