this question is from 2010 CFA sample exam, PM section “compute the expected NOMINAL exchange at the end of one year” the steps to compute the answer are: 1) given spot, price level ratio, we compute the real rate 2) multiply the REAL rate by US/UK inflation levels 3) this gives you the expected nominal exchange rate -------------------- this question is from Schweser qbank “compute the end of period real rate” the steps to compute the answer are: 1) given one year ago spot, current spot, and price level ratio 2) multiply the end of period SPOT by the US/UK inflation levels -------------------- Summary: 1) when asked to compute the NOMINAL, we compute the real and multiply by inflation 2) when asked to compute the REAL, we just multiply the (spot x inflation) is that correct?
Say you have a beginning nominal exchange rate of $2.00 / pound. Also, say the US price level is 2 and a UK price level is 1 and UK inflation is projected to be 1% and US inflation is projected to be 5%. The expected nominal exchange rate can be found with the formula… E(S)=S * (Inflation counter / Inflation base)^T So the expected nominal rate would be… 2.00 * (1.05/1.01) = 2.08 / pound. Notice that since the US had higher expected inflation, the depreciated relative to the pound. Whereas, say instead that the nominal rate actually turned out to be $2.10 / pound, the real rate is given by… real S = S end * (price level begin * inflation foreign / price level begin * inflation domestic). So the expected real rate would be… 2.1 * ([1*1.01]/[2*1.05]) = $1.01 / pound. Notice in this case had we calculated the original real rate it would have been 2.00 * (1/2) = $1.00 / pound. Which means there was real movement of 1%, which is due to the actual nominal rate of $2.10 being higher than the expected nominal rate of $2.08.