Purchasing Power Parity Strategy in Trading Forex

Abstract

Purchasing Power Parity (PPP) strategy has been implemented in the foreign currency exchange market for many years. The crucial basis for this strategy is the equilibrium of the purchasing power and disproportionate exchange rate. However, previous research has generally determined the profitability of the PPP strategy but has ambiguous signal generations, as PPP is data released annually. Thus, the repeatability of the research is low. In this paper, we use data including CPI, PPP, interest rate, market exchange rate, bid-ask spread, and DXY between January 1, 1997, to August 1, 2022, to generate a dynamic relatively purchasing power parity, which is a monthly data, and then generate our signal and test the feasibility and profitability of our research. Our finding, including the in-sample and out-of-sample tests, indicates that, RPPP could be an effective forex trading strategy. Furthermore, in the long run, the PPP strategy based on our signal is profitable, and the loss is acceptable.