Question

12. Your firm wants to convert $1.4 million Australian into U.S. dollars in purchase in 12 months. The spot rate is $0.9704 equals $1 Australian. The inflation rates in Australia and the United States are expected to be 6 percent and 2 percent, respectively. Using the concept of purchasing power parity (PPP) as it relates to future exchange rates, determine the difference in costs between completing the transaction now and doing it in 12 months.

A. $60,242 B. $54,320 C. $36,821 D. $42,568

Answer 1

First of all lets calculate forward exchange rate

according to interest rate parity

F/s =(1+r)/(1+r)

F= forward rate, s = spot rate , r = rate of interest

=F/0.9704 = (1+2%)/(1+6%)

F/0.9704 = (1.02)/(1.06)

F = 0.9704 * (1.02)/1.06

=0.9338

Now lets convert australian $ into USD at spot rate

1 australian $ = 0.9704 USD

$1.4 mln = ?

=1.4*0.9704

=1.35856 $

Now lets convert australian $ into USD at Forward rate

1 australian $ = 0.9338 USD

$1.4 mln = ?

=1.4*0.9338

=1.30732$

Difference in cost = 1.35856 - 1.30732 = 0.051268 mln

Thus ans $51,268

(PS i know the above answer is not in option as given, But this is the right answer)