Reference no: EM132460037
Long-Run Exchange Rate Risk
Assume you have undertaken a 3-year investment abroad with expected cash flows denominated in your chosen currency. At the current spot rate those cash flows are expected to provide a positive net present value (NPV) in US dollar terms. Based on relative purchasing power parity you are asked to estimate future spot rates over the next three years based on comparative inflation data.[2] With that data complete the table below.
S0 = Current Spot Rate in European Terms hUS= Annual Inflation Rate hFC = Annual Foreign Country
(Foreign currency per US dollar) in the United States Inflation Rate
1/1.0868 = .9201 2.5% 1.4%
Using the data above and equation E(St) = S0 · [1 + (hFC - hUS)]t and assuming the estimated inflation rate in Year 1 also holds for Years 2 and 3, please respond to the following:
a) Based on relative purchasing power parity, estimate S1.
b) Based on relative purchasing power parity, estimate S2.
c) Based on relative purchasing power parity, estimate S3.
d) Based on relative purchasing power parity, has the foreign currency appreciated or depreciated against the US dollar? Explain.
e) Based on relative purchasing power parity, has the NPV of the investment project increased or decreased in US dollar terms? Explain.
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