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.
Forget the formula and think of it this way. At time t; you have 95yen in Japan and your brother has a dollar in USA. Both have the same amout. A year later, you have 95*1.08 yen and brother has 1*1.04 dollars. Exchange rate is 95*1.08/1.04. Similar argument applies for interest rates.
P
Spot is given in Yen/ so you multiply by inflation of Yen/inflation of so that you keep the fraction lables correct and still have Yen/$ in the answer
Rates given in Yen per , answer stated in Yen per , multiply S by Yen per $ rate to get the right answer.
The formula you remembered assumes that the rates given are stated in $ per Yen, which in this case it is not.
There is a full proof way of doing PPP problems. Easy to remember too.
Write out the Spot Like this 98 JPY/USD (so jpy is on top of usd),then multiply it by (1+jpy inf/1+ usd inf)
however you write the spot, thats the same inflation of the currency that should be on top/bottom.
USD/CHF… means you are multiplying by (1+usd inf/1+chf inf)
simple enough eh?
Writing out the spot rates as fractions make it much easier to figure out when doing these types of calculations, including cross rates, knowing when to use the bid or ask, and triangular currency arbitrage so you can visualize when to cancel like terms and when to use the inverse of the spot rate.
dlanuez,
When working through these types of problems, I have found it very useful to notice how the quote is arranged in the three answer choics. In the question you mention, all three are set up where the dollar is the FC and the yen is the DC. Remeber, the quotes should read as FC:DC (or FC/DC) and you’ll do fine.
I hope this helps.
dlanuez,
When working through these types of problems, I have found it very useful to notice how the quote is arranged in the three answer choics. In the question you mention, all three are set up where the dollar is the FC and the yen is the DC. Remeber, the quotes should read as FC:DC (or FC/DC) and you’ll do fine.
I hope this helps.