Question

Omni Advisors, an international pension fund manager, uses the concepts of purchasingpower parity (PPP) and uncovered interest parity/international Fisher effect (IFE) toforecast spot exchange rates. Omni gathers the financial information as follows:(Note: The rand (ZAR) is the South African currency. USD refers to the U.S. dollar.The base year denotes the beginning of the period.)

Base price level (any country) 100
Current U.S. price level 105
Current South African price level 111
Base rand spot exchange rate $0.175
Current rand spot exchange rate $0.158
Expected annual U.S. inflation 7%
Expected annual South African inflation 5%
Expected U.S. one-year interest rate 10%
Expected South African one-year interest rate 8%
(a) According to PPP, what should the current ZAR spot rate in USD (USD/ZAR)be?
(b) According to PPP, is the U.S. dollar expected to appreciate or depreciate relativeto the rand over the year? Why?
(c) According to the UIP/IFE is the U.S. dollar expected to appreciate or depreciaterelative to the rand over the year? Why?
(d) Compare your answer in b) and c). Are you surprised? Why?

Answer 1

Following are the responses to the given question:

Step-by-step explanation:

In point a:

The current ZAR spot ratio by PPP is determined by
`(S_t)/(S_0)= (P_h)/(P_f)` whereas St will be the current level currencies,
`S_0` was its base point currency.
`P_h` would be in the home nation the market price
`P_f` in a different nation was its price standard.

`St= ((0.175))/(((105)/(111)))\\\\`

`=(\$0.165)/(rand)`

In point b:

According to PPP
`(S_t)/(S_0)=((1+i_h))/((1+i_f))`

where St= Expected ZAR spot rate in USD with one year

S0= The ZAR spot rate currently exists.

`i_h`= inflation rate in the home country

`i_f`= inflation rate in a foreign country

`S_t=((0.158))/(((1.07)/(1.05)))= (\$0.1609)/(rand)`

Therefore, it's indeed clear over each year, its dollar was expected to deteriorate relative to a rand as the nation's rising inflation currency is expected to depreciate as per PPP.

In point c:

Under IFE
`(S_t)/(S_0)=((1+i_h))/((1+i_f))`

In which St= ZAR spot rate expected with one year in USD

`S_0`= Current spot rate for ZAR

`r_h`= Homeland interest rate

`r_f`= foreign country interest rate

`S_t=((0.158))/(((1.10)/(1.08)))=(\$0.1609)/(rand)`

Its dollars also are projected to lose value during the year if the country with such a higher interest will see the currency lose value through IFE.

In point d:

In point (b) and (c), the same is true of PPP, which implies which exchange rates move in the other path of interest rates and an increase in deflation allows prices to rise. If IFE combines both anomalies and leads of a higher percentage nation showing a decline in exchange compared to a lower one. Thus the very same answers would be provided to both PPP and IFE.