ExpertMedium2 marksMultiple Choice
ACCA · Question 15 · Risk Management
Section A
A multinational firm is evaluating cash flows from a fictional emerging market, 'Zandia'. The current spot exchange rate is 15.00 Zandian Dollars (ZD) to 1 US Dollar ($). Annual inflation in Zandia is expected to be 12%, while US inflation is expected to be 3%.
According to Purchasing Power Parity (PPP), what is the expected exchange rate (ZD per $) in exactly one year? (Round to two decimal places)
Section A
A multinational firm is evaluating cash flows from a fictional emerging market, 'Zandia'. The current spot exchange rate is 15.00 Zandian Dollars (ZD) to 1 US Dollar ($). Annual inflation in Zandia is expected to be 12%, while US inflation is expected to be 3%.
According to Purchasing Power Parity (PPP), what is the expected exchange rate (ZD per $) in exactly one year? (Round to two decimal places)
Answer options:
A.
13.79
B.
15.00
C.
16.31
D.
16.80
How to approach this question
Use the Purchasing Power Parity formula: S1 = S0 * [(1 + hc) / (1 + hb)], where hc is the inflation rate of the counter currency (Zandia) and hb is the inflation rate of the base currency (US).
Full Answer
C.16.31✓ Correct
Purchasing Power Parity (PPP) predicts future spot rates based on inflation differentials.
Formula: Expected Spot = Current Spot * [(1 + Inflation of Quote Currency) / (1 + Inflation of Base Currency)]
Expected Spot = 15.00 * (1.12 / 1.03)
Expected Spot = 15.00 * 1.087378 = 16.31 ZD/$.
Because Zandia has higher inflation, its currency depreciates, meaning it takes more ZD to buy 1 USD.
Common mistakes
Putting the US inflation rate in the numerator and Zandian inflation in the denominator, resulting in an appreciation of the ZD.
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