Question

Today’s spot rate of the euro is USD1.1676/EUR. Assume the relative PPP holds, the

U.S. inflation over one year is expected to 3 percent, while the EU inflation is expected to

be 2 percent. If you plan to go on vacation in Paris, France and will need 5000 euros in

one year. What is the expected exchange rate of euro? What is the expected amount of

dollars you need to pay for your trip in one year?

Answer 1

According to Purchasing Power Parity Theory (PPPT)

(1+Ih) / (1+If) = F1/So

Where

Ih - Inflation rate in home country = 3%

If - Inflation rate in foreign country = 2%

F1 - 1 year forward rate =?

S0 - Spot rate = 1.1676

Exchange rate is given in the format of USD/EUR. So USA is thehome country and EU is the foreigh country.

(1+Ih) / (1+If) = F1/So

1.03/1.02 = F1/1.1676

F1 = (1.03*1.1676)/1.02

= 1.20262/1.02

= 1.1790

The expected exchange rate is 1.1790USD/EUR

Trip Amount (in Euros) = 5000

Trip Amount (in Dollar) = 5000*1.179 = 5895 Euros