Purchasing Power Parity is an economic theory which states that the cost of a good in one country should be equivalent to the cost of the same good in another country, once adjustments have been made for differences in exchange rates. This suggests that exchange rates follow a predictable pattern, instead of a “random walk”, and can therefore be forecast with more accuracy. Abuaf and Jorion (1990) published a paper on the subject titled “Purchasing Power Parity in the Long Run”. In their study, they concluded that although exchange rate deviations from PPP can be significant over the short term, half of the deviations from PPP are reversed over the following 3 to 5 years. Based on their findings, this theory (and others like it) could be the basis for a conditional currency hedging strategy that could be followed by long term investors who prefer to hedge a portion of their U.S. and international currency exposure.
Let’s look at an example for a Canadian investor investing in the U.S. Information regarding 2009 relative Purchasing Power Parities (PPPs) can be obtained online from the Organization for Economic Co-Operation and Development (OECD). PPPs are stated in terms of local currency to USD, so will need to be converted in terms of local currency to CAD by dividing the PPPLocal/USD by PPPCAD/USD/, which is equal to 0.83829USD/CAD.
The next step would be to visit the daily currency converter on the Bank of Canada’s website to obtain the current exchange rate (FXUSD/CAD), and compare this value to the PPPUSD/CAD. This will determine, based on PPP theory, if the CAD is overvalued (positive) or undervalued (negative) relative to the USD. As of June 30, 2010, the CAD was overvalued by 12.48% relative to the USD [(FXUSD/CAD / PPPUSD/CAD) - 1]. The results are shown in the table below.
This would imply that even for an investor who takes the “hedge-of-least-regret” approach (i.e. 50% foreign currency hedging and 50% foreign currency exposure) there may be a benefit to tilting their U.S. portfolio holdings towards a higher exposure to the U.S. currency. The reasoning is simple – if PPP theory suggests that the Canadian dollar is overvalued relative to the U.S. dollar, you should sell the overvalued Canadian dollar and rebalance into the undervalued U.S. dollar (by going “long” the U.S. dollar…or indirectly, by not hedging as much of the U.S. currency exposure in the portfolio).
Although somewhat more complicated, the same analysis could be done for an internationally diversified investment. The main difference is that there are various country weights with various currency exposures that must be considered (instead of a single country with only one long currency exposure of 100%). For this example, we will use the iShares MSCI EAFE Index (EFA) and weight the deviations by their currency weights in the product, as of March 31, 2010. Any countries that OECD does not provide PPPs for will be labeled under “Other”, and their PPP deviations will be assumed to cancel each other out.
Source(s): OECD, Bank of Canada, Blackrock
* Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovak Republic, Slovenia, Spain
The total weighted average PPP deviation of 2.89% for a Canadian investor investing internationally is not as drastic as the Canadian investor investing in the U.S. Although the Canadian dollar appears to be overvalued relative to the Euro and the British Pound, it is undervalued relative to the Japanese Yen, the Australian Dollar, and the Swiss Franc, among others. For a typical investor, the hedge-of-least-regret approach may be more desirable in this situation.
In conclusion, when large deviations exist between the PPP relative to the current exchange rate, an opportunity may exist to implement a conditional currency hedging strategy. Care must be taken, as PPP values are estimates. A relative PPP deviation of 20% or more (i.e. if the Canadian dollar once again reaches par with the U.S. dollar) may allow for a higher level of confidence from the investor that the Canadian dollar is overvalued and will theoretically depreciate back to its fair value. Therefore, the investor may choose to decrease the hedged portion of their U.S. holdings when these large deviations occur.
Special thanks to Raymond Kerzerho, Director of Research, for his expertise and insight.