The purchasing power parity, as known as PPP, is one of the parity conditions result from arbitrage activities. The purchasing power parity specifies that the spot exchange rate between currencies will be adjusted based on the differences of inflation rates between countries. There are some of the things that arbitrager has to take into consideration such as the law of one price, time period, spot rates, and inflation rates while using the theory of purchasing power parity to help forecast currency exchange rates. The law of one price simply means that no identical goods shall have different selling price in the worldwide when express in the same currency. Big Mac index is one famous and easy example that is used by Economist to illustrate what does the law of one price mean. Economist compared the price of McDonald’s Big Mac that sells in the franchises all over the countries. If McDonald’s sell the Big Mac for 4 US dollars in the United States, and McDonald’s sell the Big Mac for 3 pounds in Britain, then £3 equivalent to $4 by purchasing power parity. If the market exchange rate of US dollar and British pound in this Big Mac example is 1:1, then based on the theory of purchasing power parity, the spot exchange rate will be closed up to the rate of purchasing power parity. However, in order to use the purchasing power parity under the law of one price, we have to make the purchasing power parity exist first. Arbitrager have to assume the market is efficient which simply means that all goods and services are tradable, transportation and other trading costs are zero, consumers in all countries consume the same proportions of goods and services. Then the arbitrager can use the purchasing power parity theory to help avoiding the risk of inflation while forecasting the currency exchange rates.

  Reference http://www.economist.com/markets/bigmac/about.cfmhttp://en.wikipedia.org/wiki/Law_of_one_pricehttp://en.wikipedia.org/wiki/Purchasing_power_parityhttp://www.investopedia.com/terms/p/ppp.asp