Question

Does PPP Eliminate Concerns about Long-Term Exchange Rate Risk?

POINT: Yes. Studies have shown that exchange rate movements are related to inflation differentials in the long run. Based on PPP, the currency of a high-inflation country will depreciate against the dollar. A subsidiary in that country should generate inflated revenue from the inflation, which will help offset the adverse exchange effects when its earnings are remitted to the parent. If a firm is focused on long-term performance, the deviations from PPP will offset over time. In some years, the exchange rate effects may exceed the inflation effects, and in other years the inflation effects will exceed the exchange rate effects.

COUNTER-POINT: No. Even if the relationship between inflation and exchange rate effects is consistent, this does not guarantee that the effects on the firm will be offsetting. A subsidiary in a high-inflation country will not necessarily be able to adjust its price level to keep up with the increased costs of doing business there. The effects vary with each MNC’s situation. Even if the subsidiary can raise its prices to match the rising costs, there are short-term deviations from PPP. The investors who invest in an MNC’s stock may be concerned about short-term deviations from PPP, because they will not necessarily hold the stock for the long term. Thus, investors may prefer that firms manage in a manner that reduces the volatility in their performance in short-run and long-run periods.

WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

Answer 1

The solution to this question may vary depending upon the investors tenure of investments.

As we know that inflation and exchange rate effects will offset over the long run hence the investors investing for long term may generate inflated revenue with respect to the inflation rate to offset the exchange rate effects.

But there are some investors who does not agree with this. Because they may invest for short term varying from months to days, these investors will prefer that MNCs assess their exposure to exchange rate risk and attempt to limit the risk of their investments, by using various hedging techniques.