FRM Part I · FRM Exam Part I · Foreign Exchange Markets
A basket costs USD 200 in the US and EUR 160 in the euro area. The spot rate is 1.1000 USD per EUR. Absolute PPP is judged against this spot rate. Which statement is correct?
Absolute PPP implies a rate equal to the price ratio, 200 divided by 160, or 1.2500 USD per EUR. Since the market rate is only 1.1000, the euro buys fewer dollars than PPP suggests, so the euro is undervalued relative to PPP.
- AThe euro is undervalued relative to PPP, since PPP implies 1.2500 USD per EURCorrect
- BThe euro is overvalued relative to PPP, since PPP implies 1.2500 USD per EUR
- CThe euro is overvalued relative to PPP, since PPP implies 0.8000 USD per EUR
- DThe euro is fairly valued relative to PPP
Explanation
PPP rate = 200/160 = 1.2500 USD per EUR. Spot is 1.1000, below 1.2500, so the euro is undervalued. The overvalued option reverses the comparison.
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