Purchasing Power Parity (PPP)

Here’s another example from Investopedia:

Assume that the U.S. is the foreign country and that Japan is the domestic country. The current spot exchange rate is S0 = 115 yen per dollar ($1 per ¥115.00). The expected annual inflation rate for the U.S. is 4.89%, and the annual expected Japanese inflation rate is 6.23%. Compute the approximate expected spot rate and the expected spot rate one year from now.

Answer:
Because Japan is the domestic country we have:

S0 = 115 yen per dollar. (1 + Iy) is 1.0489, and (1 + Ix) is equal to 1.0623.

The approximation method would indicate that the yen should decline against the dollar by: (Iy – Ix) =(1.0489 – 1.0623) = -0.0134 = -1.34%

So the value of the yen relative to the dollar would be expected to decline to

(1 – 0.0134) × 115 = ¥113.46 per $

We can calculate the rate more exactly as:

S1 = (1.0489) / (1.0623) × 115 = ¥113.55 per $

@hairyfairy is right – the multiple choice would make sure that if you were using a ‘more accurate’ way to calculate, you should never lose points. In the essay, again you should receive full points

I think it’s a matter of what’s the approximate way of doing it (which CFAI sometimes use, confusingly enough) and the ‘true’ way of doing it.

Your way of multiplying/dividing seems to be to be the ‘true’ way of calculating, whereas the use of just the differential of 5.52% is a quick approximate way of doing it.

In the actual exam the multiple choice should be set up in a way that accepts both (slightly different) answers. The options would probably be something like:

“The amount of Canadian dollars trading for 1 Euro at the end of the period is closest to:”

1. C$1.38
2. C$1.31
3. C$1.42