Introduction

The gradual emergence of globalisation in businesses has contributed towards a significant rise in international trade. Consequently, trading across countries has been prominent among businesses in order to seek higher growth opportunities available in the international markets (Michie, 2011). “Our willingness to pay a certain price for foreign money must ultimately and essentially be due to the fact that this money possesses a purchasing power as against commodities and services in that country” (Gustav Gassel, 1922). The applications and conversions of currencies have become vitally important in international businesses in order to obtain or forecast the substantial costs and revenues for the purpose of financial information. The concept of Purchasing Power Parity (PPP) enables one to forecast the exchange rate of two different countries based on the assumption of similar purchasing power under law of one price of two countries’ currencies. However, various crucial obstacles have been encountered in real life despite the concreteness of the proposed theories and one of the projected main concerns is to determine the price for a similar product across different markets and continents (Wang, 2009). According to the theory of Purchasing Power Parity (PPP), one currency should be able to buy the same amount of products which can be purchased from other currencies. This concept suggests that the currencies should be valued in a way that it allows consumers to buy similar quantity of goods irrespective of the currencies that they utilise in making purchases (Manzur, 2008). According to the Law of One Price (LOP), consumers should be able to purchase similar or same kind of goods at the same price despite the utilisation of different currencies. Nevertheless, the application of LOP is considerably difficult and would not prevail in certain predicaments across different economies and countries despite the supportive underlying theories (Mezzera, 1990).

Conceptual Understanding of Law of One Price and Purchasing Power Parity

Law of One Price and Purchasing Power Parity play a crucial role in determining the international trade mechanism. The concept of LOP indicates that the price for homogenous goods and services should be the same despite all locations. The theory behind LOP is established through the equilibrium pricing of a product. The equilibrium market price of a product is achieved when market participants realise the different pricing for an identical product in different locations, (assuming no transaction costs and other trade restrictions) and take advantage of the arbitrage opportunities. The principle of LOP is highly justified because differences in the price of the same products in two different markets would create the perfect opportunity for arbitragers to benefit by purchasing products in a lower priced markets and selling them in markets where there are sold at a higher price. The transactions among market participants create pressure through demand and supply effect in the two locations and would substantially eliminate such opportunities and hence create an equal and transparent price. As a result, the price for the same commodity traded in two different markets should be same if they are converted into a common currency (Ignatiuk, 2009). The concept of LOP asserts that if same goods enter each country’s market basket, the PPP exchange rate should prevail between the two countries to maintain the principle of one price despite the difference in currencies (Eicher, Mutti and Turnovsky, 2009).

The Law of One Price (LOP):