Page 492 - Microsoft Word - 00 ACCA F9 IWB prelims 2017.docx

Chapter 20

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

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