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

Under relative purchasing power parity, the USD/EUR spot rate (USD per EUR) is 1.2000. Expected annual inflation is 3% in the United States and 1% in the euro area. What is the expected USD/EUR spot rate in one year (nearest 0.0001)?

Relative PPP says the currency of the higher-inflation country depreciates by the inflation ratio. The expected rate is 1.2000 times 1.03 divided by 1.01, which equals about 1.2238 USD per EUR, so the euro appreciates against the dollar.

  1. A1.2238Correct
  2. B1.1765
  3. C1.2000
  4. D1.2480

Explanation

Relative PPP: S1 = S0 x (1+inflation domestic USD)/(1+inflation foreign EUR) = 1.2000 x 1.03/1.01 = 1.2238. Option 1.1765 inverts the inflation ratio. Option 1.2480 simply adds the 4% difference... actually adds 2% differently and ignores compounding the ratio properly.

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