Arghyrou, Michael G. Gregoriou, Andros Pourpourides, Panayiotis M.
Year of Publication:
Cardiff Economics Working Papers E2009/2
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.
law of one price purchasing power parity risk aversion exchange rate uncertainty