A New Solution to the Purchasing Power Parity Puzzles: Risk-Aversion, Exchange Rate Uncertainty and the Law of One Price

31 Pages Posted: 12 Feb 2009

See all articles by Michael Arghyrou

Michael Arghyrou

University of Piraeus

Andros Gregoriou

University of East Anglia

Panayiotis M. Pourpourides

Cardiff University - Cardiff Business School

Date Written: February 12, 2009

Abstract

Market imperfections are the main explanation offered by the existing literature for violations of the Law of One Price and Purchasing Power Parity (PPP) among industrialized countries. We argue that even in perfectly frictionless markets risk aversion driven by exchange rate uncertainty causes a wedge between the domestic and foreign price of a totally homogeneous good. We test this hypothesis on a unique data set from a real-world market with minimum imperfections; and aggregate data for bilateral US dollar exchange rates in the G7 area. The empirical findings validate our hypothesis, thus providing a new, additional to market-imperfections, solution to the PPP puzzles.

Keywords: Law of one price, purchasing power parity, risk aversion, exchange rate uncertainty

JEL Classification: F31, F41

Suggested Citation

Arghyrou, Michael and Gregoriou, Andros and Pourpourides, Panayiotis M., A New Solution to the Purchasing Power Parity Puzzles: Risk-Aversion, Exchange Rate Uncertainty and the Law of One Price (February 12, 2009). Available at SSRN: https://ssrn.com/abstract=1341850 or http://dx.doi.org/10.2139/ssrn.1341850

Michael Arghyrou

University of Piraeus ( email )

Karaoli & Dimitriou 80
Piraeus, 18534
Greece
19 (Fax)

HOME PAGE: http://ideas.repec.org/e/par104.html

Andros Gregoriou

University of East Anglia ( email )

Norwich Research Park
Norwich, Norfolk NR4 7TJ
United Kingdom

Panayiotis M. Pourpourides (Contact Author)

Cardiff University - Cardiff Business School ( email )

Aberconway Building
Colum Drive
Cardiff, CF10 3EU
United Kingdom

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