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Sir,
In calculating the exchange rates using PPP, the currency regarded as base currency is the Dollar instead of Pounds. Please explain. $1.4925/£In future please do say the year of the exam – there have been many Decembers and I cannot remember the name of every question in every exam 🙂
The base currency has been treated as pounds, not dollars, because the spot rate is quoted against the pound: 1.4925 $’s = 1 Pound
Given US inflation at 4.8% and UK inflation at 2.5%, the exchange rate in 1 years time = 1.4925 x (1.048/1.025) = 1.5256 (and so on for future years).
To convert the Pounds into $’s you multiply by the exchange rate, so the cash flow in 1 years time = 5270000 x 1.5256 = 8039912.
For some reason the examiners answer has reversed the quotes. So the current spot rate of 1.4925 $ = 1 Pound is the same as 1$ = 1/1.4925 = 0.6700 Pounds.
Similarly the rate in 1 years time of 1.5256 $ = 1 Pound is the same as 1$ = 0.6555 Pounds. Having reversed the quotes, we of course divide in order to convert the pounds to $’s.The results are different because of rounding to 4 decimal places, but as always rounding is completely irrelevant in Paper P4.
Why the examiner makes his work more complicated defeats me (this was the previous examiner who often did strange things 🙂 ).
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