Global Financing and Exchange Rate Mechanisms 1
Global Financing and Exchange Rate Mechanisms
Global financing and exchange rates have become an important issue for global business. Extreme increases in the price of oil and other commodities and inflation has led to significant exchange rate risks in today's global markets. The following will analyze purchasing power parity and the "Big Mac Index", explain how purchasing power parity and the "Big Mac Index" are used in global financing operation and their importance in managing risks.
In order to understand the relation between prices and exchange rate movement's one must understand the economic proposition known as the law of one price. The law of one price states that, "Ã¢ÂÂ¦in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency" (Hill, 2009, p.
331). For example, in the text International Business: Competing in the Global Marketplace, 7th ed, the author uses an example which uses the exchange rate between the British pound and the U.S. dollar. If the exchange rate between the British pound and the dollar is ÃÂ£1 _ $1.50, a jacket that retails for $75 in New York should sell for ÃÂ£50 in London. However, if the jacket cost ÃÂ£40 in London which converted is $60 in U.S. currency a trader could purchase jackets in London and sell them in New York while making a profit of $15. The law of supply and demand would demand that the increased demand for jackets in London would increase their price and the increased supply in New York would lower their price in the U.S. and this would continue until the prices were equalized.