Stalla Question on Real Exchange Rate

CFA Level II
#1

I really don’t get their explanation on this with lots of symbols and stuff (please show your work so I know what’s going on): John Smith is a U.S. Bond portfolio manager. John is considering investing in a portfolio of Canadian dollar-denominated bonds. The current nominal spot exchange rate between the U.S. and Canada is 0.65 USD/CAD. The price level of the typical consumption basket in the U.S. to the price level of the typical consumption basket in Canada is 0.65 to 1. A year later the inflation rates have indeed been 5 percent for U.S. and 3 percent for Canada. However, the Canadian dollar has depreciated with an exchange rate of 0.61 USD/CAD at the end of year one. Assuming the real exchange rate is 1 at the beginning of the year, the real exchange rate at the end of the year is approximately: A. 0.96 USD/CAD B. 0.94 USD/CAD C. 0.92 USD/CAD

#2

Real start = 0.65 USD/CAD * 1/0.65 PCAD/PUSD = 1$/CAD 1 year later: 0.61 USD/CAD * 1/0.65 PCAD/PUSD * 1.03/1.05 (Inflation) = 0.92 USD/CAD Basket of goods changes price due to inflation.

#3

C

#4

I don’t understand what you’re doing…you’re taking next-year’s exchange rate of 0.61USD/CAD and dividing by the interest rate parity formula 1.05/1.03 to back into what the rate should be, is that it? Then using that rate to find the real exchange rate?

#5

i have a little question here, according to purchase power parity, S1 = S0 x inflation_foreign / inflation_domestic then should we multiply the real rate with 1.03/1.05 instead? (US is foreign and Canada is domestic?). It also seems to make sense cuz inflation in the U.S is higher than that of Canada, so USD should depreciate against CAD, right?

#6

please read the real-exchange rate stuff in the International asset pricing (Portfolio Mgmt) chapter. This question is solved there in great detail. 0.65 USD / CAD with a basket of 0.65 PUSD/PCAD So Real rate = 1 USD/CAD today. Price Basket 1 year later = 1.03/(1.05 * 0.65) So now adjust the 0.61 USD/CAD 1 year later back at the basket rate then.

#7

ok, i get the real rate = 1 USD/CAD today but,shouldn’t it be (0.61/0.65) x 1.05/1.03 since 5 percent inflation is foreign inflation, and 3 percent inflation is domestic inflation… … humm, i am doing this the opposite way??

#8

With real reates, Currency Y is on top of Currency X, or should I say price baskets.

#9

ahhh, right, it’s in real rates, thank you guys, one more area covered…thx