I have a quick question about PPP. I know it’s not the most difficult concept, but I seem to be getting different formulas, and I’m starting to get confused. I’m looking at CFA Sample Exam 1 from 2009 #14 ask us to compute the 1 year forward exchange rate using PPP. Spot C$/ is 1.2138. US inflation = 1.9% and Canada inflation = 2.3%. According to PPP, the forward C/$ rate is _________? In the answer they write: PPP = F/S = [1+foreign rate/1+domestic rate] = 1.2091 Then, on question 18 “based on the data in Exhibit 1, the expectation for the Brazilian Real is consistent with which of the following parity relations?” For PPP, they use the formula: F/S = [1+DOMESTIC rate/1+FOREIGN rate] HERE’S MY QUESTION, WHEN DO WE USE: F/S = [1+DOMESTIC rate/1+FOREIGN rate] AND F/S = [1+foreign rate/1+domestic rate] Thanks in advance for any responses
don’t have the exam to check, but are you looking at the rates the right way around?
your inflations are flipped. US Inflation=2.3%, CAD Inflation=1.9%
I definitely had the interest rates flipped. I studied for 6 straight hours and my brain was mush. US Inflation=2.3%, CAD Inflation=1.9%. So, PPP = Forward/Spot = [1+foreign rate/1+domestic rate] I’m sorry to trouble you, but is that how you compute PPP?
only if rates are Foreign Currency/Domestic Currency
CFA Rythm - An easier approach to PPP formula is: Check the F or Spot rate- Say its Ccy A/Ccy B. In this case use F = S* (1+ A inflation rate)/(1+ B inflation rate), i.e. use the inflation rates in numerator and denominator same as the Spot or fwd rates provided. e.g. Spot rate is in CAD/USD, now when you use the formula use CAD infl. rates in Numerator and USD infl. rates in Denominator. The logic is that - Inflation is Inversely related to Exchange rate (i.e. A per B is directly related to Inflation). So If inflation in A is higher then No. of A you can buy per B is higher => Fwd A/B is higher so S* higher/lower. I hope that helps.
thanks for the responses. I’m a little confused, but I know I can work this out. thanks CPK. I think that’s the key, whether the setup is DC/FC or FC/DC Sid, that’s the formula I’ve been doing for a long time, which is basically: F = S(1+DR/1+FR) ALSO IT MAKES ME LAUGH IF ANYBODY SAW THE SCHWESER ECON VIDEO FROM 2009 WITH THAT WOMAN TRYING TO TEACH IRP, PPP, AND FISHER RELATION WITH HER HANDS IN THE AIR, THEN REVERSING THEM…SHE LOOKED LIKE SHE WAS DOING KUNG-FU. I HAD TO LAUGH. IMAGINE TRYING TO TEACH THIS STUFF WITH NO NUMBERS, NO SLIDES, NO CALCULATIONS, JUST HANDS IN THE AIR LIKE BRUCE LEE. WHAT WAS SHE THINKING?
cfa rhythm…here is what i found useful…it is called 'the per down principle" if you have a rate that is quoted as say 10 CHF/$ it means you need 10 francs ‘per dollar’; the currency in the denominator [ie the one ‘down’] is the dollar and the one up is the francs. so let the dollar (the DOWN currency) be in the DENOMINATOR and let the francs which is ‘up’ be in the numerator of the formular. this works all the time and i hope it helps.