Question

Suppose the spot exchange rate for the Canadian dollar is Can$1.10 and the six-month forward rate is Can$1.07.

Assuming absolute PPP holds, what is the cost in the United States of an Elkhead beer if the price in Canada is Can$3.14?

Answer #1

Absolute PPP means that the price of a basket of good in one country say "a" should be same as the exchange adjusted price of the same basket of good in another country say "b". Hence, the basic motive is to make the prices in one country equal to prices in another country with repect to exchange rate.

In this case, Spot exchange rate for canadian dollar to dollar is $1.10

Prices in Canada of an Elkhead beer is $3.14.

Hence, the price of an Elkhead beer in US should be : Price of Elkhead beer in Canada/ Spot rate of canadian dollar to dollar

=3.14/1.1

Solving above will give $2.8545 which is the price of Elkhead beer in US.

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