2012

Top Stories: International

Know Your Basics: x Purchasing Power Parity x Credit Default Swap

Know Your Basics:

FIN-O-PEDIA
Lets Talk FINANCE!!

A SIMSREE Finance Forum Initiative | Issue 40

SYDENHAM INSTITUTE OF MANAGEMENT STUDIES, RESEARCH & ENTREPRENEURSHIP EDUCATION

Know Your Basics:

Purchasing Power Parity:
What is PPP? Its 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 the exchange 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 currencys 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.)

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.
Indias 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.

3|Page

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--vis the level of risk.

4|Page

Know Your Basics:

Role in 2008 crisis: AIG is an insurance company. It is Americas 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 and sold 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.

5|Page