Question

a) Mario Barnotoli wants to buy designer furniture from Poland for his mansion in Roma, Italy. Current spot rate is PLN 4.2555/EUR and the price for each set of designer furniture is PLN30,000. The annual inflation over the coming year for Poland and Italy are expected to be 6.5% and 2.5% per annum respectively. Assume purchasing power parity holds. How much EUR would Mario needs if he intends to purchase three sets of Polish designer furniture one year from now?

b) S. Krisnamoorthy is planning to purchase his dream motorcycle, a Harley V-twin next year. The Harley V-twin is currently selling at USD 12,500 in United States. However, S.Krisnamoorthy can directly purchase his dream motorcycle in MYR from Harley Davidson of Kuala Lumpur. The current spot rate is MYR4.200/USD and the current inflation rate in United States is 2% whilst in Malaysia is 5%. Assuming 60% complete pass through, what will the price of Harley V-twin be in MYR one year from now?

Answer 1

a.

According to purchasing power parity theory=

FR= SR(1+Ir1) / ( 1+ Ir2)

Where FR = forward rate

SR= Spot rate

Ir1 = Inflation rate at country 1

Ir2 = Infation rate at country 2

Current Spot rate = Euro 1 = PLN 4.2555

Inflation rate in poland = 6.25% Pa.

Inflation rate in Itly = 2.5% Pa.

Hence Expected forward rate after 1 year=

=> Euro 1 = PLN 4.2555 (1+6.25%) / Euro 1(1+2.5%)

=>Euro 1 = PLN 4.2555 (1.0625) / (1.025)

=>Euro 1 = PLN 4.4112

Euro to be paid for buying 3 furniture after 1 year,

=> (3 *PLN 30000) / PLN 4.4112 per euro

=> Euro 20402.6115

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#b

Current privce = USD 12500

Spot rate = USD 1 = MYR 4.200

US inflation rate = 2% pa

Malaysia inflation rate = 5%pa

Hence as per Puchasing power parity theory, Exchange rate after 1 year,

=> UDS 1 = MYR 4.200(1.05) / (1.02)

=>USD 1 = MYR 4.324

% Change in exchange rate = (MYR 4.324 - MYR 4.200) / MYR 4.200 *100 = 2.95% Increase

Pass Through rate = Change in price / change in exchange rate

=>60% = Change on price / 2.95%

=>Change in price= 1.77%

Hence the price of V-twin in USD after 1 year = USD 12500 *( 1+ 1.77%) = USD 12721.25

Price of V twin in MYR after 1 year = USD 12721.25 * MYR 4.324 Per USD

=>MYR 55007