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Chapter 12

Example 3

The current spot exchange rate between sterling and the dollar is USD
1.4265/GBP.

The UK inflation rate is expected to be 3.05% pa and the US inflation rate is
expected to be 2.75% pa.
What should the USD/GBP future spot rate be?

A 1.4307

B 1.3937

C 1.4601

D 1.4223

Solution

Applying purchasing power parity: 1.4265 × (1.0275/1.0305) = 1.4223

Or

Inflate GBP 1,000 at 3.05% = GBP 1,000 × 1.0305 = £1,030.50

Convert GBP1,000 to USD at 1.4265 = USD 1,426.5

Inflate that at 2.75% = USD 1,426.5 × 1.0275 = 1465.72875

Future spot rate is therefore:1465.72875/1030.50 = 1.4223

Illustrations and further practice

Look at the illustration in Chapter 12 on PPPT and try TYU 4

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