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Foreign exchange risk

Question 4

PPPT

An item costs $5,000 in the US. The spot exchange rate is $1.23 = £1.
Inflation over the next year is expected to be 4% in the US and 2% in the UK.

Assuming that the law of one price applies:

Calculate the £ value of the item today.

Calculate the exchange rate in one year’s time.

£ value of item today = $5,000/1.23 = £4,065

Apply 1 year of US inflation to US price = $5,000 × 1.04 = $5,200.

Apply 1 year of UK inflation to UK price = £4,065 × 1.02 = £4,146.

Under the law of one price, these two figures must be equivalent to each other.

For $5,200 to be equal to £4,146 in a year’s time, the exchange rate at that
point must be 5,200/4,146 = $1.254 = £1

Question 5

PPPT

The current exchange rate between Euros and US$ is €0.93 = $1.

If inflation in the Eurozone is anticipated to be 2.5% over the next year and in
the US will be 3%, calculate the expected future spot rate in a year’s time.

S 1 = 0.93 × 1.025/1.03 = €0.925 = $1

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