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Sir, I am having trouble with the following example. Please Correct me where I’m mistaken!
[Example]
The $100m is received from US Customer. The current Foreign Exchange rate is $/£ 1.543. The Local Inflation rate is 4% and Foreign Inflation rate is 3%.[Answer]
Purchase Power Parity formula is used:
S1 = $1.543 x (1.03 / 1.04) = $1.528
[If we convert $100m Cashflow today for Cash in one year’s time, we will result in £65.45 round off]If there is an increase in Inflation rate of £ to 5%
S1 = $1.543 x (1.03 / 1.05) = $1.513
[$1.513 as compared to $1.528 is less which means if we convert $100m Cashflow it will result in £66.10m round off in one year’s time – which means we are getting more money]If there is a decrease in Inflation rate of £ to 2%
S1 = $1.543 x (1.03 / 1.02) = $1.558
[$1.558 as compared to $1.528 is more which means if we convert $100m Cashflow it will result in £64.19m round off in one year’s time – which means we are getting less money]If exchange rate is lower that mean we are getting more? [Correct?]
Same goes with the Interest Rate Parity.
What you have written is all correct.
If the UK inflation rate increases then the $/Pound exchange rate will fall. This means that the Pound has depreciated (1 pound will buy fewer $’s) and the $ has appreciated (1 dollar buys more pounds). So when the dollars are converted we end up receiving more Pounds.
The opposite happens if the UK inflation rate falls 🙂
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