Please help me to understand how they derive the answer: George Gao, CFA, is a currency portfolio manager who believes that the asset market approach can be applied to make short run forecasts of exchange rates based on the long-term effects of the changes in a country’s money supply. Recently, Japan unexpectedly reduced its money supply by 5%, increasing interest rates from 1.5% to 2.0%. Japan’s current spot rate is 108.74 Japanese yen per United States dollar (JY/USD). George believes that it will take two years for the effects of the decrease in the money supply to reduce the inflation rate in Japan. The current interest rate in the U.S. is 1.5%. Based on George’s calculations, the decrease in the money supply will translate to an immediate spot exchange rate of: A) 115.59 JY/USD. B) 102.29 JY/USD. C) 103.30 JY/USD.
Don’t worry about this. This is not in econ for this year. This was so last year!
Long story short: - calculate expected spot rate E(S_{1}) using spot rate (S_{0}) and inflation differential; - calculate AMP implied spot rate by plugging in the calculated E(S_{1}) into interest rate differential.
I dont understand the first step. Step 1: Identify the long-run expected exchange rate value [E(S1)] based on purchasing power parity. E (S1) = S0 × [(1 + iDC) / (1 + iFC)] where S is quoted in DC/FC. I could understand the formular, but why: E(S1) = 108.74 JY/USD × ( 1 - 0.05/(1.00)) = 103.3 JY/USD To me, it has nothing to do with the formular. So glad it is not in this year’s exam.
Asset market approach determines spot rate (or change of spot rate) based on inflation and interest rate expectation. I don’t know why the AMP works neither. But if this type of AMP question does show up on D-Day, the above two steps are good enough to handle it. So you could save the time, get the correct answer and move on. Or is it not the reason you asked the question and prepare to write the exam on June 6th?
THIS IS NOT THERE FOR THE EXAM, Still if you like… >"I could understand the formular, but why: >E(S1) = 108.74 JY/USD × ( 1 - 0.05/(1.00)) = 103.3 JY/USD " This is because the money supply in Japan was unexpectidely reduced by 5% (1 - 5%change) and the money supply in US remained the same so (1 - 0% change) So Long term rate should be = 108.74 *(1 -0.05)/(1 - 0.00) = 103.303 JY/USD But they are asking for immediate short term rate FR/SR = (1.02/1.015)^2 FR/SR = 1.00987648 SR = 103.303/1.00987648 = 102.292708114
hi all, new to the forum, but have been following the posts regularly (somewhat…) even i thought the asset market approach was not part of the exam but how come its included in the cfai textbooks…??