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Herd Co is based in a country whose currency is the dollar ($). The company expects to
receive €1,500,000 in six months’ time from Find Co, a foreign customer. The finance
director of Herd Co is concerned that the euro (€) may depreciate against the dollar before
the foreign customer makes payment and she is looking at hedging the receipt.
Herd Co has in issue loan notes with a total nominal value of $4 million which can be
redeemed in 10 years’ time. The interest paid on the loan notes is at a variable rate linked
to the central bank base rate. The finance director of Herd Co believes that interest rates
may increase in the near future.
The spot exchange rate is €1.543 per $1. The domestic short?term interest rate is 2% per
year, while the foreign short?term interest rate is 5% per year.Which of the following statements support the finance director’s belief that the
euro will depreciate against the dollar?1 The dollar inflation rate is greater than the euro inflation rate.
2 The dollar nominal interest rate is less than the euro nominal interest rate.
A 1 only
B 2 only
C Both 1 and 2
D Neither 1 nor 2If you put the interest rates into the IRP formula, you will find that $1 will buy more than €1.543, so the euro would be depreciating against the dollar.
If you look at the PPP formula, then if Hc (the euro inflation rate) is lower than Hb (the dollar inflation rate) then should be clear that S1 will be lower that So. That would mean that $1 will buy less than €1.543, so the euro would be appreciating against the dollar.
(If you are looking at this in the BPP Revision Kit, then they have mistyped the answer regarding the inflation rates, even though the final answer is correct. They should have typed: ‘If the dollar inflation rate is greater than the euro inflation rate, PPP indicated that the euro will appreciate against the dollar.)
But there is no mention of inflation rates of either country , so how do we know that the euro is appreciated against dollar?
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