PPP, IRP, Fisher

CFA Level II
#1

Could a kind soul please shed some light on the correct formulas for each? These is a discrepancy between Schweser and the CFAI sample exams.

For instance, Schweser provides the following formula for relative PPP:

E(St) = So * (1 + Infl DC) / (1 + Infl FC)

where exchange rates are quoted FC:DC.

Conversely, the formla used in one of the sample exam questions (case on Sona and Golder Island) inflation for Foreign currency is in the numerator and Domestic is in the denominator. The spot is also quoted FC:DC similar to Schweser, so it is a different formula.

There are similar issues with IRP. Anyone able to shed light on this? What are the CORRECT representations of all these relations? Thanks so much!

#2

From Textbook page 645 econ: for IRP

spot rate is E:$ 125, Euro Rdc - 14%, US Rfc - 10%

E(s1) = 1.25 (1.1)/1.14

= 1.2601

For inflation - I know for sure higher inflation will lead to depreciation, so I put the lower inflation currency on top to get a lower value .

#3

Thanks for your insight, preppie.

Actually, perhaps a more relevant question would be where is the errata for the sample exams? I can’t find it on the CFAI site.

Another gem in the answers talks about how when the correlation between assets increases, the number of assets required for diversification decreases. I’m pretty sure I disagree with this statement as well. This whole sample test experience has left a really bad taste and it’s incredibly disappointing.

Please let me know if anyone has seen any sort of list containing errors in the sample exams. Thanks much!

#4

I like to think of it this way - If you’re quoting E: (I like to think of it as B:A) or if it is quoted /E then A/B. The formula is then S * (1+A)/(1+B)

#5

hey arial it says in the portfolio mgment book that if correlation between assets is lower, there are more benefits to diversifying BUT it takes more securities in your portfolio to realise those benefits.

So maybe the answer is saying that if correlation’s higher, you reach your optimum diversification level more quickly. I agree this is confusing…

#6

CFAI is so screwed up in this section. First they make the point that the convention they will use is the Direct quote (FC:DC), then later explaining IRP, they are giving quotes in DC:FC along with an outdated exchange rate! Really bad! The format is FC:DC, e.g. one unit FC: DC, and IRP is F = S(1+iDC)/(1+iFC).

#7

The representations are all the same, maybe that’s the point they’re trying to get across. It’s a much better use of time to understand that point than it is to complain about the switching of conventions

It doesnt matter if the rate is quoted FC:DC or domestic/foreign or $/EUR as long as they specify.

#8

Thank all for your comments! Kwalew, I respectfully disagree. While I appreciate the point you’re trying to get across, the two formulas are not mathematically equivalent. As I said above:

"E(St) = So * (1 + Infl DC) / (1 + Infl FC)

where exchange rates are quoted FC:DC.

Conversely, the formla used in one of the sample exam questions (case on Sona and Golder Island) inflation for Foreign currency is in the numerator and Domestic is in the denominator. The spot is also quoted FC:DC similar to Schweser, so it is a different formula."

If the spot was quoted differently, they would have been mathematically equivalent but in this case they really aren’t. I agree that there is no point in complaining but it is a bit disheartening that in light of time constraints, simple things like that are messed up.

Thank you all for your input and best of luck!

#9

What mock exam r u talking about?

#10

I was referring to the paid sample exams currently posted on the CFAI site.

#11

I haven’t seen the question. But, fundamentally, they are still mathematically equivalent. Take the inverse of the quote as given, and it will be in the form you “need”. Perhaps that is the issue they were trying to fool the takers on. If there is something else in the question that I am missing, I apologize… but as given, taking 1 / FC:DC will give the relationship you need.

#12

If the formula is: E(St) = So * (1 + Infl DC) / (1 + Infl FC) and the spot is quoted as FC:DC, you would have to flip BOTH the inflation rates as well as the way the spot is quoted to get a mathematical equivalent, no? If you do only one, but not the other, you will end up with a different formula. Sorry to belabor this point.

#13

Well, theres understanding the underlying principle and knowing the trick that Schweser teaches, they will both get you to the right answer (not always the case with Sch). The first is knowing that for PPP, if the rate is quoted at FC:DC, then 1 + DC rate is in numerator, and 1 + FC rate is in denominator. The underlying principle is that the currency with higher inflation will depreciate.

That being said, tt doesn’t matter which currency Schweser quotes, if the inflation in Country A is higher than in Country B, country A’s currency should depreciate. Therefore, if Schweser “gives” the formula as

1 + In DC / 1 + IN FC * Spot and spot is quoted as DC:FC you can take the inverse of the spot quote, or reverse the rates in numerator and denominator. Either way you should get an answer showing you that the country with higher inflation depreciated

#14

No, you would not flip both. Do not get hung up on letters. Think about what proof you are solving. The currency with the higher inflation rate will depreciate. If the fraction of currency is X over Y (I dont care about the quoting convention) then you multiply by Inflation X over Inflation Y.