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
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.
C
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?
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?
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.
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??
With real reates, Currency Y is on top of Currency X, or should I say price baskets.
ahhh, right, it’s in real rates, thank you guys, one more area covered…thx