AFM_Study_Text_2024-25_ISDC..-5
AFM_Study_Text_2024-25_ISDC..-5
AFM_Study_Text_2024-25_ISDC..-5
Note:
F0 = forward rate
S0 = spot rate
S1 = expected future spot rate
ib = interest rate for base currency
ic = interest rate for counter currency
hb = inflation rate for base currency
hc = inflation rate for counter currency
Use the relationships above to work out the expected spot rate for
the next three years.
KAPLAN PUBLISHING 93
International operations and international investment appraisal
Solution
Using the PPPT formula:
(1 + hc )
S1 = S0 ×
(1 + hb )
(1 + USA inflation)
S1 = S0 ×
(1 + UK inflation)
and the midpoint of the quoted spread as the exchange rate today:
1.7075 + 1.7025
൬ ൰ = 1.7050
2
The calculations for the next three years are:
1.05
Year 1 1.7050 × ቀ ቁ = 1.7551
1.02
1.03
Year 2 1.7551 × ቀ ቁ = 1.7382
1.04
1.04
Year 3 1.7382 × ቀ ቁ = 1.7382
1.04
Note that the exchange rate at the end of one year becomes the basis
of the next year’s calculation.
Required:
Use the relationships above to work out the expected spot rate for
the next three years.
94 KAPLAN PUBLISHING
Chapter 3
Cross rates
You may not be given the exchange rate you need for a particular
currency, but instead be given the relationship it has with a different
currency. You will then need to calculate a cross rate.
For example, if you have a rate in $/£ and a rate in €/£, you can derive
a cross rate for $/€ by dividing the $/£ rate by the €/£ rate.
Cross rates example
Required:
Calculate the value of the purchase in euros.
Solution
The solution could be calculated in two stages:
1 Convert the purchase into £:
$100,000/1.90 = £52,632
2 Convert the £ value into euros
£52,632 × 1.45 = €76,316
However an easier alternative, particularly if there are a number of
transactions to convert, is to calculate a cross rate:
The $/€ rate will be 1.90/1.45 = 1.3103
The value of the transaction is therefore:
$100,000/1.3103 = €76,318
When finding exchange rates it might first be necessary to calculate the inflation
rates expected in a foreign country.
KAPLAN PUBLISHING 95
International operations and international investment appraisal
Illustration 2
Inflation is currently 80% in Brazil, although the government hopes to
reduce it each year by 25% of the previous year's rate.
What will the inflation rate be in Brazil over the next four years?
Solution
Year 1 80% × 0.75 = 60%
Year 2 60% × 0.75 = 45%
Year 3 45% × 0.75 = 34%
Year 4 34% × 0.75 = 26%
OR 80% × (0.75)4 = 25.3% (more accurate)
You should also comment in your answer that it is unlikely the
government will achieve this reduction each year.
Required:
Calculate the exchange rate for the Costovian peso against the US
dollar for the next three years.
96 KAPLAN PUBLISHING