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Top Stories: International

Know Your Basics:

A SIMSREE Finance Forum Initiative | Issue 40

FIN-O-PEDIA

et’s Talk FINANCE!!

SYDENHAM INSTITUTE OF MANAGEMENT STUDIES, RESEARCH &

ENTREPRENEURSHIP EDUCATION

2012

Know Your Basics:

x Purchasing Power

Parity

x Credit Default Swap



Know Your Basics:

Purchasing Power Parity:

What is PPP?

It’s a method for calculating the correct value of a currency which may differ from its

current market value. Purchasing power parity (PPP) is helpful when comparing living

standards in different countries, as it indicates the appropriate exchange rate to use when

expressing incomes and prices in different countries in a common currency. Correct value

means the exchange rate that would bring demand and supply of a currency into

equilibrium over the long-term. The current market rate is only a short-run equilibrium. It

says that goods and services should cost the same in all countries when measured in a

common currency under the assumption that duties, curbs, etc are neglected. It is theexchange rate that equates the price of a basket of identical traded goods and services in

two countries. PPP is often very different from the current market exchange rate. Some

economists argue that once the exchange rate is pushed away from its PPP, trade and

financial flows in and out of a country can move into disequilibrium, resulting in potentially

substantial trade and current account deficits or surpluses. Because it is not just traded

goods that are affected, some economists argue that PPP is too narrow a measure for

judging a currency’s true value. They prefer the fundamental equilibrium exchange rate

(FEER), which is the rate consistent with a country achieving an overall balance with the

outside world, including both traded goods and services and capital flows.

The relative version of PPP is calculated as:

Where:

"S" represents exchange rate of currency 1 to currency 2

"P1" represents the cost of good "x" in currency 1

"P2" represents the cost of good "x" in currency 2

Example:

A chocolate bar that sells for C$1.50 in a Canadian city should cost US$1.00 in a U.S. city

when the exchange rate between Canada and the U.S. is 1.50 USD/CDN. (Both chocolate

bars cost US$1.00.)



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Know Your Basics:

GDP (Purchasing Power Parity):

A nation's GDP at purchasing power parity (PPP) exchange rates is the sum value of all goods

and services produced in the country valued at prices prevailing in the United States. This is

the measure most economists prefer when looking at per-capita welfare and when

comparing living conditions or use of resources across countries. The measure is difficult to

compute, as a US dollar value has to be assigned to all goods and services in the country

regardless of whether these goods and services have a direct equivalent in the United States

(for example, the value of an ox-cart or non-US military equipment); as a result, PPP

estimates for some countries are based on a small and sometimes different set of goods and

services.

India’s GDP (purchasing power parity): $4.463 trillion (2011 est.) (3rd Biggest in the world)

Relevance of PPP:

The concept of PPP is useful in comparing quality or standard of living in different countries

which may not be possible if one just looked at per capita income. A lower income may

allow a good quality of life in a country of prices is low. For instance, a haircut may cost lot

more in London than in Delhi. The major shortcoming of PPP exchange rates is that these

are difficult to measure.



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Know Your Basics:

Credit Default Swap:

A swap designed to transfer the credit exposure of fixed income products between parties.

A credit default swap is also referred to as a credit derivative contract, where the purchaser

of the swap makes payments up until the maturity date of a contract. The buyer of a credit

default swap receives credit protection, whereas the seller of the swap guarantees the

credit worthiness of the debt security. In doing so, the risk of default is transferred from the

holder of the fixed income security to the seller of the swap. For example, the buyer of a

credit default swap will be entitled to the par value of the contract by the seller of the swap,

should the third party default on payments. By purchasing a swap, the buyer is transferring

the risk that a debt security will default.

Example:

Suppose Bob holds a 10-year bond issued by company XYZ with a par value of $1,000 and a

coupon interest amount of $100 each year. Fearful that XYZ will default on its bond

obligations, Bob enters into a CDS with Steve and agrees to pay him income payments of

$20 (similar to an insurance premium) each year commensurate with the annual interest

payments on the bond. In return, Steve agrees to pay Bob the $1,000 par value of the bond

in addition to any remaining interest on the bond ($100 multiplied by the number of years

remaining). If XYZ fulfils its obligation on the bond through maturity after 10 years, Steve

will make a profit on the annual $20 payments.

Why it matters?

A credit default swap protects bondholders and lenders against the risk that the borrower

will default. The lender's insuring counterparty takes on this risk in return for income

payments. In this respect it is important for the insuring counterparty to fully assess the

swap's risk/return feature to ensure it is receiving fair compensation vis-à-vis the level of

risk.



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Know Your Basics:

Role in 2008 crisis: AIG is an insurance company. It is America’s one of the largest insurance company. One of

its functions is to insure bonds against default (CDS). As the sub-prime mania continued with

everyone buying the mortgage backed CDOs, they also wanted to buy insurance in the form

of credit default swaps in case some of the mortgages defaulted. This transferred the risk of

the bonds defaulting to the seller of the credit default swaps, in this case AIG. When

defaults started on the mortgages sellers also made money by owning the credit default

swaps, something like shorting a stock, you think it will go down and you short it. Owning

these credit default swaps was a way of shorting the sub-prime mortgage market. AIG

collected the premiums on all of these credit default swaps insurance and happily sold andsold and sold the credit default swaps to all. Even as foreclosures increased and it was

apparent there was a problem, AIG continued to sell the swaps for the premiums. By the fall

of 2008, AIG was losing billions of dollars per day.

oct fin mag

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