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The US $/Euro spot rate is$1.4000:Euro1 +/- 1.2c. Interest rates in the US are currently 5% whereas they are 2% in Europe. A US company buys Euro 5 million of supplies from Europe with settlement due in 12 months time. Transaction is unhedged.
What will be expected dollar cost?
A. $7,060,000
B. $7,267,500
C. $6,858,500
D. $7,144,000Thanks
Is (B) the correct answer?
US/Euro spot rate is $1.412 per Euro
thus, $1.412 X (1+0.05)/(1+0.02) = $1.4535 per Euro$1.4535 X Euro 5m = $7267647
1.4000 + 0.012 = 1.412
(The transaction involves selling $’s, so it is the higher rate)
I don’t seem to quite understand this.
Going by the interest rate parity formula which is S’ = S° * (1+If)/(1+Ih)
I would have thought that the solution should be 1.412*1.02/1.05
Given that interest rate in the foreign country (If) is 2% and the interest rate in the home country (Ih) is 5%. Applying this gives me a final answer – $6,858,285.71.
Kindly clarify.
I always believe the home currency or base currency goes on the bottom of the equation so it was 1.02/1.05?
As we are in the US, our rate is on the bottom?? No?
The rate on the bottom is the currency that is being quoted against (equivalent to what I call the ‘base’ currency) when using purchasing power parity.
So if we are in Euroland, we are quoting against the Dollar? Therefore the Dollar should be on the bottom. This is the one part I find so confusing on the whole syllabus.
Is there a hard and fast rule.
Which currency do we take as “base”.
When you say quoted against, are we quoting our CCY against USD or are we quoting their USD against our EUR.
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