I am using last year’s book. It seems like no matter what I do with foreign currency, its wrong. But the question is:
US Investor based in Dallas
Spot Rate 95 yen per $
US Inflation 4%
Japan Inflation 8%
What exchange rate is predicted by relative PPP:
A. USD:JPY 90.28
B. USD:JPY 91.49
C. USD:JPY 98.65
I know since Japan has higher inflation, their currency should depreciate, which would mean that the answer is C (which is the correct answer). But, why does the formula that I memorized not work: F = S x (1+ domestic inflation)/(1+ Foreign inflation). I originally took 95 x (1.04)/(1.08)–which would have been answer B. He is an US investor, so the US inflation should be the domestic inflation. This is the formula on the formula sheets provided by Schweser. Maybe this has somthing to do with the quote being an indirect quote versus a direct quote or something. This should be an easy question and yet I would have missed it.
Assume an item costs Y95 in Japan today and $1 in the U.S. By the end of the year, that same item because of inflation will cost Y95*1.08 = Y102.60 yens in Japan and $1.04 in the U.S. So, on a relative basis the item costs Y102.60/1.04 by year end, and so the exchange rate according to relative PPP is Y98.65/.
I think it is tricky and dangerous to think in terms of domestic and foriegn currencies/rates. I find it easier to think in terms of the numerator denominator rule. Because the spot rate is quoted as JPY/USD (yen per dollar), you must put the Japanese inflation in the numerator and US inflation in the denominator. You have that order flipped.