Question

1)i)A Canadian banker observes the spot rate between Canadian dollars and pounds is currently C$1.06/£ . One year inflation rates in Canada and Great Britain are expected to be 3% and 5%, respectively. Suppose the spot rates for Canadian dollars and pounds at the end of the year are as follows:C$1.07/$, £1.05/$ Which of the following statements is true according to relative PPP? Round intermediate steps to four decimals.

a)The pound appreciated in real terms.b)The Canadian dollar depreciated in real terms.c)The Canadian dollar appreciated in real terms.d)Neither the Canadian dollar nor the pound appreciated in real terms.

ii)A certain computer costs 1500 francs in Switzerland and 1750 dollars in the US. Suppose the current exchange rates are as follows:

CHF1.08/€ ,  €.75/$.Find the arbitrage profit (in terms of US dollars) per computer according to absolute PPP. Round intermediate steps to four decimals and your final answer to two decimals. Do not use currency symbols when entering your response. Type answer please.

iii)

Use the following information to answer the next two questions.

Investors expect inflation rates over the next twelve months in Japan and Australia to be 6% and 8%, respectively.  The current exchange rates for the two currencies are as follows:

C$.006/¥,   A$.6/C$

Suppose that twelve months from now, the exchange rate between Australian dollars (A$) and yen is A$.004/¥.  According to relative PPP, what be the impact of this new exchange rate on Australia's balance of trade?  (Assume Australia is the home country.) Round intermediate steps to four decimals.

		a)Australia's BOT will decrease
		b)Australia's BOT will increase
		c)Australia's BOT will be unaffected by the new exchange rate.
		d)None of the above

iv)What should have been the percentage change in direct quotes according to relative PPP? Round intermediate steps and your final answer to four decimal and enter your answer in decimal format (EX: .XXXX). . Please type answer .

Answer 1

1. As per PPP Model, there the interest rate between two countries will rule out any arbitrage opportunities and the future price of currencies will be as per the interest rate between the two countries.
So, Future Price of Foreign Currency = [(1+ home interest rate)/(1+ Foreign Interest Rate)]*Spot Price of Foreign Currency.

Spot Price is CD $ 1.06/£. So, here £ is the foreign Currency.
Hence Future Price of CD$/£ will be = (1+3%)/(1+5%)*1.06 = 1.0398 CD$ / £.
Since, the actual future rate is CD$1.07/$ * 1/1.05 = CD$1.019/£.
Hence, Canadian Dollar has depreciated in Value or £ has appreciated in value.

2. A Computer Cost 1500 francs in Switzerland and 1750 $ in US.
  CHF1.08/€. So, 1500 CHF will be 1500*1/1.08 = €1388.88

Similarly, 1750$ will be 1750*0.75 € = €1312.50

Now, for arbitrage, the person will buy computer from US for 1312.50€ and will sell in switzerland at €1388.88
So, Profit per computer will be €76.38

3.  As per PPP Model, there the interest rate between two countries will rule out any arbitrage opportunities and the future price of currencies will be as per the interest rate between the two countries.
So, Future Price of Foreign Currency = [(1+ home interest rate)/(1+ Foreign Interest Rate)]*Spot Price of Foreign Currency.

Calculation of Spot Rate.
A$/¥ =  C$.006/¥ * A$.6/C$= A$0.0036/¥
  
Calculation of theoretical Future Price = (1.08/1.06)*0.0036 = A$0.00366/¥
Actual Future Price = A$ 0.0040/¥
Since, Actual Price of A$/¥ is more than the theoretical price hence, people will borrow in ¥ and invest in A$. So, there will be a positive impact on the BOT of Australia.