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A new solution to the purchasing power parity puzzles? Risk-aversion, exchange rate uncertainty and the law of one price: Insights from the market of online air-travel tickets

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Abstract

We argue that even in perfectly frictionless markets risk aversion driven by exchange rate uncertainty may cause a wedge between the domestic and foreign price of a totally homogeneous good. We test our hypothesis using a natural experiment based on a unique micro-data set from a market with minimum imperfections. The empirical findings validate our hypothesis, as accounting for exchange rate uncertainty we are able to explain a substantial proportion of deviations from the law of one price. Overall, our analysis suggests the possibility of a new solution to the purchasing power parity puzzles.

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File URL: http://patrickminford.net/wp/E2009_2.pdf
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Bibliographic Info

Paper provided by Cardiff University, Cardiff Business School, Economics Section in its series Cardiff Economics Working Papers with number E2009/2.

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Length: 27 pages
Date of creation: Jan 2009
Date of revision: Jul 2009
Publication status: Forthcoming in Canadian Journal of Economics
Handle: RePEc:cdf:wpaper:2009/2

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

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  1. Sercu, Piet & Uppal, Raman & Van Hulle, Cynthia, 1995. " The Exchange Rate in the Presence of Transaction Costs: Implications for Tests of Purchasing Power Parity," Journal of Finance, American Finance Association, vol. 50(4), pages 1309-19, September.
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