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FRM Part I · FRM Exam Part I · Foreign Exchange Markets

A trader observes that a basket costs USD 200 in the United States and CHF 180 in Switzerland. The spot rate is USD 1.00 = CHF 0.95. Under absolute PPP, which statement is correct?

The CHF is undervalued relative to PPP. The PPP rate is 180 divided by 200, or CHF 0.90 per USD, while the market gives CHF 0.95 per USD, so the dollar buys more francs than the basket prices imply.

  1. AThe CHF is undervalued relative to PPP because the PPP rate is CHF 0.90 per USD
  2. BThe CHF is overvalued relative to PPP because the PPP rate is CHF 0.90 per USDCorrect
  3. CThe CHF is undervalued because the PPP rate is CHF 1.11 per USD
  4. DThe CHF is fairly valued because the rates are close

Explanation

The PPP rate is 180/200 = CHF 0.90 per USD. The market rate is CHF 0.95 per USD, so a dollar buys more francs than PPP suggests, meaning the USD is overvalued and the CHF undervalued. Recheck: the CHF is therefore undervalued, so option A is correct and B is wrong.

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