Question

Assume that the spot rate is €0.8144/$, the 180-day forward rate is €0.7933/$, and the 180-day dollar interest rate is 6 percent per year. What is the 180-day euro interest rate per year that would prevent arbitrage?

The consumer price index for the United States (U.S.) rose from approximately 121.4 in 1990 to approximately 199.3 in 2010.

a. How much inflation was there in the U.S. during the twenty-year period?

b. What is the significance of the consumer price index to a multinational corporation?

If the price level in Canada is C$18,500, the price level in France is €13,095, and the spot exchange rate is C$1.25/€, please answer the following questions:

a. What is the internal purchasing power of the Canadian dollar? (Hint: it may be best to calculate the purchasing power of C$10,000 first and divide by the price level of C$18,500 to obtain the number of consumption bundles for C$18,500).

b. What is the internal purchasing power of the euro in France? (Hint: it may be best to calculate the purchasing power of €10,000 first and divide by the price level of €13,095 to obtain the number of consumption bundles for €13,095).

c. What is the implied exchange rate of C$/€ that satisfies absolute PPP?

d. Is the euro overvalued or undervalued relative to the Canadian dollar? Explain the reasoning for your answer.

Answer 1

Question 1:

The 180-day euro interest rate per year that would prevent arbitrage is arrived as below:

180-Day Euro Interest Rate Per Year = (1/€0.8144/$*(1+6%/2)*€0.7933/$ - 1)*(360/180) = .66%

_____

Question 2:

Part a)

The value of inflation during the 20 year period is calculated as below:

Inflation during the 20 Year Period = (CPI in 2010 - CPI in 1990)/CPI in 1990*100 = (199.3 - 121.4)/121.4*100 = 64.17%

_____

Part b)

Consumer price index provides information on the price changes for a given basket of goods and services. It can help a multinational corporation to adjust the prices of its products/services to meet the requirements of people/customers in the host country. Timely changes to pricing can increase purchasing power of consumers which in turn may increase the demand for company's products/services.

______

Question 3:

Part a)

The internal purchasing power of the Canadian dollar is calculated as below:

Internal Purchasing Power of Canadian Dollar = C$10,000/C$18,500 per consumption bundle = 0.5405 consumption bundles

_____

Part b)

The internal purchasing power of the Euro in France is determined as follows:

Internal Purchasing Power of Canadian Dollar = €10,000/€13,095 per consumption bundle = 0.7637 consumption bundles

_____

Part c)

The implied exchange rate is calculated as below:

Implied Exchange Rate of C$/€ that Satisfies Absolute PPP = C$18,500/€13,095 = C$1.4128/€

_____

Part d)

The euro is undervalued relative to the Canadian dollar. It is because the actual exchange rate C$1.25/€ is less than the PPP exchange rate (which is C$1.4128/€) indicating that Euro will have to strengthen in value in order to move from C$1.25/€ to C$1.4128/€.