I dont’ undersatnd I thought formula was F=S x (1+Rd)/(1+Rf) How is the price basket here 1/2 and not 2/1. If its 1.5 dollars per pounds, isn’t it 1.6*(2*1.06)/(1*1.11) and not the way its done in the answer? Is this answer wrong?
A U.S. investor purchased a U.K. bond one year ago. The exchange rate at the time was 1.6 to 1 (dollars to pounds) and the beginning-of-period ratio of the price levels of the consumption baskets was 2 ($ to £). During the year, inflation in the U.S. was 6% and in the U.K. was 11%. Today the exchange rate is 1.7. Which of the following is closest to the end-of-period real exchange rate?
A) 0.890. B) 1.123. C) 1.005.
Your answer: B was incorrect. The correct answer was A) 0.890.
The end-of-period real exchange rate is calculated as: X = S (PF/PD). Here, the new price levels are 1.11 for the U.K. (1 × 1.11 = 1.11) and 2.12 for the U.S. (2 × 1.06 = 2.12). Hence, the end-of-period real rate is 0.890 [= X = S (PF/PD) = 1.7 (1.11 / 2.12)].