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5. Purchasing power parity The law of one price The theory of purchasing power parity (PPP) states that in the long-run exchange rates between two countries adjusts so that the price of an identical good is the same when expressed in the same currency. A pair of headphones costs 40.11 in England. The spot rate is currently $1.9472 per pound. Interest rate parity recognizes that when you invest in a country other than your home country, two factors affect your investment-returns on the investment itself and changes in the exchange rate. Which of the following would cause the overall return on your investment to be higher than the investment's stated return? The currency in which the investment is denominated appreciates relative to your home currency. Your home currency appreciates relative to the currency in which the investment is denominated. The currency in which the investment is denominated depreciates relative to your home currency. 4. Interest rate parity The rise of globalization is due to the many companies that have become multinational corporations for various reasons-for example, to access better technology, to enter new markets, to obtain more raw materials, to find funding resources, to minimize production costs, or to diversify business risk. This multimarket presence exposes companies to different kinds of risk as well-for example, political risk and exchange rate risk. The relationship between interest rates and exchange rates can be represented through the concept of interest rate parity. Consider the following: Suppose you observe the following spot and forward exchange rates between the U.S. dollar (\$) and the Canadian dollar (C\$): Assuming that PPP holds true, what is the price of the pair of headphones in the United States? $78.10 $22.66 $24.72 $82.01 Suppose the price of the pair of headphones in the United States was actually $85.91. Assuming no transaction costs, transportation costs, or import restrictions, what does PPP predict would happen to the demand for the pair of headphones in the United States? The demand for the pair of headphones would decrease in the United States. The demand for the pair of headphones would increase in the United States