Foreign Exchange and Derivative Markets

Essay by davelong13University, Bachelor'sA, December 2007

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Foreign Exchange and Derivative MarketsStar Jeans Company is considering an expansion into Brazil and must evaluate some key factors before reaching a final decision. The foreign exchange and derivative markets play a pivotal role in helping a firm decide whether to invest in a country's economy. There are many factors that enter into this decision that need both time and analysis. After evaluating an investment decision in our last paper, Team B will discuss exchange rate convertibility, bid-ask spreads, real exchange rates, and the interest parity on the relative investments attractiveness of investing in Brazil for Star Jeans Company this week.

Purchasing Power Parity SignificancePurchasing Power Parity (PPP) is understood best in terms of consumption. It is the rate of exchange between two currencies that makes the purchase of a certain quantity of goods inconsequential with regard to which currency is used. If a consumer can purchase two apples for one U.S. dollar (USD) or two apples for four Brazilian reals (BRL), then the purchasing power is the same as long as the exchange rate for BRL to USD is two for one.

In June of 2006, The World Bank's International Comparison Programme (ICP) released the first comprehensive study of household consumption in 10 South American countries. That study revealed that Brazil was 10% below the regional average in per capita expenditures, but well above the average in price levels (Correia, 2006). The purchasing power parity calculations for Brazil are used to determine the Gross Domestic Product (GDP). The following table shows the growth of PPP over the last five years.

YearGDP (purchasing power parity)RankPercent ChangeDate of Information2003$1,340,000,000,000102002 est.

2004$1,375,000,000,00092.61 %2003 est.

2005$1,492,000,000,00098.51 %2004 est.

2006$1,536,000,000,000102.95 %2005 est.

2007$1,655,000,000,000107.75 %2006 est.

Table One (IndexMundi, 2007)Evidence of PPP to the U. S. is stronger in countries that have similar growth rates,