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ACCA Strategic Professional · Advanced Financial Management · Strategic business and financial planning for multinational organisations

Zeta Co (home currency Z$) plans a one-year investment in a country whose inflation is expected at 8% a year, against 2% in Zeta's home country. The current spot rate is 40.00 foreign currency units (F) per Z$1. Assuming purchasing power parity holds, what is the expected spot rate in one year, to two decimal places?

Under purchasing power parity, the expected spot rate equals 40.00 multiplied by 1.08/1.02, which gives 42.35 foreign units per Z$1. The foreign currency depreciates because its inflation is higher, so more units are needed to buy one Z$ in a year's time.

  1. A42.35Correct
  2. B37.78
  3. C40.00
  4. D42.00

Explanation

PPP: expected spot = 40.00 × (1.08/1.02) = 40.00 × 1.058824 = 42.35 F per Z$. The inverted ratio (1.02/1.08) gives 37.78, which would be wrong because the higher-inflation currency depreciates, so more F are needed per Z$. Simply adding the 2% differential... 42.00 ignores compounding and the base.

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