International Finance

Purchasing Parity Theory

Balkrishna Parab
AICWA, FCS

A BigMac costs 21.3 yuan in China and 128.2 dinar in Bahrain. Suppose that business and other costs for the McDonalds in both countries are identical. Inflation over the next year is 24 per cent in China and 31 per cent in Bahrain. If exchange rate movements over the next year reestablish the Purchasing Power Parity relation, what is the exchange rate (dinar per yuan) for next year? Todays spot exchange rate is that 1 koruna = 6.90 zloty. Everybody correctly knows that over the next year inflation will equal 20% in Slovakia (koruna) and 26 per cent in Poland (zloty). If exchange rate movements strictly adhere to the Purchasing Power Parity relation (PPP), complete the following statement. What is the exchange rate next year (zloty per koruna) implied by PPP? Suppose the Swiss inflation rate is forecast to be 2 per cent during the

coming year and the United States rate over the same period will be 5 per cent. The current exchange rate is CHF = USD 1.50. What is the expected spot exchange rate in one year?

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A Canadian firm is considering purchasing a subsidiary in Great Britain. The subsidiary will cost 16 million and will generate cash inflows of GBP 7.6 million per year at the end of each of the next three years. After that, the company will be worthless. The current exchange rate is GBP 0.43 per CAD 1.00. The Canadian inflation rate is expected to be 4 per cent over this period. The current risk-free rate of interest in Canada is 5 per cent and the riskfree rate in Great Britain is 8 per cent. (a) What is the approximate rate of inflation in Great Britain? (b) What is the cost of the project in Canadian dollars? (c) If uncovered interest parity holds, what is the expected spot rate two years from now? (d) What is the cash inflow for year three in terms of Canadian dollars?

The Economist publishes annually the hamburger standard by which they compare the prices of the McDonalds Corporation Big Mac hamburger around the world. The index estimates the exchange rates for currencies based on the assumption that the burgers in question are the same across the world and therefore, the price should be the same. If a Big Mac costs $2.90 in the United States and 1.99 in Britain, what is the estimated exchange rate of pounds per dollar as hypothesized by the Hamburger index? The USA and France both produce Cabernet Sauvignon wine. A bottle of this wine costs USD 18 in the USA and FRF 100 in France. (a) What should be the exchange rate between USD and FRF (FRF/USD) according to purchasing power parity theory? (b) Lets assume that the price of a Cabernet Sauvignon bottle in the USA is expected to rise to USD 20 in the following year, and to FRF 118 in France. What should the 1-year forward exchange rate (FRF/USD) be? (c) What are the expected interest rates in France, if you take in consideration the above calculations and the fact that the 1-year interest rate in the USA is 6%?

The price of a Big Mac in the U. S. is USD 2.54, while in Chile it costs Peso 1260. The current spot rate is Peso/USD=601. Using the absolute purchasing power parity, determine what should be the spot rate. Compare the implied PPP and the actual market spot rate and determine which currency is overvalued and which is undervalued. The current spot rate between Euro and Canada is 1.27 per $1.00. Expected inflation in Germany is 9% per year and expected inflation in Canada is 4% per year. If relative purchasing power parity holds, what is the expected exchange rate 3 years from now? 9

Youre planning for the next year to go on a 1-month luxury vacation to Bali. Price for the all-inclusive package today is 28.000 rupias or USD 800 according to the current spot rate Rps 36/USD. At the hotel they told you that their prices will

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increase according to the inflation on Bali, for which you expect to be 16% next year. American inflation is expected to be 4%. When you were introduced to different theories of explaining future exchange rates at the International finance course, you preferred the PPP theory. How many USD will you need next year to pay the planned vacation? 10 January 1st an American company borrows 5 million Swiss franks (CHF) from a Swiss bank at 3% interest rate.The company wants to exchange the CHF for USD, as it needs funds for financing a project in the USA. Spot rate on January 1st is CHF 1,4515/$. Expected rate of inflation for the USA is 4% and 1% for Switzerland. The company expects that the future spot rate after 1 year (when the company needs to exchange USD back to CHF in order to repay the loan) will be formed according to PPP. What is the real cost of borrowing the fund for the American company (what should the yield of the project be in order to allow the company to repay its debt)? 11 Suppose the inflation rate in Portugal is 8 percent during 2005 and the inflation rate in hungary is 12 percent during 2005. Then the purchasing power parity condition in rates-of-change form predicts that, during 2005, the value of the Portuguese currency (escudos) measured in terms of hungarian currency (forints) i.e., the number of forints per escudo will rise or fall, and by what amount? 12 During a shopping spree in Hong Kong, C. Dundee has bought a Sony

CD boom box (with woofers and tweeters) for HKD 2,000, jade jewelry for HKD 4,000, and four custom-made suits for HKD 25,000. The spot exchange rate is HKD/ AUD 5. (a) If CPP held, what should the same boom box, jewelry, and suits cost in Australia? (b) Suppose Mr Dundee is (unexpectedly) stopped at customs as he arrives in Melbourne, and must pay import duties of 20 percent. If the same boom box, jewelry, and suits cost AUD 450, AUD 1,500, and AUD 8,000 in Australia, respectively, was his shopping spree worth at least the HKD 10,000 paid for airfare and hotels during his trip? 13 Suppose that there is no uncertainty. Inflation is 10 percent at home, and 5 per cent abroad. Solve the following questions. (a) What is the change in the exchange rate if PPP holds? (b) What are the nominal rates in the two countries if the real rate is 2 percent (on all assetsrecall that we have certainty, and PPP holds)? (c) What is the forward premium? (d) Is the forward premium equal to the change in the spot rate? 14 A television set costs $500 in the United States. The same set costs 725 euros. If purchasing power parity holds, what is the spot exchange rate between the euro and the dollar? 15 In the spot market 7.8 Mexican pesos can be exchanged for 1 U.S. dollar. A compact disc costs $15 in the United

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payments in foreign currency. The French government begins to undertake an expansionary monetary policy. If it is certain that the result will be higher inflation in France than in other countries, you would be wise to use forward markets to protect yourself against future losses resulting from the deterioration of the value of the French franc. (c) If you could accurately estimate differences in relative inflation between two countries over a long period of time (and other participants in the market were unable to do so), you could successfully speculate in spot currency markets. 18 The inflation rates for Empire White and Empire Black are 5 percent and 10 percent, respectively. At the beginning of the year, the spot rate between the two currencies is 2.5 black dollars per white dollar. What is the approximate spot rate at yearend?

States. If purchasing power parity (PPP) holds, what should be the price of the same disc in Mexico? 16 A chair costs 500 euros. The same chair also costs 10,000 Japanese yen. If purchasing power parity (PPP) holds, what should be the exchange rate between the yen and the euro? 17 Are the following statements true or false? Explain. (a) If the general price index in Japan rises faster than that in the United States (assuming that there are zero transaction costs, that no barriers to trade exist, and that products are identical in both countries), we would expect the yen to appreciate with respect to the dollar. (b) Suppose you are a French wine exporter who receives all