The sales manager considers that there will be substantial foreign exchange risk in trading with Werland. Payment is unpaid in Werland francs in three months time. The current sterling equal of the payment of 3 million Werland francs is £10344.83.

Purchasing power parity theory may be utilized to estimate future exchange rates although this theory doesn't provide a perfect estimate of future currency prices especially in the short term.

Presumptuous those current currency relationships are in equilibrium the expected annual change in the value of the Werland franc relative to sterling is

(1.12 -1.03)/ 1.03= 0.0874 or an 8.74% deflation of the Werland franc in a three month period this is approximately 2.18%.

The present spot rate for the purchase of Werland francs is Wf290/£

The expected rate in three months is found from (X - 290)/ 290= 0.0218

   X = 296.32

At this expected rate the sterling payment would be 3000000/296.32= £10124.19

Although exchange rate risk surely exists for the Werland transaction the probable movement in exchange rates is beneficial to Vertid Ltd and will result in less sterling being paid than at the current spot rate. This is obviously by no means certain as the spot rate in three months time could differ significantly from the expected rate.

The sales manager expects small exchange risk in trading with Thodia as the Thodian peso is linked to the US$. Nevertheless the US$ floats freely against£. Utilizing purchasing power parity the dollar is expected to depreciate annually by: (1.06 -1.03)/ 1.03 = 0.0291 or 2.91% relative to sterling In six months this is a depreciation of approximately 1.46% leading to a rate for the sale of dollars in six months of 1.469*1.0146 = $1.4904/£ making the expected receipts from Vertid a little less in sterling terms. Thus Vertid would suffer a foreign exchange loss.

A greater hazard is that the Thodian currency might break its link with the dollar or devalue against the dollar. There is a importance chance of this as inflation is 20% in Thodia and only 6% in the US making it very difficult for the Thodian currency to maintain the existing currency exchange rate relative to the dollar. What isn't known is whether any significant change in the Thodian peso/US$ relationship will occur within the next six months.

The sales manager isn't correct. Regardless of the current link with the US$ the transaction with Thodia exposes Vertid Ltd to significant foreign exchange risk.