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MGMT 474 Quiz #2 Cheat Sheat

MGMT 474 Quiz #2 Cheat Sheat - PUS = PUK S(\$ where S = spot...

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P US = P UK * S(\$/£) where S = spot exchange rate P US UK are prices for a basket of goods (i.e., price indices) Example: \$4.08 = £2 * \$2.04/£ (Big Mac in NY and London) Absolute PPP : The spot exchange rate is determined by relative prices of similar basket of goods S(A/B) = P A /P B Example : Suppose a six pack of beer in Canada = CAN\$10 A six pack of beer in U.S. = \$6.00 Then spot exchange rate: \$6.00/CAN\$10 = \$0.600/CAN\$ . Only works for uniform goods. Relative PPP Idea: The relative change in prices between countries over a period of time determines the change in exchange rates Consider inflation rates: P US = S 0 (\$/U )* P UK (the law of one price) ------(1) One year later, P US [1 +π(US)] = S 1 (\$ /* ) * P UK [1 +π(UK)]-------(2) (2)/(1): S 1 (\$/U)/ S 0 (\$/U) = [1+π(US)] / [1+π(UK)] S 0 : current spot rate; S 1 : spot rate in one year % change in FX rate (appreciation/depreciation of GBP; recall our “share” story) = 0 0 1 S S S - = UK) ( 1 UK) ( - US) ( π + = % S(\$/ ) For direct quote (HC/FC), (S 1 – S 0 )/S 0 = [п (domestic) - п (foreign)]/[1 + п (foreign)] Approximately, %ΔS ≈ п (domestic) - п (foreign) For indirect quote (FC/HC): S 1 /S 0 = domestic)] ( 1 [ foreign)] ( 1 [ + + , п = inflation rate Or, (S 1 – S 0 )/S 0 = [п (foreign) - п (domestic)]/[1 + п (domestic)] Approximately, %ΔS ≈ п (foreign) - п (domestic) (1) Assume that the U.S. has an expected inflation rate of 3% per annum, Switzerland has an expected inflation rate of 5% per annum and the current exchange rate is SFr1.6971/\$. What is the expected spot rate in one year given the above information? S 1 = (SFr1.6971/\$)*(1.05/1.03) = SFr1.7300/\$ (a) Higher inflation in Switzerland → Depreciation of the SFr; Appreciation of the \$ What is the expected % appreciation of the \$? (1.7300-1.6971)/1.6971 = 1.94% What is the expected % depreciation of the SFr? (1.6971-1.7300)/1.7300 = -1.90% (b) For direct quote (HC/FC), Relative PPP S 1 /S 0 = [1 + п (HC)] / [1 + п (FC)]; S 1 & S 0 are in direct quote . The % change in exchange rates = (S 1 – S 0 )/S 0 = [п (HC) - п (FC)]/[1 + п (FC)] Approximately, % change in exchange rates ≈ п (HC) - п (FC) (2) Assume that the U.S. has an expected inflation rate over the next 6 months of 3% per annum, U.K. has an expected inflation rate over the next 6 months of 5% per annum and the current exchange rate is \$1.4309/£. What is the expected spot rate in 6 months given the above information? S 1 = (\$1.4309/£)*[1+(0.03*(180/360)]/[1+(0.05*(180/360)] = \$1.4169/£ Higher inflation in U.K. → Depreciation of the £; Appreciation of the \$ What is the expected % depreciation of the £? (1.4169-1.4309)/1.4309 = -0.98% The difference in inflation rate in 6 months = 1.5% - 2.5% = -1% (3) An example with more than 1 year: Suppose the U.S. and Japan are running annual inflation rates of 3% and 1%, respectively. The spot rate is ¥132.07/\$. According to the PPP, what is the expected spot rate in 3 years? S

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MGMT 474 Quiz #2 Cheat Sheat - PUS = PUK S(\$ where S = spot...

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