Question

In: Finance

C. 1)The inflation rates in the British pound and the Australian dollar are 2% and 8%...

C. 1)The inflation rates in the British pound and the Australian dollar are 2% and 8% respectively. What should the Sex /Forward ER be, if the Spot ER is BP/ A$ .5? 2) Describe the concept of purchasing power.

Please Show Work, Thank you.

Expert Solution

1) CORRECT SOLUTION FORWARD EXCHANGE RATE BP / A$ = 0.4722

AS PER THEORY ON PURCHASING POWER PARITY

FORWARD EXCHANGE RATE = SPOT EXCHANGE RATE * (1+ i pound inflation) / (1 + i aud inflation)

FORWARD EXCHANGE RATE = 0.50 * (1.02) / (1.08)

FORWARD EXCHANGE RATE = 0.50 * 0.9444444444444..

FORWARD EXCHANGE RATE = 0.472222.. or 0.4722 (rounded-off)

2) CONCEPT OF PURCHASING POWER PARITY

PPP theory is generary known as "law of one price". the markets provides same price for a good in two countries.

it states that it will be indifferent for a person to purchase a good from different countries at different prices

e. g. Mr.A buy a iphone for 150 british pounds in uk

EXCHANGE RATES pound = 2.40 usd , pound = 100 inr

if he wants to buy it in usa, it will cost 360 usd (150 * 2.40)

if he wants to buy it in INDIA, it will cost 15,000 RUPEE (150 * 100)

So, it will not be any cheaper or expensive to buy iphone in any country

similarly

it will also help in finding future exchange rates as exchange rates are dependent on inflation rates of that countries

FORWARD EXCHANGE RATE = SPOT EXCHANGE RATE * (1+ i pound inflation) / (1 + i aud inflation)

jeff jeffy answered 1 year ago

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